Exchange-traded funds are having a moment. ETFs have achieved significant growth over the past decade and the number of ETF sponsors, ETF listings, and ETF assets under management have exploded. There are nearly 1,500 such products that trade in the U.S. markets alone, more than 200 associated sponsors, and global ETF assets approached the $2 trillion mark in 2014.
Despite these impressive numbers, when compared to other asset classes and investment vehicles, ETFs are still treated like the new kids on the block.
This shouldnt be the case. Institutional investors often look for products that are liquid, transparent and flexible, and these qualities are often associated with ETFs. Pensions, endowments, hedge funds, and other institutions which were once using ETFs solely for cash equitization, liquidity management, transition management, and hedging are now using them for increasingly strategic purposes with longer holding periods and tool to gain tactical active exposures. Investment advisors are also expanding their use of ETFs in order to satisfy their clients thirst for lower costs and access to exposures previously unattainable.
While most other asset classes have technology platforms and workflows refined after decades of existence, ETFs are still the youngest child who gets hand-me-down toys. Standalone data platforms originally built to assist in the evaluation of mutual funds have shoehorned ETFs into their universe. Most of the electronic trading platforms, even those with multi-asset support, still give ETFs the plain-vanilla equity treatment. The ETF trade lifecycle is in some ways uniquely different from other investment products and, therefore, warrants commitment from serious ETF market participants if the market is expected to continue growing.
ETFs are a distinctive asset class and using the same tools and methodologies of other, more traditional products will not work to the advantage of investors. This is especially true when it comes to the habits, tools and processes associated with ETFs, including establishing investment plans, product selection, trade execution and settlement. Simply slapping on an order/execution management system that was designed for equities or futures wont cut it any longer.
Some ETF Pain Points
Let’s take a look at the trade lifecycle of a typical exchange-traded fund, including some common pain points.
Step 1: Portfolio Management Strategy Development. Some of the ways that ETFs can be put to use by institutional investors are relatively simple. Other strategies can be more complex and many investors will consult one or more of their partners, advisors, or brokers for advice on how to best execute their investment strategy or thesis using ETFs.
Step 2: ETF Product Selection. Asset managers should have a robust and integrated workflow to be able to easily navigate the universe of ETFs and evaluate their structure, implied exposures, liquidity, and costs.
Step 3: Trade Execution Profiling. High-level trade profiling of how the asset manager is going to gain access to the ETF market and the trade horizon will have a significant impact on how ETFs will be utilized in the portfolio strategy.
Step 4: Pre-Trade Analysis. Determining an appropriate performance benchmark for portfolio execution will help guide decisions and analyze how to put on a trade.
Step 5: Trade Implementation Planning. Brokers and vendors are expanding the suite of products to include tools for dynamically managing and hedging ETF trading and meet or exceed their execution benchmarks. They also provide insight into ETF liquidity, how to limit costs, and avoid impact.
Step 6: Trade Execution and Management. When trading in the listed markets, ETFs are typically characterized by narrower spreads, lower volatility levels, smaller order sizes, and lower price impact costs than stocks. While algorithmic trading tools are the most common way to execute ETFs that exhibit high liquidity profiles, low liquidity ETFs require more consideration.
Step 7: Post-trade Analysis. Evaluating the implicit costs of an ETF transaction can be complicated. A trader needs to consider the impact costs on the ETF and its underlying components and the opportunity costs of trading the ETF instead of the underlying components.
Step 8: Settlement. After the trade is made, procedures for ETF settlement are typically not too different from plain-vanilla equities. That said, the operational costs and risks associated with trading OTC with an ETF market maker performing an ETF creation/redemption go up.
ETFs have already undermined traditional distribution models and reshaped the investment industry in myriad ways. Going forward, there will be more sponsors, more users, more solutions providers, and more penetration by ETFs in the worldwide market for managed assets. Now might be a good time for buyside firms and broker dealers to review related workflows and tools in order to best handle this dynamic and growing asset class.
Spencer Mindlin is a research analyst for Aite Group where he focuses on financial IT.
