Raghu Ramachandran, Head of Insurance Asset Channel, S&P Dow Jones Indices

We know that there is $37tr in US institutional assets. But the question is, how do institutions use Exchange Traded Funds (ETFs)?

Because, frankly, not a lot of institutions know how or when they can be using them.

Regarding this $37tr, there is $8tr in corporate DC, another bit in DB, IRAs account for the same amount combined, public DB and not for profit DC as well, with a little over $7tr in insurance. For the last six years S&P has been publishing a report on ETF usage by insurance companies. Insurance companies are institutional investors and there is an institutional process that goes into asset allocation. Insurance companies have a strict set of regulations that control how they make investments and have traditionally been very conservative in how they invest their assets.

"If we look at the percentage of assets that are invested in ETFs, small companies tend to have more, whereas larger companies have very little"

Therefore, if ETFs are seen as important in insurance strategies, then it is certainly something more institutional investors can find value in when assessing their asset classes. As of year-end 2020, insurance companies had invested $37bn, growing from an initial investment of $5bn back in 2004. What is surprising, is how consistent this growth has been. Insurance companies have been consistently doubling their ETF usage over the last 14 years.

If we look at the percentage of assets that are invested in ETFs, small companies tend to have more, whereas larger companies have very little. Assets have grown consistently over the past several years; for smaller companies’ usage of ETFs has grown from 10% to 30%, 20% of medium companies used to invest in them but now we are at 50%, large companies started out at 20% to now reach 50%. The most interesting development is the mega companies, where about 50% have always invested in ETFs, but this number has not grown.

In terms of the types of ETFs that insurance companies are using, we see that equities outperform fixed income. Equities came into effect because they are a beta substitution, so instead of having equity portfolios that need to be actively managed, companies switched to a passive ETF vehicle, and this growth has been consistent. Over the past six years, the predominant use of active ETFs have been in active fixed income.

"For an institutional investor, this shows that if liquidity is needed at any point, they can write a billion-dollar ticket in one ETF, in order to reposition the portfolio"

Initially, insurance companies were using ETFs because it was easy for them to manage the regulatory hurdles. As this constraint was released, we saw fixed income start increasing. Culminating in 2019 when there were more fixed income ETFs than equity ETFs traded by insurance companies. This was compounded by crises, as the best place to find liquidity in the fixed income market has been in the ETF market. We see that when markets go haywire, the liquidity in ETFs increases relative to the underlying market.

For an institutional investor, this shows that if liquidity is needed at any point, they can write a billion-dollar ticket in one ETF, in order to reposition the portfolio. This is very attractive for an institutional investor, to be able to facilitate this kind of movement in these assets.

"Insurance companies are a source of liquidity for the ETF market, but the ETF market is also a source of liquidity for insurance companies, and we see this mostly in fixed income ETFs"

For example, in March 2020, the economy started shutting down and no one was sure if the Federal Reserve would accept ETFs as part of the collateral pool. As people started trading ETFs at a discount, insurance companies were buying them. Insurers were taking advantage of the fact that they could place money at a time when they could not have possibly done a $300m trade in the bond market. We watched as they were able to place security and get access to it right away. For the ETF market, this is also advantageous because it showcases the large institutional players who will come in and provide liquidity to the market.

If we look at the first quarter of 2021, we see that for ETF A, $10bn came out of this ETF, but insurance companies added a billion dollars into it. Insurance companies are a source of liquidity for the ETF market, but the ETF market is also a source of liquidity for insurance companies, and we see this mostly in fixed income ETFs.

When institutions do use ETFs, they trade more than we assumed. Insurance companies are traditionally seen as ‘buy and hold’ investors, however as this paper has shown, they are actively trading ETFs with the desire to get liquidity when they need it. To manage their positions by increasing or decreasing in a particular beta. Insurance companies are also using ETFs systematically, holding their positions where the AUM has grown consistently.

"Not only do institutions take advantage of the liquidity in the ETF market, but in doing so, insurance companies are also adding liquidity to the ETF markets"

What is particularly attractive for the mega companies in the case of ETFs, is that the market can support their trading demands. Unlike the fixed income market, which completely dried up in the first quarter of 2020, the ETF market performed perfectly well throughout. This is not just in the first quarter of 2020; we have seen over and over again that when markets get disrupted people go where there is liquidity, and the best place for liquidity, insurance companies have found, is in the ETF market.

Not only do institutions take advantage of the liquidity in the ETF market, but in doing so, insurance companies are also adding liquidity to the ETF markets. This reciprocal benefit to both institutions has seen institutions supporting the ETF market and the ETF market supporting institutions in managing their portfolio.

This analysis appears in full in Clear Path Analysis’s report Fund Technology, Data & Operations, North America. To read the report in full, please click here.

 

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