Usage of ETFs on the part of pension funds is on the increase according to a survey of asset managers and smart beta take-up is marching in lock-step.

The latest investing survey of 127 pension fund managers in 20 countries from CREATE Research shows that of the fund managers that use passive , 26% use ETFs compared to 23% in 2018. The same percentage of managers said they used smart beta ETFs.

In comparison, 53% of managers who used passive invested in index funds while 34% invested via segregated accounts.

The report’s author Amin Rajan, chief executive at CREATE, noted that ETFs “remain an easy route into an asset class without having to pick individual funds or securities”.

“Furthermore, they are seen as a cash equitisation vehicle that parks excess money that would otherwise languish in a low interest rate environment. They are also used to hedge or short the market.”

When it comes to their usage of smart beta, the report suggests that ever more pension funds are moving to these systematic strategies because they are seen as “combining the best of active and passive investing".

In terms of share of asset portfolios, passive represented 34% this year up from 32% in 2018. Both ETFs and smart beta saw the percentage share of asset portfolios also rise by 2 percentage points to 7% and 3%, respectively.

The report, undertaken on behalf of DWS, cautions against reading too much into a relatively limited year-on-year shifts. However, the reports cites the qualitative interviews with 50 pension fund managers undertaken as part of the survey for suggesting that while markets continue to trade in positive territory “allocations to index funds will continue to rise.”

Rajan also suggests there is an “acceptance that passive funds reduce diversification benefits” on the basis that since the stocks within passive funds move with the swings in the overall market. “Reportedly, the correlations within indices have quadrupled over the past two decades”, he writes.

“But this is not yet a concern at present”, he adds. “While market valuations remain distorted by central bank action, the emphasis remains two-fold: use investment styles that are delivering good returns, but also take actions to guard against major reversals, as shown in the next sub-section.”

Downside protection

Looking ahead to the next three years, the report predicts there will be an across-the-board increase in passive funds with a particular emphasis on smart beta, ESG strategies and other thematic strategies.

“The rising interest in smart beta is based on the belief that seemingly different asset classes can have unusually high correlations due to their common exposure to their underlying risk factors”, says Rajan.

Smart beta’s active-like characteristics, but at the cost of beta funds, is their main appeal.

Another area covered by the report is the widening extent of asset classes covered by the passive element of the managers’ portfolios. Equity investment increased from 82% to 88% - which the report suggests is significant – but the report in particular points to the 11% jump in fixed income.

“Much of this is due to the growing reliance on ETFs to gain liquidity in bond markets, as banks have shrunk their market-making role in the aftermath of the Volcker Rule”, Rajan suggests.

Finally, the report also shows that holding periods for both ETFs and smart beta products are on the increase, albeit marginally with those holding ETFs as part of their portfolios for over two years rising to 48% this year from 45% in 2018 and smart beta rising to 67% from 66%.

Looking at passive as a whole, Rajan concludes that “the upshot is clear: “Index funds are going mainstream in buy-and-hold pension portfolios. They are expanding their breadth, depth and reach.”

Moreover, this expansion appears to be something of a one-way ratchet. “Looking ahead, a swing of the pendulum back towards active funds cannot be ruled out”, Rajan writes. “But there will always be uncertainty about when that might happen and how far it will go. The prevailing view amongst our survey respondents is that it will not go back to where it was at the start of this decade, but it will moderate.”

“In the emerging configuration, index funds are increasingly becoming part of the core portfolio targeting beta and active funds are left to target alpha. The alpha–beta distinction will continue to become more pronounced.”