As I stated last week, ETFs are a wonderful product innovation for the individual investor. However, most people don’t realize that ETFs were actually created for institutional investors.
Those who are worried about passive investing taking over the markets point to the $3 trillion or so in ETFs as their main point of contention. In The Institutional ETF Toolbox, Eric Balchunas estimates that there is $700 billion or so of institutional money invested in ETFs.
I think it’s great that institutions are taking advantage of ETFs to allow their portfolios to function more efficiently. But the majority of institutions aren’t using ETFs for passive, long-term buy and hold investing. Their holdings serve a host of other purposes. When professional money managers and the media talk about a passive investing bubble it’s worth remembering that not all ETF buyers are passive investors. In his book Balchunas lists thirteen different ways that institutional investors utilize ETFs in their portfolios:
1. Cash equitization
2. Manager transistions
3. Portfolio rebalancing
4. Portfolio completion
5. Liquidity sleeves
7. Long and lend
8. Tactical moves
9. In-kind creation/redemptions
10. Bespoke ETFs
11. Tax-loss harvesting
12. Long-term allocation
13. Personal usage
You should notice that ‘long-term allocation’ is pretty far down the list here. There’s a reason for this. The majority of institutional investors aren’t using ETFs through a passive approach. They’re using them as placeholder investments, for tactical moves, as a way to provide portfolio liquidity or for shorting and hedging; not as a long-term strategic allocation.
Eric interviewed me for his book to gain a better understanding about how various institutional investors were using ETFs in their portfolios. After a lengthy back and forth on the topic he asked me very simply, “Why don’t any institutional investors just create a portfolio using all ETFs.”
Here was my response, which appears in the book:
I personally think it would make sense for a lot of them. I think changing the structure of institutional funds is kind of like turning a battleship. This goes back to what David Swensen said that you can’t really get caught up in the middle of half-assing an alternatives program. You have to be all in. And a lot of places don’t have the bandwidth to be able to handle the due diligence, the tracking, and the risk reporting of an active portfolio. So yeah, [an all-ETF portfolio] would probably be a good idea for many. It’s just getting them to admit it’s a good idea. It would take time, probably longer than common sense would dictate.
There are a number of reasons for this. The majority of institutions manage their portfolios in one of two ways:
1. They have a fully-staffed investment office who either manages the money in-house or farms it out to third party money managers of their choosing (or a combination of the two).
2. They hire a consultant who comes in to pick third party money managers for them (see more about the consulting model here).
For these investment approaches the bulk of their time and energy is spent trying to find investment opportunities on their own or outside managers who will outperform on their behalf. It’s the way things have always been done so I don’t see it changing anytime soon for the majority of institutional money (this goes back to the turning of the battleship analogy).
This is part ego, part incentives and part inertia on the part of institutional investors. This group of investors are highly competitive with one another. Opting for a simpler approach using mainly ETFs is almost a form of admitting defeat for them, even though many would see their results improve and their fees and complexity go down substantially. The consulting model currently used by institutional funds who don’t have an in-house teams revolves around a manager-of-managers approach. Consultants sell their ability to pick outperforming money managers. ETFs don’t really fit into that model.
So it’s a huge change in strategy. This-is-how-we’ve-always-done-things can be a difficult mindset to overcome. Going to a more ETF-centric portfolio would require more of a focus on asset allocation. Something I’m continually shocked about in the investment industry is how overlooked asset allocation is as an input for a successful investment program. Far too many professional investors assume that the only way to improve their performance is through market-beating returns at the security or manager level. They don’t realize that only a tiny number of institutions have the bandwidth to pull this off consistently across a wide range of investment managers. Most of the gains actually come at the asset allocation level.
As David Swensen once said, “Instead of concentrating on the central issue of creating sensible long-term asset-allocation targets, investors too frequently focus on the unproductive diversions of security selection and market timing.”
A focus on asset allocation, low-costs and organizational alpha can be a tough combination to beat for institutional investors but it would require a re-thinking of the current strategy for many. Turning that battleship takes time.
The Institutional ETF Toolbox
Bogle vs. Goliath