As world markets endure worsening volatility due to global uncertainty from inflation anxieties, the ongoing Ukrainian war, the related worry of a looming European energy crisis, and several other factors, institutional investors may want to protect their portfolios and find safer growth opportunities.
ETFs play a pivotal role in this plan for many – and some are employing ETFs in more innovative ways as economic challenges escalate.
How are ETFs used now?
A recent survey shed light on how institutional investors were using ETFs earlier this year, and how they said that usage would likely evolve in the future. In the first quarter of 2022, Institutional Investor surveyed 759 decision makers located at pensions, endowments, foundations, insurance companies, family offices, and asset management firms across the world. A report on the survey’s findings, Rising to the Challenge of a Dynamic Market: Institutional Investors Respond to Uncertainty in 2022, relayed that 39% of the respondents planned to increase their use of ETFs in the following 18 months, while another 30% said they’d continue to use ETFs at the same rate and 25% said they’d decrease their use. Only 6% said they didn’t use ETFs (n=758).
While the broad uses for ETFs may be familiar, investors are finding innovative ways to derive more value from these versatile instruments.
The Institutional Investor survey offers a view of how investment professionals are utilizing ETFs in managing their portfolios. The survey quantified several key uses, such as executing strategic asset allocation (53%), managing liquidity (51%), complementing or replacing derivatives (50%), rebalancing (49%), making tactical adjustments (48%), and transition management (42%; n=758).
“ETFs are complementary to both alpha seeking strategies and tactical asset allocation, said a head of investment strategy at an asset manager with $540 billion AUM, one of 12 institutional investment decision makers interviewed for the survey report. They added that “the paradigm of investors demanding increased transparency from their service providers is going to force us to do more with ETFs and less with mutual funds. I’m shocked by upfront fees on some mutual funds that are still available on leading platforms.”
“For rebalancing purposes, we like ETFs as low-cost options that closely track macroeconomic trends – and for diversification,” said a head of alternative investments of a family office with $7.5 billion AUM. “[And] because of the way they are structured, ETFs offer huge tax advantages, specifically around capital gains.”
Naturally, the flexibility ETFs allow has also become a more vital need for institutional investors as volatility has increased. “We’re active managers, so the value of ETFs in our multi-asset portfolios is tactical asset allocation – the ability to move money across growth versus value, U.S. versus international versus emerging, across sectors and fixed income,” offered a head of portfolio management at an asset manager/private bank with $1.6 trillion AUM.
ETF Innovation Continues
Investors at all levels can benefit from advancing innovations in ETFs. For one example, smart-beta ETFs – which employ a rules-based system to acquire holdings according to certain metrics, factors, or other criteria – are continuing to evolve in sophistication and reliability. Asset managers can use them to express a particular investment viewpoint, or target a specific obligation set by the asset owner (such as unique ESG requirements). Smart-beta ETFs can also incorporate a degree of factor investing into a portfolio in an easy, cost-effective way.
Thematic ETFs also continue to advance. These strategies target themes that cut across traditional geographic and sector classifications, such as clean energy, robotics, self-driving vehicles and gene therapies. In fact, thematic ETFs have been amongst the fastest growing category of ETFs, with 12% of financial advisors leveraging them within portfolios, up from just 5% at the end of 2019.1
As thematic ETFs have proliferated, investors have likely recognized the growing need for due diligence before implementation. With nearly 300 thematic ETFs on the market across 77 issuers, diligence can be complex.2 Additionally, strategies which claim to target the same theme can have a significant return differential, making diligence increasingly crucial. Let’s use cybersecurity as an example. The iShares Cybersecurity and Tech ETF, IHAK, has a total return of 24.85% over the past three years. Its peer fund, the ETFMG Prime Cyber Security ETF, has returned 8.47%, a difference of 1,638 bps.3 Differences in index construction help drive differentiated returns, with ETFs leveraging data sets such as company revenues, supply chain data, natural language processing and fundamental research to identify which companies provide the highest exposure to a particular theme.
With these facts in mind, several investment management firms have set out to simplify thematic investing for clients via a thematic ETF model which tactically allocates to a variety of themes to manage volatility and seek alpha. One such firm is 3EDGE which uses a proprietary research model and investment process that leverages an algorithm which sifts through decades worth of fundamental data points, dating back to 1995, to determine their allocation decisions. Chief Investment Strategist Fritz Folts noted “as the thematic ETF space continues to expand, we see advisors increasingly turning to models as a complement to their existing portfolios in a bid to generate alpha, simplify their investment process and to have more time to focus on growing their business”.4
Institutional investors are also finding innovative ways to structure bond ETFs within portfolios seeking to gain precise, liquid, and low-cost access to markets during volatile periods – when sourcing new bonds has been historically difficult. Bond ETFs are also more versatile than individual bonds (for example, they’re viable for securities lending programs), so they can provide solutions during challenging conditions.
“If you’re managing a portfolio subject to policy constraints, you can set up an equity ETF and a bond ETF for the purpose of managing capital calls and distributions as you also manage your equity/bond mix,” said a CIO of a family office with an undisclosed AUM.
Innovations in ETFs typically rely on the fundamental strengths this investment tool has long offered: high liquidity, transparency, flexibility, and ease/speed – often at significantly lower cost than mutual funds. And given the rapid pace of advancements that ETFs have seen in the past decade alone, the future looks bright for these vital tools – and the resourceful investors who will likely continue to find new ways to use them to pursue their goals, streamline processes and solve problems.
1 Based on 18,664 portfolios analyzed by BlackRock’s 360⁰ Evaluator tool in Advisor Center between 1/1/2021 and 12/31/2021.
2 BlackRock Global Business Intelligence, 12/31/22.
3 Morningstar, 12/31/22. Standardized performance can be found at the end of the article.
4 Institutional Investor conducted a global survey of 759 institutional investment decision makers in Q1 2022, nearly half (49%) of the 348 institutional asset managers and advisors in the survey population said they use model portfolios as part of their solutions for allocators, and another 35% say they’re likely to do so in the future.
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The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com. Shares of ETFs are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Any applicable brokerage commissions will reduce returns. Beginning August 10, 2020, market price returns for BlackRock and iShares ETFs are calculated using the closing price and account for distributions from the fund. Prior to August 10, 2020, market price returns for BlackRock and iShares ETFs were calculated using the midpoint price and accounted for distributions from the fund. The midpoint is the average of the bid/ask prices at 4:00 PM ET (when NAV is normally determined for most ETFs). The returns shown do not represent the returns you would receive if you traded shares at other times.
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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.
Buying and selling shares of ETFs may result in brokerage commissions.
There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.
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