You beta watch out, you beta not cry

OK, they’re not literally dying. We’re still talking about a multitrillion dollar universe that will be around for many decades to come. But ETFs are definitely coming to town. From MainFT just now:

Assets in global exchange traded funds have soared to $15tn, powered by a stampede away from mutual funds that underscores how the vehicles are reshaping the asset management industry . . . 

 . . . “The ETF structure is becoming the everything structure for the investment management industry,” said Daniil Shapiro, director of product development practice at consultancy Cerulli Associates, citing ETFs’ lower costs, innovative strategies and “tremendous fit” for a wide variety of portfolios.

This is not a broad “animal spirits” inflow thing either, despite the headline (thanks to which goes to BofA rates strategist Mark Capleton, btw! 🤜🤛) Active, non-ETF equity mutual funds have suffered outflows of $450bn this year, already the biggest ever annual withdrawal on record according to EPFR data.

People often think of ETFs as purely (or at least overwhelmingly) as a retail product, used by individuals, financial advisers and wealth managers. However, as mainFT’s Will Schmitt points out, this just isn’t true any more.

Asset managers and hedge funds have long been heavy users of ETFs for liquidity purposes or for quick trade implementation, but big pension plans, sovereign wealth funds and especially insurance companies are now also embracing them, as a report from Cerulli pointed out earlier this week:

Calculated as the percentage of investors that expect to increase allocations less the percentage of investors that expect to decrease allocations, Cerulli’s research finds that a net 37% of institutions expect to increase allocations to ETFs in the next two years, while a net 11% expect to decrease allocations to mutual funds. Among institutional channels, this trend is most notable among insurance general accounts — a net 40% expect to increase allocations to ETFs while a net 25% expect to decrease allocations to mutual funds.

This is not just about low cost either. After all, big institutional investors can generally negotiate rock-bottom fees for separately managed or segregated accounts.

Over half of the respondents in Cerulli’s survey say they use ETFs to manage exposures, a third say they do it for liquidity management purposes, and a quarter say they use ETFs for more tactical bets. Only 16 per cent said they use ETFs as a “core” part of their portfolios, but that’s still pretty notable given how rare that practice was a decade ago.

This also jumped out to FT Alphaville, with our emphasis below:

While institutional investors predominantly use passively managed equity ETFs, the use of other strategy types has become much more common. According to Cerulli, at least 76% of institutional investors across channels employ passive equity ETFs. Insurance companies, which have the highest rate of adoption across all ETF types, use active equity and passive fixed-income ETFs at the same rate (78%).

A lot of institutional investors have long been instinctively (and understandably wary) of bond ETFs, given the mismatch between the liquidity that the wrapper promises and the assets they contain.

However, the sight of bond ETFs proving so resilient in March 2020 — at the depths of the crisis even Treasuries were struck by a bout of illiquidity, but ETF trading volumes exploded — seems to have triggered a radical reappraisal. Even the BIS wrote in 2021 that “ETFs may be more effective in managing illiquid assets than mutual funds”.

You can see this in the flow data. Traditional bond funds have done better than equity funds, with inflows of $211bn so far this year. However, that compares to the $378bn taken in by bond ETFs. In fact, bond ETFs have now taken in more than traditional bond funds for five straight years — ever since 2020.

Still, despite the vindication of the “bond ETF risks are massively overplayed” camp, there could be a few things to worry about. Among them is the danger that the recent flood of institutional money into bond ETFs might actually undermine the very resilience that investors are now seeking out.

In other words, the ETF machinery could still end up being overwhelmed by selling pressures if absolutely everyone piles into them for the liquidity and then starts to dump shares in a crisis. It’s something to explore in more depth in a future post, but for now it’s at least worth some thought.

Further reading:

— ETFs are eating the bond market
— Why ETFs work better in illiquid markets
— The increasing complexity of the ETF universe