Institutions Changing Styles

On the equities side, institutions typically represent anywhere from a quarter to a third of iShares’ ownership, according to estimates. In the past, mutual funds seem to be the predominant institutional player. That seems to be staying rather steady. But as with iShares, other fund families are seeing institutions using ETFs in more varied ways these days.

“I’m not sure we’re seeing wildly innovative ways of institutions using ETFs. But we’re seeing institutional investors more prominently using certain tactical strategies with ETFs,” said Melissa Nassar, who’s in charge of Vanguard’s adviser and institutional marketing operations.

One of those is so-called "pair trading." That’s where someone will buy or sell more than one ETF at a time to get extremely precise market exposure. For example, if investors feel strongly that stocks will continue to rally but financials are overbought, they might short the Vanguard Financials ETF (NYSE: VFH). At the same time, they could go long through the Vanguard Total Stock Market ETF (NYSE: VTI).

“It’s a strategy that’s harder to do with mutual funds. In some ways, it’s nearly impossible,” said Nessar. “With mutual funds, even if they pair traded all on the long side, there’s just a lot more redemption fees and policies that makes it far more burdensome for an institutional investor from an administrative and regulatory view.”

Blurring Of The Lines

It’s important to note that Nassar, Fuhr and Kelly never broached the subject of mergers and acquisitions within the industry. These interviews, in fact, were part of ongoing discussions I’ve been having with different key executives in the industry over the past several months. My intention was to get a feel of what’s happening in terms of the general complexion of the ETF marketplace – not to address the more recent BGI mega-deal rumors.

But as I’ve grappled to comprehend what a horrific bear market and simultaneous credit meltdown might mean for the future of ETFs, the growing number of warnings about how a BGI merger could have monolithic implications to investors seemed to ring false.

Consolidation has been a foregone conclusion in the ETF industry for years. But the growing interplay between institutional and retail investors seems fundamental in shaping the course of how sponsors design and service their new product lines.

In many respects, it’s not where any new owner comes from – active, institutional or retail. More to the point is how quickly they come to realize the degree of convergence taking place in the ETF marketplace now.

“At this point, the lines between institutional and retail uses of ETFs are to a great extent rather artificial,” said Rob Arnott, founder and chairman of Research Affiliates.

He points to a rising number of independent advisers who invest in big blocks like institutions but serve high net worth individuals. That’s skewering traditional ways of analyzing fund flow data.

“For example, the biggest use of ETFs by far comes in taxable accounts. So if a dividing line of taxable vs. tax-exempt is used to define activity, it would seem to indicate that institutions are more involved in the ETF market,” said Arnott.

The tax efficiency of ETFs, though, opens new avenues for retail investors and their advisers. “Retail mutual fund investors typically shy away from taxable accounts,” said Arnott. “But with more advisers warming to the tax-efficient structure of ETFs, an argument can also be made that more of that increased taxable investing is coming from individuals – not just big endowments and other institutions.”

As the industry grows in popularity, he adds, “the lines are blurring between institutional and retail uses of ETFs and the companies that serve those investors.”

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