Institutional interest in exchange traded funds (ETFs) has risen significantly in the last few years and is being driven by trader demand, says BlackRock’s Samara Cohen.
Speaking to The TRADE, Cohen suggested that portfolio managers were increasingly turning to ETFs as a result of demand from traders to add fixed income exposure, create cash management sleeves or replace derivatives.
According to research published by BlackRock in October, fixed income ETFs, in particular, have seen a large increase, with assets to date now topping $1.7 trillion globally.
“We have seen uptake in fixed income ETFs by institutional investors who are looking to add fixed income exposures based on characteristics like credit quality or duration or things that they can capture at the index level, which gives them the ability then to focus a lot of their time and attention on single securities in sectors where they have the highest conviction,” said Cohen.
She added that many institutions had discovered ETFs through the options market and were increasingly using them as derivatives replacements in their long and short portfolios with meaningful options ecosystems developing around certain fixed-income ETFs. In the first quarter of this year, average daily volume for fixed income ETF index options was $5 billion, according to research conducted by BlackRock.
This is a long-term ongoing trend and Cohen highlighted Blackrock’s US-listed ETF – ticker EWU – as an example. In the few weeks prior to the UK’s Brexit referendum in 2016, options on EWU increased by 1800% in open interest as many participants viewed it as an opportunity to place non-linear views on what might happen on 24 June 2016, bringing many of them into the ETF market for the first time.
“There is a very deep and liquid market in interest rate options both in futures and swaps, but there haven’t been very deep liquid markets in options on corporate credit, and so both in EMEA and in US ETFs have been really the first vehicle to create sizeable interest in index- level fixed-income credit volatility strategies,” Cohen said.
The uptake in institutional interest in fixed income ETFs has had a more general market impact on market structure and technology development, adds Cohen. For market structure in particular she highlighted how ETFs had begun offering a bridge between fixed income markets and on-exchange trading.
“This exchange-traded layer of fixed-income exposures provides a pricing reference point that improves the tradability and velocity of the underlying market, so what is very interesting to market structure junkies like myself, but also traders, is how these levels of market structure co-exist and support each other,” she said.
According to Cohen, the uptake in interest in ETFs by banks and broker dealers sparked by the Covid market volatility has also led to an injection of investment into systems that didn’t previously hold much value in the market.
Over the last few years, banks have shifted towards principal and agency trading with increased use of electronic trading and all-to-all platforms, which has created a breeding ground for index or basket-based financial instruments.
“Algorithmic pricing systems that price multiple line items of bonds aren’t something that historically have had a very high place on tech budgets, which were previously more focused on data science around equity businesses. But bringing that to their bond businesses initially to support ETF market making has opened up a whole new avenue of business for them which they call portfolio trading,” said Cohen.
Outside of the fixed-income markets, Cohen also pointed towards institutional adoption of ETFs because of their abilities to create a cash management sleeve whereby participants can equitise cash using an ETF and avoid “cash drag”.
ETFs have evolved significantly over the last few years, moving away from the standard market cap-weighted index tracker to more factor-based strategies, ESG overlays and even actively managed and non-transparent ETFs in the US.
The TRADE did a recent deep dive into the market’s uptake in active ETFs, finding that due to regulation, among other factors, Europe had a way to go before they garnered the attention they have gained in the US. According to data published by FactSet, 2020 was the first year that there were more active ETFs launched in the US than passive ones that simply track an index.
As a changing force in the market, Cohen warned that the index-based segment of the market is now less predictable and therefore something that all participants should understand from a strategic point of view.
“It has become much more strategic to understand and be predictive around index flows in the market, which we have to do on our side to ensure that we have adequate liquidity when we come to trade the re balance. The various liquidity providers to index funds will look to index flows to figure out where they want to trade those dynamics that I think are increasingly discussed in the market,” concluded Cohen.