Over the last year, the volatile interest rate period has increased demand for fixed income exchange-traded funds among institutional investors, said Robert Forsyth, head of SPDR ETF strategy and research at State Street Global Advisors, during the Canadian Investment Review‘s 2023 Investment Innovation Conference in November.
“Institutional investors were using ETFs to gain really quick access to different areas of the interest rate curve to speculate on the slope of that curve as they were making various investment decisions in their portfolios.”
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Fixed income ETF action picked up on the back of the coronavirus pandemic after the U.S. Federal Reserve began purchasing these products, said Forsyth, noting the move sparked a tremendous amount of growth among institutional investors. “During periods of volatility in fixed income markets, investors flocked to ETFs to get centralized liquidity, as well as some degree of price discovery.”
Defined outcome and hedged-equity ETFs also gained popularity last year, as new regulation provided clarity for ETFs using derivative strategies as underlying components and made it easier to differentiate risk and return profiles.
As well, growth in the ETF space has led to many investment options coming to market, so much so they’re now a staple component in institutional investors’ active strategies, he added. “We’re now at a position in which the attractive features of the ETF structure — tradability, tax efficiency and transparency — are now being used extensively by active investment managers that are providing alpha to their end investors.”
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Additionally, many derivative-based strategies, including structured products, equity income or hedged-equity-like strategies, use ETF options as their underlying components seeking to provide above-benchmark return profiles.
Liquidity management and improving due diligence processes are driving investments in ETFs, said Forsyth, noting the way in which institutional investors have been analyzing these products has also changed dramatically. Much of the change is due to greater analysis and due diligence on transaction costs associated with ETFs. In addition to looking at the expense ratios for the annual holding period for an ETF, investors are also considering how those transaction costs can cut into potential returns and they’re undertaking cost comparisons based on the expense ratio inclusive of transaction costs and potential market impact for large block-sized transactions.
It’s important that institutional investors select products that are liquid in times when they’re needed. “When you look at periods of really heightened volatility, you can see how S&P 500 vehicles can change dramatically over time and how some ETFs actually represent additive liquidity, relative to their underlying basket of portfolios.”
Read: Attracted by liquidity, institutional investors broadening use of ETFs
One way in which the organization’s institutional clients are using ETFs is for securities lending, he said, noting they’ll hold an ETF and then lend those shares out. “As an example, there are times in which biotech stocks can be hard to borrow. Because the ETF structure allows the creation of new shares, institutional investors can generate alpha by lending out shares of a biotech ETF.”
While the institutional use of ETFs differs slightly, he said their ability to get tailored exposure in fixed income markets today, compared to five or ten years ago, has dramatically changed. “You can now get the entire aggregate bond universe in all these different flavours for two, three, four [and] five basis points. It’s a really [cost-effective], efficient way to gain exposures, which is why ETFs are popular tools from a transition management perspective.”
Read more coverage of the 2023 Investment Innovation Conference.