by Oliver Renick
Exchange-traded funds, long the province of small-time investors, are finding increasing acceptance with professionals who are expected to add $300 billion to the products each year by 2020.
That’s the finding of research by Greenwich Associates, which said institutions are developing new ways to exploit the funds by investing across asset classes. Big asset managers are using ETFs to augment core holdings, replace derivatives and to maintain sources of liquidity. Even smart beta funds, which bridge the gap between passive and active management, are starting to appeal to bigger players.
More enthusiasm from institutions would be welcome in an industry that is experiencing one of its weaker years. Investors have yanked $4.6 billion from State Street’s SPDR S&P 500 ETF Trust this year and $5.4 billion from another tracking stocks in the Nasdaq 100 Index, according to data compiled by Bloomberg.
“The intersection of an increasingly diverse slate of institutional needs and the inherent flexibility of the ETF structure will spur the spread of the funds into new areas and asset classes,” wrote Andrew McCollum, managing director at Greenwich Associates, which published the study.
ETFs have drawn individuals since their inception, giving investors the ability to invest in virtually every asset class. Today, ETFs are a $3 trillion global industry with more than 6,780 products on 60 exchanges -- and sometimes a fancy ticker to boot. In the U.S. last year, ETFs traded about $20 trillion worth of shares -- more than the country’s gross domestic product.
Inflows into ETFs the next four years will be driven by five things, according to the report by Greenwich, which was based on interviews with 408 institutional investors around the world. Respondents included corporate and public pension funds, asset managers and insurance companies.
Broader use of ETFs across asset classes and the application of ETFs to plug liquidity holes in the fixed income market will be the two biggest drivers of inflows, the report says. Those two uses alone will attract $200 billion annually by 2020.
Migration by investors that need exposure to benchmarks or specific strategies tracked by the funds will attract $42 billion, and the use of ETFs as a tool to replace derivatives will account for $28 billion in flows. The group expects smart-beta ETFs to bring in $25 billion over the time period.
Adoption of ETFs has been particularly strong in the U.S., where institutions investing in the products allocate an average 20 percent of assets to the funds, according to the report. That compares with 9 percent for European investors and 2 percent in Asia.
The growth of the industry could have drawbacks, according to Ken Murphy, portfolio manager of U.S. equities at Standard Life Investments. As their popularity grows, returns in stocks may grow homogeneous as the influence of broader funds supplants the discretion of individual traders who focus on companies, he said.
“The more and more money that goes into these products, there has to be a tipping point somewhere -- say, if you go to the extreme, where everyone owns an ETF -- there will be mispricings,” Boston-based Murphy said by phone. “Correlations also go way up and it all moves in the same direction and it confounds investors as to why their outcomes are the same.”
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