According to a new global survey of 766 institutional investors, many institutional investors are using ETFs instead of or as a complement to derivatives when seeking certain goals. The study was conducted by Institutional Investor during Q3 of 2020, meaning investors had ample time to reflect on how they’d navigated heightened volatility in the early days of the Covid-19 pandemic.
“Clients adding ETFs as an investment vehicle to replace or supplement derivatives often make the change based on cost and liquidity considerations. As secondary liquidity increases across the ETF ecosystem, many institutional investors have opted to keep strategic positions in less flexible derivatives while using ETFs for more tactical portfolio management. This helps avoid expensive break fees when allocation or liquidity needs change. Increased funding costs, futures roll cost uncertainty, and mandates to reduce counterparty risk can also drive diversification to ETFs when clients do not require leverage” says Katie Stiner, Vice President, Institutional Equity Sales, Citadel Securities.
Trend gathers momentum
In the survey, 52%1 of institutional investors say they already use ETFs as a substitute for (or complement to) derivatives, and another 30% say they are considering doing so.
ETFs can be considered as an alternative to both swaps and futures. The typical scenario differs for each, as does the rationale. For example, ETFs can replace swaps to help add liquidity and flexibility and remove operational burdens around paperwork and the assessment of counterparty risk. When ETFs are used as a substitute for futures it is often because funding costs embedded in futures prices are either high or variable. In such a scenario, ETFs may help reduce costs.
For Richard Bernstein, CEO and CIO of Richard Bernstein Advisors LLC, the focus is on minimizing operational complexity and maximizing efficiency. Bernstein states, “For a long time, investors used futures to equitize cash. However, using futures added operational complexities and the potential for trading losses as futures contracts were rolled. For us at RBA, ETFs are a much more efficient tool when seeking similar goals.”
According to the survey, timely market access (63%) and liquidity (62%)2 are the main drivers behind the trend of switching out ETFs for derivatives.
“While the exchange-traded product universe’s breadth makes it a desirable vehicle for many asset classes and exposures, institutional clients gravitate primarily towards two categories of ETFs,” says Stiner. “The first is macro trading products with high secondary market liquidity and deep borrow markets, and the second is products aligned with institutional investors’ benchmarks. Macro trading products – for example, U.S. equity sectors, precious metals, benchmark-tracking IG and HY credit – are preferred for their reliable liquidity, while ETFs seeking to track popular benchmark indices are often used in rotation with derivatives based on holding period horizon and funding costs.”
Avoidance of single-transaction burdens
The survey also reveals that 55% of institutional investors say using ETFs in traditionally derivative scenarios allows them to avoid the derivative analysis and counterparty negotiation required for single transactions. Many investors combine the use of the two instruments to aid in seeking their goals. For example, 52%3 of investors use both for tactical adjustments to their portfolios and 48% use both during periods when they are transferring assets from one asset manager to another. In the report from Institutional Investor, 90% of all respondents said they rebalanced their portfolios within six months of the period of heightened market volatility triggered by the pandemic – and 33%4 used a combination of ETFs and derivatives during that process.
For the 18% of institutional investors who don’t use ETFs to replace or complement derivatives, and who don’t anticipate that will change in the future, the reasons are overwhelmingly related to regulatory or organizational restrictions (87%).5 Some investors also see management fees and transaction costs as a roadblock (31%), although both have fallen in recent years in response to such concerns.
Institutional investors in North America appear to be leading the trend of using ETFs instead of or alongside derivatives, with 84%6 saying they currently use ETFs in that fashion and the remaining 16% saying they believe they will do so in the future. Investors in EMEA and Asia-Pacific are more likely to be considering the future use of ETFs as a replacement for or complement to derivatives than to be currently using ETFs in such scenarios. EMEA (31%)7 and Latin America (43%)8 report the highest levels of doubt about a future scenario in which they would use ETFs as a stand-in for or complement to derivatives.
Full lineup of ETFs used
Fixed income ETFs (66%), equity ETFs (59%), and factor/smart beta ETFs (40%)9 have all been widely used as alternatives to derivatives. Factor ETFs are used as substitutes less often, perhaps because derivatives are largely blunt tools deployed for broad market exposures, and thus less frequently used to express targeted factor views. Fixed income ETFs, however, have seen a lot of action as a substitute for derivatives.
During pandemic-related volatility in the depths of Spring 2020 “most of the ETF asset allocator behavioral change observed occurred in the fixed income ETF space,” says Stiner. “As markets for Treasuries and credit seized up, institutional investors sought liquidity by making fixed income ETFs both the default liquidity instrument in certain asset classes and duration buckets, as well as the primary price discovery mechanism prior to Fed intervention.”
Distinct views exist among institutional investors in the four regions surveyed regarding their preferences for ETF types to use with or instead of derivatives. Among North American investors, 78%10 believe fixed income ETFs are the way to go. That strong preference is echoed by investors in Latin America, but not by those in EMEA or Asia-Pacific. In those two regions, equity ETFs are considered best suited for replacing or complementing derivatives. North American institutional investors are also most likely to find factor and smart beta ETFs well suited for use alongside or instead of derivatives (51%).11 More than a third of investors in EMEA agree with that belief (37%).12
1 Of 746 respondents.
2 Of 612 respondents.
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In Q3 2020, Institutional Investor conducted a global survey of 766 institutional investment decision makers at insurers, endowments, family offices, foundations, pensions, and asset management firms regarding their experiences and actions during the severe market volatility triggered by the Covid-19 pandemic in the first half of 2020. The report focuses specifically on one emerging trend: the use of exchange-traded funds (ETFs) to replace or complement derivatives in multi-asset strategies. Unless otherwise noted, survey data citations throughout this report refer to questions answered by 760 or more respondents.
This study was sponsored by BlackRock. BlackRock is not affiliated with Institutional Investor or any of its affiliates.
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Investing involves risk, including possible loss of principal.
Investing in derivatives may involve a high degree of risk and are not suitable for all investors. Derivatives may be volatile and are subject to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. An investor could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that hedging transactions will be effective. Information on derivatives is for educational purposes only. BlackRock is not offering to implement a derivatives strategy.
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. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
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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