GREENWICH ASSOCIATES. Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market

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1 GREENWICH ASSOCIATES Institutional Investors Turning to Fixed-Income ETFs in Evolving Bond Market

2 CONTENTS CHARTS & GRAPHICS Executive Summary 3 Shift in Rate Environment Triggers Changes in Fixed-Income Portfolios 5 ETFs Helping Institutions Adapt 5 Fixed-Income ETF Usage Poised for Growth 7 New Products Could Further Lift Demand for Bond ETFs 7 Broker Support of Fixed-Income ETFs Expected to Grow 8 Current Reasons for Not Using Fixed-Income ETFs to Subside 8 Top Provider of Bond ETFs: ishares/blackrock 9 Use of Fixed-Income ETFs Among Participating Institutions 4 Expected Changes to Fixed-Income Sector Allocations Over the Next Year 5 Top 5 Reasons Institutions Use Fixed-Income ETFs 5 Fixed-Income ETF Applications by Institution Type 6 New ETF Product Demand 7 Reasons Institutions Don't Currently Use Fixed-Income ETFs 8 Preferred Fixed-Income ETF Provider 9 Conclusion 10 METHODOLOGY Greenwich Associates interviewed 110 U.S.-based institutional investors about their use and perceptions of fixed-income exchange-traded funds. The respondent base included 42 investment managers (firms managing assets to specific investment strategies/guidelines), 29 registered investment advisers, 21 institutional funds (pensions, endowments and foundations), and 18 insurance companies. The sample population comprised 59 current active users of fixed-income ETFs and 51 non-users in order to determine current and future use of fixed-income ETFs by active users, as well as the current reasons non-users don't actively use fixed-income ETFs and their expected interest. Insurers 16% Institutional funds Investment managers 38% Respondents 19% 29% RIAs Cover photo: istockphoto.com/derrrek 2014 Greenwich Associates, LLC. Javelin Strategy & Research is a division of Greenwich Associates. All rights reserved. No portion of these materials may be copied, reproduced, distributed or transmitted, electronically or otherwise, to external parties or publicly without the permission of Greenwich Associates, LLC. Greenwich Associates, Competitive Challenges, Greenwich Quality Index, Greenwich ACCESS, Greenwich AIM and Greenwich Reports are registered marks of Greenwich Associates, LLC. Greenwich Associates may also have rights in certain other marks used in these materials. GREENWICH REPORT 2

3 Executive Summary Fixed-income exchange-traded funds (ETFs) are poised to take on a bigger role in institutional portfolios as the impacts of post-crisis regulatory changes are challenging institutions to reposition their portfolios. Despite record bond issuance, new regulations have pushed dealer inventories sharply lower, driving down trading volumes and liquidity for individual bonds. At the same time that individual bonds have become harder to trade, liquidity in fixedincome ETFs has risen dramatically. Since the onset of the financial crisis in 2008, fixedincome ETF trading volumes have grown more than 800%, making them a logical option to help institutional investors efficiently implement strategic and tactical shifts within their fixedincome portfolios. Although investors seem to be holding their overall allocations to fixed income steady as they prepare for a rising rate environment, they are making significant changes within their fixed-income portfolio. Many institutions have chosen to replace intermediate and longer term bonds with shorter duration instruments while also exploring other niche segments of the bond market to seek yield. In fact, the data suggest that institutional investors are already using fixed-income ETFs as part of their investment strategies in both tactical and strategic manners. With a third of these institutions planning to use bond ETFs even more in the next year and additional new users expected to come on line, fixed-income ETFs should experience a boost in assets. Institutional investment in fixed-income ETFs should continue to grow in the long term as current barriers to use slowly break down, much as they have with equity ETFs. Some investors currently express concerns about liquidity and the cost of investing in fixedincome ETFs versus traditional bonds. However, data from previous Greenwich Associates ETF studies show that initial concerns around ETF products dissipate as institutional investors learn more about these investment vehicles and gain hands-on experience with them. GREENWICH REPORT 3

4 Since the financial crisis, the U.S. fixed-income market has undergone a series of significant and well-documented changes that continue to play out among dealers, investors and debt issuers. Regulations aimed at reducing risk and providing more transparency have driven many fixed-income dealers to hold less bond inventory, leading to a decline in volumes and liquidity in the secondary market despite record primary issuance levels. And while the Federal Reserve s crisis response policy provided a telegraphed boost to bond prices, investors now face the effects of the taper, which have already begun to surface in the emerging markets. Fixed-income exchange-traded funds (ETFs) stand as one tool at the institutional investor s disposal to access liquidity and implement portfolio strategies in a shifting interest rate environment. Since their inception in 2002, fixed-income ETF assets have grown considerably, with the Investment Company Institute estimating assets in bond ETFs domiciled in the United States at about $246 billion in December Amidst this backdrop, Greenwich Associates conducted its first U.S. Fixed-Income ETF Study to better understand how institutional investors use ETFs in their fixed-income portfolios. The study was designed to learn about the behaviors of current bond ETF users (54% of participants) and the attitudes and projected ETF use of non-users (46%). This paper presents the most compelling results of this research, including the drivers of fixed-income ETF use, how institutional investors are employing ETFs as part of their fixed-income strategies, and investors projections about the role these vehicles will play in portfolios in the future. Use of Fixed-Income ETFs Among Participating Institutions Many current users allocate a sizable portion of their fixed-income portfolios to ETFs, with 59% allocating 10% or more to the vehicles. And, of the one-out-of -five non-users expecting to start employing fixed-income ETFs soon, two-thirds plan to allocate more than 5% to ETFs. CURRENT USE FUTURE USE Expected Additional Allocation Yes 54% Today s Allocation 41% 31% 14% 14% 1 9% 10 29% % 100% Don t know Yes 32% 7% Will Use More in 1 Year 63% 26% 11% 1 5% 6 10% Over 20% 61% No Use Today Expected Allocation Yes 33% 67% 46% No Don t know 10% 18% Will Start Using Within 1 Year 72% 1 5% 6 10% No Note: Based on 104 responses: 39 investment managers, 28 RIAs, 19 institutional funds, and 18 insurance companies. GREENWICH REPORT 4

5 Shift in Rate Environment Triggers Changes in Fixed-Income Portfolios Last year s announcement by the U.S. Federal Reserve that it would begin slowly tapering its stimulus program set in motion what most market participants expect to be a gradual, long-term increase in interest rates. Institutions have been preparing for this event for more than a year, and while they haven t changed the size of their fixedincome allocations, they have made substantial changes to the composition of their fixed-income portfolios. Only a quarter of the institutions participating in Greenwich Associates research say they have made any significant changes to the size of their fixed-income portfolios in the last two years, with significantly being defined as a movement of +/- 10%. An examination of the results at a channel level show that only investment managers have shown a tendency to change their portfolio size, with 35% indicating they had done so. A much larger 65% of the institutions say they have altered sector allocations within their fixed-income portfolios, including 81% of institutional funds. The most common changes made by these institutions include shortening portfolio duration and moving Expected Changes to Fixed-Income Sector Allocations Over the Next Year Low duration or rate hedged 3% 34% assets into sectors with the potential to generate higher levels of yield. As part of this latter shift, institutions moved assets into corporate bonds, international bonds, emerging markets, and high yield. Institutions say they made these moves in response to existing market conditions, their outlook on future interest rate direction and a desire to increase total yield in the current low-rate environment. Those changes appear likely to continue and perhaps even accelerate in the year ahead, with a number of institutions planning to increase allocations to lowduration or rate-hedged securities, emerging markets, investment-grade credit, and/or international income (see chart at lower left for details). ETFs Helping Institutions Adapt Institutions realize they need to make both strategic and tactical shifts in their fixed-income portfolios to adapt to recent market changes. Greenwich Associates data show that institutions are already using fixed-income ETFs for such purposes, setting the stage for increased ETF use as institutions continue to adapt investment strategies to the rapidly changing fixed-income market. Institutions indicate their top application of fixedincome ETFs is a strategic one to obtain passive exposures in the core component of core-satellite portfolio constructions. Forty-five percent of institutional ETF users say they often use ETFs Emerging markets 6% 27% High yield Investment-grade credit/corporate 9% 8% 24% 24% Top 5 Reasons Institutions Use Fixed-Income ETFs International developed 0% 22% Easy to use 81% Municipal 8% 19% Liquidity 80% Asset-backed 8% 14% Quick access 78% U.S. Treasuries 30% 5% Single-trade diversification 73% 40% 20% 0% 20% 40% Percentage of institutions expecting allocations to: Decrease Increase Lower trading costs 56% 0% 40% 80% Note: Based on 110 responses: 42 investment managers, 29 RIAs, 21 institutional funds, and 18 insurance companies in Note: Based on 59 responses: 21 investment managers, 21 RIAs, 9 insurance companies, and 8 institutional funds in GREENWICH REPORT 5

6 Fixed-Income ETF Applications by Institution Type Passive exposure in the core Tactical adjustments 38% 56% 63% 48% 67% 81% 76% 76% With a strategic application already emerging as the most-cited fixedincome ETF use case among institutions, the evolution from tactical to strategic use appears to be taking place even more rapidly for this asset class. Rebalancing Portfolio completion 33% 38% 52% 62% 52% 52% 56% 63% to obtain core exposures and another third do so periodically. The second-most common application of bond ETFs is as a tool for making tactical adjustments to portfolios, followed by the strategic process of portfolio completion. ETFs are also used widely for rebalancing, manager transitions and other purposes. Cash equitization/ Interim beta Transitions 25% 48% 48% 56% 43% 43% 67% 50% These study findings echo those found in the Federal Reserve s December 2013 Senior Credit Officer Opinion Survey on Dealer Financing Terms. About three-quarters of dealers participating in the survey say their insurance and endowment clients use fixedincome ETFs for both strategic and tactical purposes, as do two-thirds of their pension clients and half of their hedge fund clients. ETF overlay/ Liquidity sleeve Hedging Investment managers RIAs Insurers Institutional funds 0% 13% 24% 10% 13% 38% 29% 44% 0% 50% 100% Note: Based on 59 responses: 21 investment managers, 21 RIAs, 9 insurance companies, and 8 institutional funds in Several years of Greenwich Associates research on equity ETFs has shown that institutional use of ETFs becomes more strategic over time. Typically institutions first employ ETFs as tools in implementing manager transitions, cash equitization and in other tactical functions. As they gain experience with the products, they discover that ETFs prove effective in achieving more strategic goals and obtaining longer-term exposures. This process has been playing out in equity ETFs for the past decade. With a strategic application already emerging as the most-cited fixed-income ETF use case among institutions, the evolution from tactical to strategic use appears to be taking place even more rapidly for this asset class, perhaps due to the challenges to investing in fixed-income secondary markets. GREENWICH REPORT 6

7 Fixed-Income ETF Usage Poised for Growth The need for flexible tools to adapt to fixed-income markets represents just one of several potential drivers of increased institutional use of bond ETFs. The growing momentum of institutional ETF use and increased levels of investor comfort with the product also point to rising use. Perhaps the clearest signal that the use of fixed-income ETFs will increase among institutions comes from the relatively bullish sentiment expressed by some institutional investors. One-in-five non-users plan to start investing in fixed-income ETFs in the coming year. And among current ETF users participating in Greenwich Associates research, many have already been using the products for a few years, with a propensity to increase their usage over time. Eighty-five percent have employed fixed-income ETFs in their portfolios for at least two years and two-thirds of users have increased their usage since The Fed s Senior Credit Officer Opinion Survey confirms the trend of increasing institutional usage, with 30% of dealers clients increasing their use of fixed-income ETFs over the past year. The upward trend should continue given one-third of institutions currently employing fixed-income ETFs say they plan to increase their investments in them in the next 12 months, including 43% of investment managers and 38% of institutional funds. While most current users expect to increase allocations to ETFs by 1 5%, a quarter plan increases of 6 10% and about one-in-10 expects to boost ETF investment by more than 20%. The recent growth in the institutional use of ETFs overall also provides a strong signal for growth in the use of fixed-income ETFs. Data from the Greenwich Associates U.S. Institutional Investors Study shows 21% of U.S. institutional funds employed ETFs in their portfolios in 2013, up from 18% in 2012 and 14% in Usage is significantly higher among certain types of institutions, such as U.S. endowments where 40% use ETFs, and corporate and public pension funds with more than $5 billion in assets under management. The increasing use of ETFs by institutional funds coupled with the growing ubiquity of the product in financial markets has given the current generation of New Products Could Further Lift Demand for Bond ETFs Institutions say demand for new ETF products will be strongest in high yield, emerging markets, international fixed income, and corporate credit all areas targeted by investors seeking to boost yields amid low and potentially increasing interest rates. Institutions also seem open to investing in fixed-maturity bond ETFs (ETFs with a defined maturity date and regular payments). The most widely anticipated applications for fixed-maturity ETFs were duration management and risk control with investment-grade corporate bonds emerging as the most desired fixed-income sector exposure. New ETF Product Demand Fixed maturity USD-denominated international bond Active Local currency bond, hedged Local currency bond, unhedged Interest rate hedged 31% 31% 41% 39% 37% 39% 47% Percent of institutions interested in product: ETF users Non-users 66% 61% 59% 56% 0% 40% 80% 80% Note: Based on responses from 59 U.S. institutions using fixed-income ETFs and 51 non-users in GREENWICH REPORT 7

8 Broker Support of Fixed-Income ETFs Expected to Grow Limited levels of sell-side support could also be tempering institutional use of fixed-income ETFs. About half the institutions in the study say they receive information about fixed-income ETFs from their brokers and 36% say their brokers actively quote markets in the products. This is not surprising as ETFs are listed and trade as equities, which traditionally left responsibility for making markets and providing liquidity to equity desks. However, as more institutional investors have adopted fixed-income ETFs, this role is increasingly moving to bond desks, which are becoming more involved in providing liquidity for fixed-income ETFs. Greenwich Associates expects institutional use of bond ETFs to accelerate in coming years as brokers realize the potential of the products in the institutional market and begin to support ETFs more broadly. Reasons Institutions Don t Currently Use Fixed-Income ETFs Investment guidelines Expenses Low trading volumes Concerns from clients/ investment committee members Regulatory limits Use other vehicle for fixed income Lack of understanding/familiarity ETFs not supported on trading/ PM platform 18% Internal limits 18% 14% 12% 22% 31% 29% 26% 37% 0% 20% 40% Note: Based on 51 responses: 21 investment managers, 13 institutional funds, 9 insurance companies, and 8 RIAs in institutional investors a level of comfort with ETFs that would not have been found in this group just a decade ago. As an example, 90% of institutional investors in the U.S. Fixed-Income ETF Study say they feel comfortable trading bond ETFs, including every one of the 21 investment managers participating in the research. Current Reasons for Not Using Fixed- Income ETFs to Subside Institutions that don t employ fixed-income ETFs cite three main reasons. Some investors say internal investment guidelines don t currently allow the use of bond ETFs. Others indicate they believe all-in expenses are higher relative to alternatives, and some perceive trading volumes to be low. All of these attitudes are beginning to fade as investors gain hands-on experience with these products. ETFs are regularly employed as tools by institutional investors in a variety of basic portfolio functions, including manager transitions and cash equitization. Through their regular use in these applications, ETFs have evolved from a novelty to a proven commodity, and institutions should be updating their investment guidelines to reflect this change especially in light of the fact that 80% of institutions say their clients and investment committees have no general concerns about ETFs. Investors unwilling to update practices to allow for ETF usage risk placing their institutions at a disadvantage relative to peers and competitors. As such, Greenwich Associates expects this current barrier to gradually give way in coming years. Some institutions also say high prices dissuade them from using fixed-income ETFs. While management fees for fixed-income ETFs can in fact be higher than those of other products institutions have access to, investors are learning that the transaction cost savings ETFs provide often make them a cheaper alternative when viewed on a total cost basis. Currently, some of the most liquid corporate bond ETFs trade at a spread of 1 to 2 basis points, compared to a trading spread of 30 to 50 basis points for the underlying corporate bond market. This often makes ETFs the most cost efficient solution for institutional investors. GREENWICH REPORT 8

9 Greenwich Associates sees fixed-income ETF adoption rates and investment flows continuing to rise as barriers to adoption inevitably weaken. Also ranking as one of the top factors holding back institutions from trying ETFs are perceptions of low trading volumes and liquidity. Slightly more than 80% of institutions in the study say they are concerned about the limited liquidity of ETFs. In addition to making institutions hesitate before incorporating ETFs into their portfolios, concerns about liquidity also stand as one of the main factors limiting ETF investment among institutions that do employ the products. That said, crisis-related regulatory changes have made transacting in individual bonds increasingly challenging, sending investors to alternate sources of liquidity, including fixed-income ETFs. As a result, trading volumes in fixed-income ETF volumes have grown. In Q an average of more than $3.6 billion in fixed-income ETFs traded on exchange every day, up four-fold from just over $900 million in Additionally, investors are increasingly aware that available ETF liquidity is often much greater than what is observable on the exchange. New ETF shares can be created or redeemed as needed to support larger institutional transactions. Although these attitudes may act as near-term dampers on institutional investment in ETFs, Greenwich Associates sees fixed-income ETF adoption rates and investment flows continuing to rise as barriers to adoption inevitably weaken. Previous research shows that initial concerns about equity ETFs dissipate as institutional investors gain hands-on experience using them, with investors tending to quickly expand their use of equity ETFs once they have begun working with the vehicles. The same scenario is likely to occur in bond ETFs. Top Provider of Bond ETFs: ishares/blackrock Fixed-income ETF users participating in Greenwich Associates research name ishares/blackrock as their preferred provider of bond ETFs. Pricing represents a key driver of provider choice. Thirty-eight percent of institutions name better pricing as one of the three most important factors considered when selecting an ETF provider. The next closest factors are liquidity and breadth of product offering, which are named as the top consideration by about 21% each. Preferred Fixed-Income ETF Provider ishares/blackrock Vanguard SPDRs/State Street 5% PIMCO PowerShares Van Eck 3% 2% 2% 17% 0% 20% 40% 60% 58% Note: Based on 59 responses: 21 investment managers, 21 RIAs, 9 insurance companies, and 8 institutional funds in GREENWICH REPORT 9

10 Conclusion Fixed-income ETFs have established their presence in the institutional marketplace as effective and reliable tools. Although usage of ETFs overall remains limited relative to other investment vehicles, the share of institutional investors employing the products is growing. The sweeping changes unfolding within institutional fixed-income portfolios could boost the adoption and expansion of bond ETFs in the year ahead. As institutions move to shorten duration and find new sources of yield, current users of fixed-income ETFs expect to increase their use of the product and some non-users will elect to employ ETFs in implementing their portfolio strategies. Both current fixed-income ETF users and non-users express interest in upping their use of ETFs, poising the products for further growth in the long term. Increased adoption of ETFs should translate into even larger increases in investment flows because institutions tend to expand their usage of ETFs after introducing them into their portfolios. Generally this expansion occurs as institutions gain experience through using ETFs to achieve relatively simple tactical goals, like manager transitions and cash equitization. This experience helps them overcome initial concerns and realize the products broader, strategic applications. Current barriers to widespread institutional use of fixed-income ETFs investment guidelines, liquidity concerns, expense perceptions, and low levels of sellside coverage are surmountable and will likely break down as ETF use continues to gain momentum. n RELATED GREENWICH REPORTS The Great Transformation: A Credit Liquidity Story (2013) U.S. Fixed-Income Market Forecast: Cloudy with Silver Linings (2013) Versatility Fuels ETF Growth in Canadian Institutional Portfolios (2013) Institutional Investors' Relationship with ETFs Deepens (2013) RIAs Expect to Increase ETF Use Significantly by 2014 (2013) Institutions Find New, Increasingly Strategic Uses for ETFs (2012) The findings reported in this document reflect solely the views reported to Greenwich Associates by the research participants. They do not represent opinions or endorsements by Greenwich Associates or its staff. Interviewees may be asked about their use of and demand for financial products and services and about investment practices in relevant financial markets. Greenwich Associates compiles the data received, conducts statistical analysis and reviews for presentation purposes in order to produce the final results. Consultant Andrew McCollum advises on the investment management market in the United States. GREENWICH REPORT 10

11 Reprinted with permission of Greenwich Associates, LLC, February, The information in this reprint is intended to provide insight or education and is not intended as individual investment advice. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Carefully consider the ishares Funds investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds prospectuses and, if available, the summary prospectuses which may be obtained by calling iShares ( ) or by visiting Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Shares of ETFs may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained. Buying and selling shares of ETFs may result in brokerage commissions. This study was sponsored by BlackRock. The ishares Funds ( Funds ) are distributed by BlackRock Investments, LLC (together with its affiliates, BlackRock ). BlackRock is not affiliated with Greenwich Associates, LLC, and its affiliates. Information on other ETF providers is provided strictly for illustrative purposes and should not be deemed an offer to sell or a solicitation of an offer to buy shares of any funds or securities, other than the ishares Funds, that are described in this material. ishares and BLACKROCK are registered trademarks of BlackRock, Inc. All other marks are the property of their respective owners. is

12 NOTES

13 GREENWICH ASSOCIATES 6 High Ridge Park Stamford CT USA Ph /

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