How institutional investors use ETFs

Canadian institutional investors are increasingly using ETFs for strategic asset allocations, and are also adopting non-traditional ETFs, says a Greenwich Associates study.

The survey, sponsored by BlackRock Canada, found institutions hold 21.2% of their assets as ETFs, while asset managers hold more than a quarter of total AUM as ETFs. Nearly a third of those surveyed plan to increase their ETF allocations in the coming year.

Read: BMO AM changes indices of two ETFs

More ETFs, used more strategically

Institutions typically start using ETFs for short-term tactical tasks, such as portfolio rebalancing and manager transitions. As they become more familiar with the funds, they begin to integrate them into more complex, strategic functions. In this evolution, Canadian institutions are ahead of their U.S. and European counterparts. The most commonly cited reasons for using the funds today are portfolio diversification (83%) and obtaining core investment exposures (78%) – both of which are strategic applications.

This increasingly strategic approach is reflected in the fact that institutions are tending to hold ETFs longer: 47% of reporting institutions hold ETF assets for at least two years on average – up from 31% last year.

Read: BlackRock announces fee changes

Liquidity needs and fixed-income ETFs

Nearly 70% of Canadian institutions use fixed-income ETFs, the survey found.

One driver of this increase is the current interest rate environment. Institutional investors are seeking shorter durations in anticipation of rising rates. They’re moving assets out of individual bond positions and into ETFs. The most common reason, cited by 95% of respondents, was ease of use and quick access. The same proportion, however, cited another factor: liquidity.

Tighter bond regulation at home and abroad is pushing institutional investors to use bond ETFs to achieve fixed income exposures. Greenwich predicts that even with the relatively high adoption rates for bond ETFs in Canada, continuing concerns over liquidity in fixed income will drive growth in future.

Read: Horizons launches China High Dividend Yield Index ETF

Canada leads the way

Non-traditional ETF use is growing much faster in Canada than elsewhere. The Greenwich survey finds 44% of institutional investors are employing non-market-cap-weighted or smart beta ETFs in their funds. That compares with 28% in the U.S.

Among those who have invested in non-market-cap-weighted or smart beta funds, 80% use multi-factor ETFs, 75% use equal-weighted ETFs, 70% use minimum volatility ETFs and 56% employ single-factor ETFs.

ETFs as derivative replacements

A growing trend among Canadian institutions is using ETFs to replace traditional derivatives: 50% use futures to access beta, 46% use them for hedging and 31% use derivatives for fully-funded long positions. However, three-quarters of survey respondents said an S&P 500 Index ETF provides more cost-effective beta exposure than an S&P 500 future – and many are acting on that insight.

Nearly three in five Canadian institutions that use futures for beta access say they replaced derivatives products with ETFs over the past year to simplify operations, while 25% did so to reduce costs. More tellingly, 80% of institutions say they expect to swap existing futures positions for ETFs in the next year, while about 10% say they will use bond ETFs to replace fixed income futures.