How are pensions using ETFs?

Perception still a barrier to growth.

January 7, 2014

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under car hoodInstitutional use of exchange-traded funds (ETFs) is rising exponentially, according to numerous experts and surveys. And yet plan sponsors in Canada at least have expressed the challenges they face when it comes to using them. Moreover, exactly how they are using ETFs isn’t 100% clear, unless, of course, you have access to anecdotal information (see Trend 1 in my last post). The burgeoning relationship between plan sponsors and ETFs was the topic of a recent Pensions & Investmentsarticle on how difficult it is to show exactly how plan sponsors are using these products.

According to ETFGI, for example, half (51%) of U.S.-listed ETFs were held by institutions at the end of 2012; however, the firm also estimates that the number could be closer to 60%.

Why the disparity? Because pension funds, endowments and foundations tend to discuss how they’re using the products via word of mouth—that makes it hard to pinpoint exactly who is using what and how. The thing is, there could be a lot more room for plan sponsors to use ETFs for their core exposures.

Jeffrey Blazek, Dallas-based managing director for Cambridge Associates and a former portfolio manager for the Teacher Retirement System of Texas, Austin, told Pensions & Investments that some mid-size institutions are willing to have more static allocations while smaller organizations might look to ETFs for easier implementation. Larger institutions, however, are using them to maintain exposures during manager transitions.

So where are they headed in the future? That’s the $64,000 question, especially for ETF providers keen to gain a larger and more permanent foothold in the pension space.

One factor is purely operational—does a pension fund trade securities, and are they looking to beat an index? And what role does “the noise” of daily tracking error play on the reporting and governance front?

Another barrier to adoption could be perception: some institutions think that ETFs aren’t big enough to handle their money. Reginald Browne, formerly with market maker Knight Capital and now ETF group senior managing director at Cantor Fitzgerald, says that many institutions want to make trades in the range of $25 million to $100 million at a time. In the fixed income space, however, things are heating up as more and more institutions look to make transition trades—exchanging large numbers of bonds for ETF shares as liquidity concerns increase in the bond market.

So what does this mean for Canadian plan sponsors and ETF providers that serve them? It still means that education and access are top issues that will determine which pension funds use these products and how. Liquidity, tracking error and, above all, ease of use will loom as barriers in 2014 unless the industry can find ways to address them and bring Canada’s pension investors into the ETF fold.

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