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Trends in Institutional Investor Use of Fixed Income ETFs

Presenter:

ANDREW MCCOLLUM Partner & Managing Director Greenwich Associates

Greenwich Associates

Table of Contents

2

Drivers of Growth

Institutional Fixed-Income ETF Outlook

Conclusions

Role in Institutional Portfolios

Role in Institutional Portfolios

3


Direct feedback from the institutional community.

The Appeal of ETFs in the Institutional Market

4

“We have found a lot of new

innovative products are

available in ETF form.” – RIA

“At times active managers

have difficulty beating their

benchmarks and ETFs are

considerably less

expensive.”

– Pension fund

“ETFs allow me to

diversify exposure to

style, market

capitalization and

sectors that I would not

be able to efficiently

achieve trading

individual names. The

key word is

diversification.”

– Asset manager

“We are making greater use

of ETFs as we delve into

other parts of the market

that we would not access

with individual stocks, such

as European, international

and emerging markets. Over

time, we will make even

greater use of ETFs as we

try to tap additional areas

of the market.” – RIA

“We use ETFs to fill out when we

can’t find individual bonds.”

– Investment manager

“It started out as a

tactical tool to

temporarily hold cash;

over time our use has

evolved into

permanent holdings.”

– Insurance company

Greenwich Associates 5

Fed Policy

Regulatory and policy shifts upended fixed income markets, spelling uncertainty

for its participants.

The Root Cause of Growth

• U.S. Federal Reserve - Low interest

rate environment put in place to

inject liquidity and help spur

economic growth

• Dodd-Frank – Limited size of

financial institutions and lowered

tolerance for risk market-wide

• Basel III – Heightened liquidity

standards for financial institutions

Regulatory Shifts

Dramatic increase of bond issuances

in pursuit of cheap money flooded

primary markets

Confluence of regulatory restrictions

constricted liquidity in

secondary markets


Illiquidity in Fixed Income Markets

6

Increased regulatory pressure on financial institutions and a flooded bond

market combined for depleted dealer inventories, high costs, and volatility.

Investor Concerns

• When should I buy the bond?

• Will I have trouble offloading the

bond?

• When would I expect to sell? Is

that feasible?

• How do I recalibrate my portfolio

to adjust for this difficulty?

• How do I offset the increased

cost executing trades?

Note: Based on 119 respondents in 2015.

Source: Greenwich Associates 2015 U.S. Fixed Income ETF Study

No 48%

Yes 52%

5%

61%

34% MoreChallenging

About theSame

LessChallenging

Fixed Income Trading Environment Over

the Past Two Years

Challenges in Trading, Liquidity

or Sourcing Securities

in Fixed Income Markets

Have Challenges Affected

Investment Process?

Drivers of Growth

7


Investors employ Fixed-Income ETFs for a variety of applications.

Many Tools in the Toolkit

8

Note: Based on 60 respondents: 10 institutional funds, 21 RIAs, 22 investment managers, and 7 insurance companies in 2015.


43% 43%

0%

57% 57%

14%

71%

57%

32%

45%

27%

41%

73%

64%

59%

64%

38%

33%

19%

43%

73%

62%

76% 76%

10% 10%

20%

30%

40%

60%

70%

80%

ETFOverlay/Liquidity

Sleeve

Transitions Hedging CashEquitization/Interim

Beta

TacticalAdjustments

PortfolioCompletion

Rebalancing Passive Exposurein the Core

Insurers Investment Managers RIAs Institutional Funds

Fixed-Income ETF Applications by Institution Type


Current ETF users are broadening their deployment of fixed-income ETFs from

tactical applications to more strategic portfolios uses.

Broadening from Tactical to Strategic Use

42%

57%

58%

63%

74%

2011

2012

2013

2014

2015

Source: Greenwich Associates U.S. Exchange-Traded Funds Study.

Note: Based on 201 responses: 49 institutional funds, 19 investment consultants, 31 insurance companies, 70 RIAs, and 32 asset managers in 2014. Percentages may not add to 100 due to respondents

preferring not to answer.

.

% of Fixed-Income ETF Assets

Considered Strategic

Average Fixed-Income ETF

Holding Period

70%

62% 62%

46%

1 Year or More

2015

2014

2013

2012

9


Healthy trading volumes and asset growth positions ETFs as complements to

traditional fixed income securities.

Serving as a Complement to Bonds

10

75x 17x

Positive

Velocity

1.7x 2.1x

Negative

Velocity

Trade Volume Growth Since 2008

Total Asset Growth Since 2008


Fund assets and trading volume compiled from Bloomberg. Trading volumes based on cumulative monthly ADV from the period 12/31/2007– 12/31/2014. “Five largest credit ETFs” determined by ranking

the total net asset value of the funds as of 12/31/14.

Overall Investment Grade and

High-Yield Credit Market

Five Largest Credit ETFs

3%

6%

6%

9%

9%

16%

19%

19%

34%

38%

Ability to Use Instead of Individual Bonds

Easy to Use/Access

Good Value/Low Cost

Use of a Placeholder/Replacement

Tactical Asset Allocation

Use for Duration Management/Transition

Diversification

Depends on Business/Client Requirement

More Liquidity

Ease of Exposure

Reasons for Using Bond ETFs Alongside

Individual Bonds


Given liquidity issues, investors have looked elsewhere for fixed income

exposure, primarily derivatives.

More Cost Effective Beta than Derivatives

• ETFs offer another option to

investors using derivatives to gain

fixed income exposure.

• 61% believe S&P 500 ETF provides

more cost effective beta exposure

than S&P 500 future.

• 43% have shifted to ETF from

derivatives in the past year.

• 15% will replace existing fixed

income futures position with ETF in

the next year.

Yes 58%

No 42%

No 72%

Yes 28%

Bond ETFs as Substitutes for Derivatives

Use of Derivatives (Credit Default

Swaps, Treasury Futures, Total Return

Swaps) to Gain Fixed Income Exposure1

Would Consider Using Fixed-

Income ETFs as Alternative to

Gain Fixed Income Exposure2

Note: 1Based on 128 respondents in 2015. 2Based on 36 respondents in 2015 who use derivatives


11


Investors not currently using fixed-income ETFs cite several common themes

behind their hesitations.

Barriers to ETF Adoption

12

• Despite asset growth, perceptions of

limited liquidity still persist.

• Specific events add fuel to concerns

about liquidity when it is needed

most.

• Internal rules and guidelines have yet

to evolve at certain organizations.

• 40% of those who feel uncomfortable

trading ETFs attribute that feeling to

a lack of understanding of the

product.

8%

8%

12%

15%

20%

27%

28%

48%

ETFs Not Supported on Trading/PMPlatform

Regulatory Limits

Lack of Understanding/Familiarity

Expenses

Investment Guidelines

Constant Maturity Profile of Many ETFsvs. Declining Maturity of Bonds

Internal Limits

Low Trading Volumes or Assets

Reasons Institutions Don’t Currently Use

Fixed-Income ETFs

Note: Based on 60 respondents: 10 institutional funds, 22 investment managers. 21 RIAs, and 7 insurance companies in 2015.


Institutional Fixed-Income ETF Outlook

13


ETF demand likely to mirror broader shifts in institutional fixed income product

demand.

Shifting Fixed Income Dynamics

4%

19%

1%

9%

9%

5%

9%

7%

9%

14%

14%

15%

20%

22%

23%

24%

Asset-Backed

U.S. Treasuries

Municipal

International Developed

Investment-Grade Credit/Corporate

Emerging Markets

High Yield

Short Duration or Rate Hedge

Decrease Increase

Expected Changes to Fixed Income Sector

Allocations Over the Next Year

Proportion of institutions expecting allocation to:

Note: Based on 128 responses: 50 institutional funds, 37 investment managers, 27 RIAs, and 14 insurance companies in 2015.


• Institutional portfolios

diversifying / shifting toward

specialty products, largely in

search of yield in low interest

rate environment.

• Likely to see increasing

demand for new approaches,

such as „smart beta‟.

• Role for fixed-income ETFs in

multi-asset class portfolios, a

growth segment.

14


Large-scale trades are becoming increasingly common among institutional

investors.

Increasing Comfort Trading Fixed-Income ETFs

Note: Based on 60 respondents: 10 institutional funds, 21 RIAs, 22 investment managers, and 7 insurance companies in 2015.


12%

7%

31%

17%

33%

More than$100 million

$51-$100million

$11-$50million

$6-$10 million $0-$5 million

Largest Single Trade Using a Fixed-Income ETF

15

92%

93%

98%

ComfortableTrading ETFs

Satisfied withExperience

Likelihood toTrade Again

Experiential Feedback


Investor expectations suggest further expansion of ETFs in the years ahead.

Fixed-Income ETF Forecast

• About half of institutions not currently

using ETFs are considering use in the

next twelve months.

• Greatest growth channels: insurance

and asset managers.

• Expect continuation of current trends:

Greater comfort / familiarity

Eroding concerns with greater

liquidity

Broader applications

Compliment to bonds

Replacement of derivatives

Note: 1Based on 58 respondents in 2015, 0% expected to decrease bond ETF use. 2Based on 11 respondents in 2015 who plan to increase use of bond ETFs in next 12 months.


0%

Stay the

Same 76%

Increase 24%

Expected Use of Bond ETFs Over Next 12 Months

Expected increases or decrease1

Of those expecting to increase

expected magnitude of change2

45%

27%

18%

9%

16-20%

Over 20%

6-10%

1-5%

11-15%

16


A select few have garnered the attention of institutional investors.

Leading Fixed-Income ETF Providers

• Matches exposure needed

• Liquidity / trading volume

• Expense ratio

• Performance / tracking error

• Fund company

• Benchmark used

• AUM

• Breadth of ETF offerings

12%

17%

22%

50%

Other

StateStreet/SPDRs

Vanguard

iShares/Blackrock

Investment Mangers

Note: Based on 46 respondents expressing a preference: 8 institutional funds, 18 investment managers, 14 RIAs, and 6 insurance companies in 2015.


Preferred Fixed-Income ETF Provider

13%

13%

25%

50%

Other

PIMCO

Vanguard

iShares/Blackrock

Institutional Funds

17

Key Selection Criteria

Conclusions

18


Key Takeaways

• Broadening use in insurance channel.

• Product innovation to meet client needs.

• Growth of fixed-income ETFs in global markets.

Growth trends to watch

• Liquidity challenges will persist.

• Awareness / comfort levels will rise.

• Hesitations about liquidity will erode.

No change to growth drivers

• Shifting uses from tactical to strategic.

• A liquidity complement to bonds.

• A replacement for derivatives.

Institutional market remains in growth phase

1

3

2

19


© 2015 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 ACCESSTM, Greenwich AIMTM, and Greenwich Reports® are registered marks of Greenwich Associates,

LLC. Greenwich Associates may also have rights in certain other marks used in these materials.

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1st Floor

London, EC2V 5AY

United Kingdom

Tel: +44.207.726.9400

ASIA

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#03-05 Far East Square

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Tel: +65.6236.0142

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USA

Tel: +1 203.625.5038

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JAPAN

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Tel: +813.3475.5212

Contact Information

Andrew McCollum

Managing Director

Direct: +1 203.625.5018

Email: [email protected]

20

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Trends in Institutional Investor Use of Fixed Income ETFs

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