A fresh angle on the debate regarding the degree to which the huge inflows into passive strategies - and specifically ETFs - comes from a new report from Deutsche Bank on institutional ETF ownership.
The report shows that as of the end of 2017 institutional ETF ownership in the US rose significantly above trend and totalled 60.1% of the entire universe of US-facing products.
In percentage terms, while retail investor interest in ETFs rose 30 percent, institutional interest was up 39 percent over the course of the previous 12 months.
Leading the charge was investment advisers where the total assets held in ETFs rose 49% to $1.2trn out of a total institutional AUM of just over $2trn. Total retail AUM in ETFs totalled $1.33trn.
The report's authors, strategists Chin Okuro, Hallie Martin and Srineel Jalagani pointed out that the increased use of ETFs by institutions can in part be explained by the continued shift of investment assets from active to passive and the move towards lower cost ETF wrappers.
"However, asset ownership underestimates the rising adoption of ETFs by institutional users as it doesn't capture the pick-up in trading activity by institutional users," the team added. "As the product's ecosystem evolves, institutional investors are increasingly using ETFs for traditional asset allocation purposes but also for trading liquidity and cash management purposes."
Another trend noted by the analysts was that institutional investors appeared to be "taking notice" of the evolution towards more smart beta strategies. Indeed, the use of smart beta among all types of institutions rose in 2017 and now represent 22% of total institutional ETF assets, up from 20% in 2016.
The most interest in smart beta came from investment advisers and private wealth management firms at circa 30% of their total ETF assets. In comparison, pension providers only allocated around 10% to smart beta ETFs (out of their total ETF assets of $38bn).
Momentum, quality, and low volatility were the most popular single-factor exposures favoured by institutions. "The significant usage of smart beta by investment advisors reflects their demand for a wider range of exposures in the ETF wrapper," noted the Deutsche strategists. "While Pensions are most surely interested in quantitative strategies, they're more likely investing in cross-asset risk premia strategies via external mandates or bespoke structures."
A related issue around increased smart beta usage was that the trend towards low-cost ETFs actually slowed from 2013 but the figures form last year would suggest that this has resumed its previous trajectory.
The survey found that 85% of total institutional ETF assets had a total expense ratio of less than 40 basis points while the percentage invested at TERs of less than 20 basis points stood at 70 percent. Both measures were up on 2016.
Concentration and asset allocation
One important point is the degree of assets that are held among relatively few institutions. "Notably" the strategists says, only 200 institutions held roughly 80% of institutional ETF assets and 500 institutions held roughly 90% of institutional ETF assets at the end of 2017.
There are differences across the various sub-sectors of institution. Investment advisers as a category have a large number of firms using ETFs, but less than 1% of this group account for 50% of all ETF assets held, for instance, while the same metric for pension funds stood at 10%.
When it comes to allocations, it is no surprise to find that core equity and fixed income asset ownership predominates while international exposure was on the increase. US-specific assets were down 3 percentage points at 55% while developed international and emerging market exposures were up 2 percentage points and 1 percentage point at 14% and 7%.
Institutional holdings of large cap stood at 31% of all ETF assets. "Large-cap exposure retain a major allocation among institutions due to versatility to both core allocators and liquidity seekers," the Deutsche team suggested.
Equity dominated institutional ETF assets at 80%. However, the fixed income total of $353bn represented a 39 percent increase on 2016. Investment grade exposure was 63% of total institutional fixed income ETFs, increasing three percentage points from a year prior. "The incremental change to higher quality bond exposure seem to align with the changing investment landscape amid rising interest rate policy mandate," said the strategists.
Bulwark against panic
The sheer scale of institutional ETF ownership brings further perspective to the debate over whether the huge increase of passive investment is, as an opinion piece in the FT by the Megan Greene, chief economist at ManuLife Asset Management, suggested "storing up trouble".
A robust defence was subsequently given in a letter to the FT from Samara Cohen, the managing director of iShare global markets at BlackRock, who suggested the fears expressed by Greene were based on three "unfounded" assumptions.
First, ETFs do not control the direction of investment flows. "Rather, it's the reverse: investors develop their views on the market and then can use ETFs to implement them."
Second, that time and again ETFs have been tested in periods of market stress. "In each case, ETFs acted as a shock absorber to markets by providing incremental liquidity (through on-exchange trading) and price discovery.
Finally, the argument that the growth of passive investing adds complexity and opaqueness to the markets is also untrue. "It's quite the opposite," Cohen wrote. "ETFs add transparency to markets, as the rules of the index, its risk-return profile and its constituents are publicly disclosed."
This is arguably reflected in the degree of institutional interest in ETFs. Their simplicity, their transparency and their risk-return profile make them an easy 'sell' to institutions hoping to provide the best investment returns to their clients. Far from adding instability to the system, the degree of institutional interest in ETFs arguably mitigates (to a degree) and acts as a bulwark against market panics.