Institutional Investors on the ETF Freight Train

By Karl Mergenthaler and Alexander Smorczewski
J.P. Morgan Investment Analytics and Consulting
karl.c.mergenthaler@jpmorgan.com

Despite the recent turbulent market conditions, the Exchange Traded Fund (“ETF”) freight train continues to roll on. In recent weeks, ETFs have experienced net cash inflows while mutual funds have experienced significant outflows. As of October 2008, ETFs have grown to account for approximately 35% of U.S. equity trading volume. Clearly, investors have discovered the benefits – low cost, liquidity, tax-efficiency – of these innovative financial products.

In our view, institutional investors should consider a number of potential uses for ETFs, such as cash equitization, rebalancing, and transition management. Also, institutional investors should consider some of the potential benefits of ETFs, such as cost savings and potential added revenue from securities lending fees. In most cases, institutional investors can gain exposure to a desired market or asset class in a low-cost, liquid and efficient Exchange Traded Fund.

Background

Exchange Traded Funds, or “ETFs,” have exploded in popularity since the first ETF – the Standard & Poor’s Depositary Receipt (“spider”) – was introduced in 1993. According to the Investment Company Institute, the U.S. ETF industry has grown from 1 ETF and $464 million AUM in 1993 to 720 ETFs and $588 billion AUM as of September 2008.

The ETF industry is dominated by three major players: Barclays Global Investors (iShares), State Street Global Advisors (SPDR), and Vanguard. These three firms control approximately 48%, 29%, and 8% of total U.S. ETF assets under management, respectively, according to data compiled by the National Stock Exchange. The largest single ETF by AUM remains the State Street SPDR Index 500, which tracks the performance of the S&P 500 Index. This product alone accounts for roughly 15% of total U.S. ETF assets under management and over one-third of notional trading volume. Moreover, a number of smaller firms, such as Van Eck, Claymore, and many others, have entered the ETF marketplace.

Institutional Uses and Benefits

Institutional investors can utilize ETFs to implement and enhance several investment strategies. Most frequently, investors may use ETFs to quickly and efficiently equitize cash in their portfolios. Similarly, investors can use ETFs to effectively implement a transition, or to rebalance portfolios. Finally, institutional investors may be able to gain the benefits of securities lending revenue.

Cash Equitization: Institutional investors can use ETFs to reduce cash drag in their portfolios. However, given that there are several different methods of equitizing cash, including futures, options and traditional mutual funds, any investor should first undertake a cost-benefit analysis of the alternatives in comparison to ETFs. One benefit of ETFs in comparison to mutual funds is, of course, a lower expense ratio. However, the relative importance of this benefit will depend on the holding period. Also, in contrast to mutual funds, which usually discourage short-term buying and selling through various fees and restrictions, ETFs trade relatively freely and incur only spread and commission expenses. Again, this benefit will depend on the size of the trade and the trading costs specific to an investor.

For risk-averse investors, an alternative to the full downside exposure of an ETF is option exposure to an index, in which case the maximum downside is limited to the premium of the option. However, options are typically more complex to execute than the buying and selling of ETFs.

Transition Management: Institutional investors may be able to utilize ETFs as a low-cost and efficient vehicle to implement a manager transition. ETFs allow institutional investors to target a specific style, benchmark, or country during a transition period between managers. The variety, liquidity, and targeted focus of ETFs can provide an advantage over other alternatives to cash when seeking a replacement manager.

Rebalancing: The highly liquid nature of most common ETFs allows for a reduction in the time needed to implement periodic rebalancing of a portfolio. Also, in contrast to mutual funds, which usually discourage short-term buying and selling through various fees and restrictions, ETFs trade relatively freely and incur only spread and commission expenses. The importance of this benefit will depend on the size of the trade and an investor’s specific trading costs.

Cost Analysis

In many cases, ETFs may offer a low-cost and liquid alternative to index funds and actively managed funds. However, depending on the underlying index, an ETF may or may not be less expensive than a comparable index fund (see examples in Exhibit 1). Also, the relative importance of this cost consideration will depend on the holding period. In Exhibit 1, we compare the expense ratio for representative ETFs, index funds, and actively managed funds for traditional equity and fixed income exposure. As indicated in Exhibit 1, ETFs frequently offer expense ratios that are lower than or comparable to index funds. Moreover, both ETFs and index funds are typically less expensive than actively managed funds.		Exhibit 1: Cost Analysis
		Source: J.P. Morgan Investment Analytics & Consulting estimates, eVestment Alliance, Bloomberg, iShares.

Securities Lending Fees

Institutional investors may be able to supplement the returns on their portfolio through the securities lending fees available to ETFs. The securities lending industry is a large and important market that includes an estimated $2 trillion in loans at any time. Furthermore, ETFs are becoming an increasingly important part of the securities lending market.

ETFs may benefit from securities lending fees in two ways. First, the investment manager of an ETF can lend the constituent securities within the ETF. For example, Barclays Global Investors typically lends the stocks within its ETFs and splits the revenue 50/50 between the ETF and Barclays. The lending revenue increases the returns on the ETF, which in some cases results in the ETF actually beating its underlying index.

Second, plan sponsors are able to lend the ETFs themselves. If a large pension plan holds a long position in an ETF, the plan can lend the security to brokers. It is important to realize that certain ETFs, such as the iShares Russell 2000 and MSCI Emerging Markets, are in high demand to fulfill trading strategies and consequently may command high securities lending fees.

Many institutional investors are reviewing their securities lending programs due to recent market turmoil, but securities lending is expected to continue to be a source of incremental return for institutions. Meanwhile, there has been a dramatic increase in sophisticated trading strategies at hedge funds, 130/30 funds, and others, that tap into the securities lending market. In this environment, the lending feature of ETFs, which is unique among pooled securities, may provide a distinct advantage over index funds.

An ETF Endowment Portfolio

It is often asked whether one can utilize ETFs to build a portfolio with the diversity and complexity of the endowments of the major universities, such as Harvard and Yale. In our view, the breadth of ETFs could allow investors to build a portfolio with broad exposure to traditional asset classes, such as domestic and international equities as well as fixed income. Furthermore, investors are able to gain some exposure to many of the alternative asset classes using ETFs. In Exhibit 2, we illustrate a hypothetical portfolio of ETFs.

In our opinion, significant limitations exist for the investor wishing to gain exposure to alternative asset classes such as absolute return and private equity. One option available is the Powershares Listed Private Equity ETF (PSP); however, investors should approach this fund with caution. This ETF represents exposure to the publicly-traded private equity companies, which is an investment in carried interest and fees. In our opinion, this is a very rough approximation for an actual investment in a private company itself. Furthermore, a number of the ETFs holdings focus on either providing debt investments in private firms or services related to private equity rather than equity investments. Importantly, we believe the key to the success of private equity investments by notable investors such as the Yale Endowment is often the ability to identify and gain access to the best and most exclusive private equity funds, which is something an ETF cannot necessarily provide.

In our view, similar limitations exist for the investor seeking exposure to absolute return. However, a number of firms are currently developing products to address this asset class. For example, Société Générale Asset Management recently released on the NYSE Euronext Paris exchange the SGAM ETF T-Rex, a fund designed to replicate synthetically the performance of the Hedge Funds Research Index (HFRI). The fund uses a quantitative model to take long and short positions in traditional asset classes in order to optimize correlation with the HFRI.

Conclusions

Exchange Traded Funds have experienced explosive growth over the past two decades. It is clear that retail investors recognize many of the benefits of these low-cost, tax-efficient, and liquid products. Also, many plan sponsors and other institutional investors have begun to recognize some of the potential uses and benefits of these products.

Clearly, it is possible to gain market exposure to the traditional asset classes through the use of ETFs. In recent years, the ETF industry has developed a plethora of products that address alternative asset classes, such as commodities, currencies, and real estate. It is possible that new and innovative products may be rolled out in the coming years that address other alternative asset classes such as private equity and hedge funds.

There are many potential uses and benefits of Exchange Traded Funds for tax-exempt institutional investors. Notably, many institutional investors use ETFs to equitize cash, rebalance portfolios, or implement manager transitions. In our view, it is worth the effort for institutions to analyze ETFs for use in various types of portfolios.