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Pairing exchange traded funds with institutional investors

Explosion of ETFs has changed the worlds money management industry

By Imran Ahmed

very few decades a new product revolutionises the operations of international financial markets. In their day, open-end mutual funds, futures and options have all played a ground-breaking role in modifying investor attitudes. The most recent innovation is the exchange traded fund1 or ETF. ETFs are baskets of securities listed on a stock exchange which are traded like individual stocks, i.e. through a brokerage firm during exchange trading hours. Like stocks, but unlike open-end mutual funds, investors may take short positions in ETFs. Since the launch of the first ETF in 1993, the Standard and Poors Depositary Receipt or SPDR, ETF securities have significantly altered institutional investor behaviour.

decisions. Many institutions have also been attracted to ETFs by the securitys broadening underlying investment subjects. The ETF is more than merely a costeffective way to gain market exposure to broad stock indices. Todays list of ETFs is endless. Virtually any asset class, index, sector, country, currency or region in passive or active investment styles is available in ETF form for the discerning investor. Gold bugs access the yellow metal via the SPDR GLD Trust. The gold fund which seeks to replicate the price performance of gold bullion, net of fees, has assets upwards of $50 billion. Based on average three-month daily trading volume of 14.3 million shares, GLD trades almost $2 billion in value during every session.

inversely related to the underlying index or commodity are commonplace. Inverse ETFs trade like ordinary stocks and investors do not require any special approvals to transact in the securities.

Variety of uses
With sufficient trading volumes and a diversified ETF menu, institutions look to ETFs for various purposes. To be sure, not all ETFs have an adequate trading volume for large institutional investors to trade directly through the exchange. Nonetheless, ETF structures generally allow for direct co-ordination with Authorised Participants for the specific creation and redemption of large numbers of units directly with the fund company. For large institutions, ETFs are simply another option available to implement their investment theses. Other investment mediums, including mutual funds, common stocks, futures, etc, are all accessible to institutions with investments measured in tens and hundreds of millions of dollars. As one would expect, the nature of the investing institution virtually defines how the entity uses ETFs. Large investors, such as sovereign wealth funds, pension funds or even mutual funds, generally avoid proprietary active trading. Such institutions often manage a stable of investment managers with expertise in specific investment areas who indulge in active trading on their behalf. These types of investment institutions, often long only, tend to use ETFs for three main purposes: cash equitisation, transition management and rebalancing. Certainly, there will be some institutions within this category that will utilise ETFs for implementing investment strategies, especially with a core-satellite and thematic (e.g. emerging market) approach. Cash equitisation endeavours to reduce the cash drag on portfolios.
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Large investors, such as sovereign wealth funds, pension funds or even mutual funds, generally avoid proprietary active trading
As at December 2010, ETFs had total assets of approximately US$1.3 trillion, an increase of almost 27% over the previous year. These assets were divided across approximately 2,500 ETFs listed on almost 50 exchanges around the world. However, the top 100 ETFs accounted for almost two thirds (63%) of ETF assets. In December 2010, the average daily trading volume for ETFs was approximately $46 billion.2 Institutions demand high liquidity standards from securities before including them into their investable universe. In this regard, the virtuous cycle created by an ever deepening and liquid ETF market has undoubtedly induced many institutions to consider ETFs for both strategic and tactical investment 6
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Investors seeking more exotic opportunities may wish instead to look towards the CYB or BALT. The $630 million WisdomTree Dreyfus Chinese yuan ETF (CYB) aims to replicate the returns available to foreigners on Chinese yuan money market instruments, along with expected yuan currency exchange gains versus the US dollar. The Baltic Limited Trading ETF (BALT) is a way to play international trade and shipping growth. The $165 million ETF attempts to track returns associated with the Baltic Dry Index calculated daily by the Baltic Exchange. In an ironical twist on the concept of buying stocks, contemporary investors may gain short exposure by going long. Bear ETFs or ETFs that deliver returns

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An institution faced with a large cash infusion can immediately place the money in an ETF so as to reduce benchmark risk or tracking error. For example, a US large cap stock fund can use fresh cash to purchase the SPDR ETF and gain immediate exposure to the US stock market Standard and Poors 500 Index. It should be noted that cash equitisation can be achieved through other instruments such as futures, options and even mutual funds. any front or back-end fees. Hence, an institution can rebalance a Core Portfolio as often as each quarter as part of a longterm investment strategy. For active traders such as hedge funds, ETFs hold a particular attraction, especially given two of their noteworthy characteristics: the ability to sell ETFs short and the prevalence of sector ETFs such as energy, financials, etc. These traits make ETFs useful instruments in implementing several hedging and risk

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ETFs have had a democratising impact on certain investor categories, by granting easier access to indices, sectors and exotic asset classes

Transition management allows an institution to reduce the performance risks associated with a transition between different managers. Appropriately benchmarked ETFs can be used as a temporary cash parking space until either a new portfolio manager is identified or ready to construct the relevant portfolio. Transition management benefits tremendously from the ETF industrys diversified range of benchmarks and styles.

Rebalancing portfolios
Actively rebalancing portfolios using ETFs is generally low cost and time efficient. ETFs trade freely without
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management strategies. This is markedly true for small and mid-size hedge funds as their position sizes make ETFs a viable trading vehicle. The simplest strategies involve a version of pairs trading and market neutral strategies. Such trading strategies are designed to capture the spread from the price movements of two separate securities. It should be noted that the pair trade is a relative trade so if the long position declines by less than the short position, the overall trade is profitable. The strategy can be executed in several ways. For example, one sells short a particular sector ETF, say energy,

and purchases another sector ETF, e.g. financials on the assumption that a peak in energy prices has been reached and the worst of the financial crisis is over. In such a scenario, the oil ETF should decline more than the financials ETF. Another variation is to sell short a sector ETF and go long on a stock within the sector, or vice versa, in the belief that the specific stock will outperform the sector. An example may be to sell short the Consumer Discretionary sector ETF while purchasing shares of Target Corporation (TGT) in the hope that TGT will outperform its industry sector. The pair trade strategy can be converted into a market neutral trade except that a broad market ETF is used for one leg of the trade. For example, an energy sector ETF is sold short while a long position in the Standard and Poors 500 SPDR ETF is initiated. In this case, the investment thesis is that energy stocks will decline more than the broad market. The recent explosion of ETFs has changed the worlds money management industry. ETFs have had a democratising impact on certain investor categories, by granting easier access to indices, sectors and exotic asset classes. The ETF industry has not gone unnoticed by institutional investors. Undoubtedly, institutional investor participation within the ETF industry is set to grow with time. Even the recent global financial crisis hardly dented the ETF industrys growth momentum.
Imran Ahmed is a principal at Deodar Advisors LLP. He can be reached at Imran@deodaradvisors.com

For the purposes of this article, the term ETF includes all forms of exchange traded portfolios or ETPs, including exchange traded notes (ETNs). Source: Deodar Advisors, BlackRock.

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