How should institutional money managers use ETFs?

What's the value of investment vehicle to institutional investors?

How should institutional money managers use ETFs?

ETFs should be used as a tool - not just for the core portfolio. That was one of the main takeaways at the 5th annual ETFGI Global ETFs Insights Summit in Toronto last week from a panel that featured guest speakers from several of Canada’s largest banks.

Daniel Stanley, director of ETF distribution and institutional sales and service at BMO Global Asset Management and Daniela Fajardo, associate of ETF services at Scotia Capital Inc. highlighted a few reasons why institutions should look to  ETFs.

“You do have to think about how retail thinks of the portfolio of their clients,” Farjardo says. “What is their end goal? Whereas the institutional side, what they want is a quick and effective way of managing their exposures. As a result, use ETFs as a tool rather as the long-only portfolio.”

Fajardo adds that rarely will you ever see an institutional player using covered calls, or using smart beta ETFs because it’s not part of their strategy.

“Institutionals, they use the tool as a hedging of their exposure,” Fajardo says. “In long, short strategies, they can short the ETFs, they pair trades or relative value trades. We've also seen ETFs being used as cash management tool, or as a way to manage the flows they get into their strategy.”

Stanley’s job is to educate institutional investors on where ETFs can be delivered alongside cash bonds and derivatives. He says the benefits are largely down to all-in costs.

“It changes, so you're comparing all-in costs on the ETF, you're talking about the cost to access the market,” Stanley says. “That's the spread if you do a market trade or the CAF (cash adjustment factor). Then there's the cost to transact the trade, the commission, and then there's the management fee.”

Stanely says if all those three costs end up being less than the spread in the high yield bond space, which is where they see a lot of action from, the all-in cost of trading is less than the underlying bonds themselves.

The retail channel, of course, is using ETFs as an access point and a low-cost access vehicle, providing them with access to factor strategies like low volatility or covered call writing, which would otherwise be inaccessible.

Institutions, on the other hand, have the resources to do it themselves and it's not the low-cost solution.

“It therefore becomes an exercise of presenting to an institution, ‘What's the value of that ETF that makes up for the slightly higher cost versus a pool or a derivative instrument?’ And, in my opinion, the value comes from the unique information that can be gathered from ETF flows,” Stanley said.

Stanley put forward the bond market as an example. Most people who are buying and selling ETFs won't ever touch cash bond security these days and that means that there's going to be times where there's going to be slippage between the bond ETF and the cash bond. He added: “Anytime there’s slippage between the pricing of two things that are, in effect, the same thing, there's opportunity. So, for an institutional investor, value number one is any information that can be derived from the ETF market.”