Eugene Grygo, Chief Content Editor, FTF News
It’s no secret that exchange-traded funds (ETFs) have become quite popular as instruments that “help institutions manage their cash flow, hedge risk, gain quick exposures to illiquid market segments and more,” as market research firm Greenwich Associates has noted.
But is it time for the industry to take ETFs to the next level?
A new Greenwich Associates report, “Letting ETFs Stand on Their Own” is arguing that ETFs might have a future “as an asset class all their own.”
The report’s findings stem from 111 interviews with “investment-grade credit investors in the United States in 2017 and 112 in 2018. Major broker-dealers, ETF market makers and ETF issuers were also interviewed for this research,” according to the researchers.
So, the current situation for ETFs has buy- and sell-side firms engaging in “suboptimal executions, limiting ETF growth,” according to the report. Even more troubling, the conventional wisdom among asset managers is that ETFs “are just portfolios packaged up under a particular regulatory construct and analogous to ‘40 Act mutual funds.”
Yet, at the same time, ETFs have developed multiple personalities via the needs of the securities industry.
“Most equity broker-dealers and market makers see them as simply equities: If it looks and feels like a stock, then it should be traded like a stock. Some fixed-income traders treat ETFs like derivatives — a quick way to get broad market exposure to an otherwise illiquid market segment,” according to the new report. “ETFs are used as credit default swap (CDS) replacements and to help trade baskets of bonds. To many real-money investors — nearly 60 percent according to recent Greenwich Associates research — ETFs are simply a cheaper alternative to mutual funds. Why pay 100 basis points to track an index when you can pay 10?”
While the multifaceted nature of ETFs may be appealing to some, “the many faces of ETFs have made them very difficult for banks to manage and have left many investors executing their ETF trades sub-optimally,” according to the report. “They are not single stocks, so trading them via the same algorithms isn’t wise. And while fixed-income ETFs trade on equity exchanges, they move like the bond market, putting equity traders out of their comfort zone.”
So, treating ETFs as a new asset class is not going to be easy. In fact, for institutional usage of ETFs to mature, “long-held structures for managing clients and trading products need to change.” Operations and IT infrastructures are also likely to face an overhaul.
To make their case that these structures must evolve, the researchers cite an example from recent history: “Corporate bond traders didn’t trade CDS when they first came on the scene — CDS specialists did that. ETFs should be treated no differently.”
By taking this leap, the industry “would help improve execution quality and ramp up client commissions and overall profitability,” according to the report.
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