Volatility shines spotlight on ETFs' utility

Worldwide index assets managed in exchange-traded funds and exchange-traded notes totaled $6.51 trillion as of June 30, down 4.8% from $6.84 trillion a year earlier, according to Pensions & Investments' annual survey of index managers.

That decline was barely a nick compared with the drop in worldwide index assets overall, which fell 12.7% to $18.23 trillion as of June 30, P&I's survey showed. In fact, despite high inflation, central bank rate hikes, and stock and bond market losses, the overall global ETF industry in September saw its 40th straight month of net inflows and is on pace for calendar year net inflows second only to last year's $1.29 trillion record haul , according to London-based research and consultancy firm ETFGI LLP.

That index assets managed in ETFs declined less than index assets overall came as little surprise to Emily Foote McKinley, New York-based head of institutional specialists for ETFs and indexed strategies at Atlanta-based Invesco Ltd., who along with other ETF industry executives said ETFs have proven yet again to be a tool that institutional investors reach for in turbulent times. Invesco ranked fourth on the list of ETF/ETN index managers by worldwide assets according to P&I's survey, with assets of $383.5 billion as of June 30, down from $403.8 billion a year earlier.

"I think that we've always seen the biggest pickups in institutional usage of ETFs around and after times of severe market volatility," Ms. McKinley said, adding such periods — which in the past have included the global financial crisis and COVID-19-related market turmoil — spotlight ETFs' most institutionally relevant benefits.

That's because "the ETF wrapper is able to prove itself as a provider of liquidity and access and transparency to underlying markets in times of crisis," Ms. McKinley said.

During the first half of 2022 — a time frame when markets were contending with stressors including surging global inflation, Russia's invasion of Ukraine and the start of the Federal Reserve's aggressive rate-hiking campaign — the average daily total volume traded in Invesco's ETFs rose by 40% compared with the first half of 2021, she said.

"I'd say it's an indication both of current institutional usage, certainly, and then also I think it's an indication that we're just building future institutional viability," Ms. McKinley said, adding that as an ETF's trading volume increases, "it just becomes more viable for institutions to use."

Christopher Huemmer, a Chicago-based senior vice president and senior investment strategist for Northern Trust Asset Management's FlexShares Exchange Traded Funds, said inflation protection and reducing portfolio risk have been key concerns for its institutional clients, which have used a variety of FlexShares ETFs to help adjust their portfolios.

Northern Trust ranked No. 10 in P&I's ETF/ETN index managers ranking, with assets of $20 billion as of June 30, up from $17.8 billion a year earlier. It reported $1.9 billion in institutional AUM as of June 30.

"ETFs are a flexible tool to make those changes to your portfolio swiftly," Mr. Huemmer said, adding that the FlexShares products that clients have used during the past year include its infrastructure, low-volatility and high-yield ETFs.

In some cases, the changes investors made between last November and today have been so significant from a directional standpoint that speed in making those decisions was critical, he said.

"And so, making those shifts even temporarily using ETFs in transition management has been a tool that institutional investors have relied on," Mr. Huemmer said.

With global stock and bond markets both down this year, institutional investors in particular have sought investments uncorrelated to public markets, he said. Areas such as private infrastructure have become increasingly popular, Mr. Huemmer said, adding that infrastructure has proven to be a useful tool to combat inflation over the intermediate to long term.

One of NTAM's clients, a U.S. defined benefit plan, is using the FlexShares STOXX Global Broad Infrastructure Index Fund as the liquidity tranche within its infrastructure allocation, which includes both public and private investment, he said.

"And I think with the volatility in markets today and inflationary pressures, liquidity is a key, key piece," Mr. Huemmer said. "And so, they view that infrastructure product as that liquidity tranche within their infrastructure exposure that they can draw from if necessary."

Clients who want to derisk their portfolios, but still want equity market exposure, have made low-volatility ETFs a strong trend, he said. A non-profit organization is currently using two such products — the FlexShares Developed Markets ex-U.S. Quality Low Volatility Index Fund and the FlexShares Emerging Markets Quality Low Volatility Index Fund — to bring low-volatility exposure into its equity allocation, Mr. Huemmer said.

Another trend that has emerged as institutional investors are rethinking the way they view risk involves high-yield bonds, he said.

As investors seek alternatives to global equity market risk, one of things NTAM has been talking to its clients about is looking at high yield as "essentially a less risky risk asset," Mr. Huemmer said, adding that high yield has historically offered equity-like returns with less volatility. NTAM's fixed-income team also believes that high-yield companies' balance sheets are stronger these days than they have been historically going into other downturns.

A sovereign wealth fund invested in the FlexShares High Yield Value-Scored Bond Index Fund because it was looking to add some credit exposure, he said.

"And that's something they put into use this year," Mr. Huemmer said.

A NTAM spokesman said it doesn't comment on client identities or their investment amounts.

Salim Ramji, New York-based senior managing director and global head of ETF and index investments at BlackRock Inc., agreed that "when market volatility increases, more people turn to ETFs." That's been true this year as well, he said. BlackRock topped P&I's list of ETF/ETN index managers, with assets of $2.78 trillion as of June 30, down 8.2% from $3.03 trillion a year earlier.

"And so there absolutely has been heightened and greater use by institutions of ETFs for things like tactical asset allocation," Mr. Ramji said, adding that whether it's particular countries or sectors, people will use what BlackRock calls its "precision ETFs" within iShares to implement tactical decisions about getting in or out of a particular marketplace.

Such precision ETFs include equity funds like the $5.6 billion iShares MSCI Brazil ETF and the $8.1 billion iShares Biotechnology ETF as well as fixed-income funds like the $14.5 billion iShares iBoxx $ High Yield Corporate Bond ETF.

"And many of those exposures are highly liquid, sometimes have options markets around them and are used as tactical instruments often by institutions, even other asset managers," Mr. Ramji said. "And I think that case is even more notable in fixed income."

Among the most interesting things about the growth of fixed-income ETFs is that other active managers have become one of BlackRock's biggest client segments, he said.

"Of the 10 largest global asset managers, nine of those 10 use our bond ETFs," Mr. Ramji said.

Those asset managers, whom Mr. Ramji declined to name, are using those ETFs as a "better, cheaper, more liquid means by which to access the bond market than the underlying bond securities themselves," he said.

BlackRock launched the first U.S.-listed bond ETFs in July 2002 and Mr. Ramji recently joined BlackRock colleagues to commemorate that 20th anniversary with a bell ringing at the New York Stock Exchange.

Bond ETF assets globally totaled $1.7 trillion as of March 31, according to a BlackRock report issued earlier this year.

While iShares is "far and away" the category leader, "the category has expanded very significantly over 20 years," said Mr. Ramji. He cited the BlackRock report, which predicted that assets under management of bond ETFs globally will hit $5 trillion by the end of 2030.

Within the past three years in particular, market participants have seen that BlackRock's fixed-income ETFs perform extremely well under stressed conditions, he said.

"I think two, two-and-a-half years ago was probably some of the most extreme stresses that bond ETFs came under," Mr. Ramji said, adding that isn't necessary just to just take his word that they performed well.

He cited published reports from a variety of regulators, "who really saw these as being additive and shock absorbers and all the things that we've been talking about for 20 years that they were doing under those conditions."

Mr. Ramji believes the institutional use case for ETFs "is most pronounced in bond ETFs" and particularly evident over the past three years, he said.

"Because if you asked me three years ago how many of the big active fixed-income managers use bond ETFs, it would be a minority," he said. "Today it is the vast majority."

Hilary Corman, the New York-based head of U.S. institutional for SPDR ETFs at State Street Global Advisors, said SSGA is seeing lots of sector ETF usage by both pension funds and insurance companies to express tactical views. Examples of such funds offered by SSGA include the Technology Select Sector SPDR Fund and the Energy Select Sector SPDR Fund.

SSGA ranked third in P&I's ETF/ETN index managers ranking with $986.2 billion as June 30, down from slightly more than $1 trillion a year earlier.

"In volatile markets like these, a great tool is our sector SPDRs that can be utilized to tilt towards or away from a given sector in an efficient manner," Ms. Corman said, adding that while such usage has been happening a lot over the past three to six months, it's become more apparent during the last three.

For example, if investors believe a sector is oversold, they can invest in an ETF representing that sector, Ms. Corman said. "This gives clients an option of investing in a sector and taking the time to decide which exact names they want to own," she said.

While such usage of ETFs by pension funds and insurance companies isn't new, "I'm just seeing more of it," Ms. Corman said.