Mark Brady, Director, Capital Markets team at iShares.
There’s a huge convenience aspect to it. Obviously, the index businesses are really about scale, and we have a mass of scale in our business which allows us to construct products that offer access and simplicity into markets and places that even the average institutional investor cannot make this level of commitment to. But I also think there is a definite need for transparency. These are products that are easy to understand. If you’re sitting at a pension fund and you need to get access to Brazil, you can buy a Brazil ETF that is listed, you can buy the stocks listed on the Brazilian exchange, or you can buy some kind of derivative.
When you start looking at some of the derivatives out there you rapidly develop single counter party exposure, and obviously there’s a lot of concern about counter party risk as it is difficult for institutions to justify the risk to investment committees.
ETFs are a simple and transparent way to help them implement an investment model or an allocation strategy. You can short an ETF just like any stock; we do see clients that are adverse to leverage or inversed ETFs, but are very comfortable shorting an ETF as a means to hedge a portfolio for an exposure.
Institutions are in-housing some of their operations, and that’s definitely a trend that we’re seeing globally. However, within that trend, while firms are in-housing the CIO function, they do not want to build out the necessary infrastructure to support a full blown trading operation.
They also don’t want to hire a whole team of analysts to help them look at companies. If your model tells you to buy Brazil – you need to buy Brazil. The easiest way to do that is through an ETF exposure. If you have a preferred index provider, there are multiple exposures out there and you can implement a model very cheaply and efficiently versus buying the underlying index or making a bet on a few stocks that you think would give you a proxy to the exposure that you’re trying to achieve.
Wider uses of ETFs
I could grossly characterise uses according to the client’s size, the big institutions are using ETFs for tactical allocations. Blackrock has extremely good relationships with many of these firms and in the last couple years they have definitely woken up to the ability to help to implement these portfolios effectively through the use of ETFs. Asset managers will often use ETFs as a cash equitization tool or a liquidity sleeve.
For example, we’ll see an active fund manager that has got an inflow of capital but isn’t prepared to put it to work yet. One of the things they can do, to reduce cash drag in the portfolio, is to invest it in an ETF that is the same benchmark or a very close benchmark and thereby achieve some kind of performance versus having it sit in cash and just dragging down performance.
Cash equitization could be one-day, it could be five-days and we’ve seen people come in with very large sizes and then come out in bits and pieces as they allocated their cash. It is a very useful tool for them and it’s also, I think, a good story to an investor who’s saying, “Look, we’re not just sitting on your cash. It’s being put to work” and then invested as a firm can find the opportunity.
The other use that we’ve seen is as a liquidity sleeve, and that’s very similar to cash equitization. A liquidity sleeve is very similar in that you might have someone who is managing a small cap portfolio for example. Small caps can be incredibly hard to buy and sell. In certain cases you can spend months trying to build up a position and if there was a fund redemption, all the hard work building the positions could be gone. If you have a liquidity sleeve you have a mechanism whereby a portion of your portfolio is made up of liquid ETFs which can be sold at any time to generate cash. You don’t have to touch the underlying portfolio which reduces trading costs and so forth. I think it’s a pretty obvious argument that it’s a great tool for that type of portfolio or exposure.
The client’s questions
ETFs are still very much on the ground floor in terms of understanding. We spend a lot of time educating investors. We spend a lot of time talking about the hidden liquidity in ETFs whereby we’ll have funds that may or may not have a large amount of secondary liquidity, but the fact is that as long as the primary market is liquid you can create and redeem that fund at any time without any market impact and get the exposure you want. Once clients understand that, we have seen clients come into funds and quadruple the fund’s AUM in one trade because they understand that the underlying liquidity is really the key. The other questions we get asked are just the basic questions that someone will need to know to understand how to value the product, such as how we’ve constructed the portfolio and how we manage it and so forth. Transparency is one of our absolute headline beliefs; one of the things that makes our job easier in explaining how ETFs work to our clients, is that our websites across the globe have so much information freely available we are frequently sending out links to materials already put together.
In terms of niche products, we have over 600 ETFs and we have some niche plays where a client will come to us and say, “I’d really like this exposure. Could you work with us and make it?” and in a lot of cases we’ll do that. It’s like a custom basket. In some cases, we can get a fund into the market in three months, so we can actually bring some very niche products to market. Do they all trade fantastically? No, they don’t, because they’re niche and the client that’s really interested in them is looking at them more as a fund than an exchange traded instrument, and they understand that the underlying primary market allows them to create and redeem this fund to achieve the exposure without having to access the secondary market. The worry in this case is that the lack of secondary liquidity could be misconstrued by certain investors, which is one of the main misconceptions we are trying to alleviate on a daily basis. ETFs definitely encourage liquidity because ETFs require market makers to make two-way pricing on exchange, market makers will be hedging exposures and they’ll be creating, redeeming, etc. Off the back of this, they’ll be trading futures and so forth, so ETFs definitely increase the pie rather than sucking liquidity out of the exchange.
We have two very well-developed platforms in the US and in Europe. In Asia, we have what we call manufacturing centres in Hong-Kong, Singapore, Sydney and Tokyo, which means we have locally domiciled funds with Participating Dealers who are able to create and redeem. Institutional clients can really go anywhere they want for their liquidity and we’ve spent a lot of time working with our Participating Dealers bringing this liquidity closer to clients, so we really don’t need to build out a mirror set of products in Asia-Pacific. Part of the capital markets team’s mandate is to really leverage our global platform and become as global as possible.
So potentially you could see a move towards a 24-hour trading model for the underlying primary market, for some of the US listed funds, so clients in Asia could access these funds without having to send an order overnight and wait for fill.
In terms of retail investors, that’s really the other half of the liquidity puzzle as ETFs do not live by institutional liquidity alone. We need the retail flow in there because that really drives these funds into moving them up the liquidity curve and making them trade a lot more like equities. And so in that case it’s really trying to find a product that solves a particular need or problem for our customers.
Mark Brady, Director, Capital Markets team at iShares.