The relentless growth of passive investing in general, and ETFs in particular, has been extensively discussed on the pages over the past few years, most recently overnight when we presented a note from Convergex which laid out some ideas how investors can profit from the unstoppable - for now - shift from active, and expensive, management to cheaper, passive forms of asset allocation. Others, such as One River's Eric Peters have a decidedly more downbeat outlook on what the creeping growth of ETFs means for capital markets and price formation, warning that “there is no such thing as price discovery in index investing. And there will be no price discovery on the downside either. The stocks that have been blindly bought on the way up will be blindly sold."
That simplified analysis touches on the biggest threat facing ETF investors: namely "phantom liquidity" of what has effectively become the market's biggest quasi-derivative product. In a nutshell, the threat here is that what is traditionally considered to be the market's most liquid instrument, would be unable to satisfy a massive redemption wave due to a huge liquidity mismatch between the synthetic product, the ETF itself, and its underlying instruments, particularly in various types of debt ETFs.
The most comprehensive take on that particular concern remains Howard Marks' letter from March 2015, dubbed simply enough "Liquidity", and which parses all the various nuances of how ETF liquidity would disappear in an instant should a wholesale "risk off" event occur:
ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity?
As Marks explained, most don't (we urge readers who may not have read it to skim Marks' piece), despite some very painful events such as the August 2015 ETFlash crash (which took place after Marks' warning) and numerous subsequent bond ETF mini crashes, especially in the junk bond space. For now, these events have been seen as outliers by the professional investing community, and as a result, there has been a continued flood of capital out of active managed venues into ETFs.
Which brings us to a comprehensive, 66-page report released overnight by Deutsche Bank titled "The 2016 Guide to Institutional ETF Ownership" which shows that, not surprisingly, capital continues to shift into ETFs, not just from retail investors whose seemingly endless appetite for ETFs is no secret, but for virtually every institutional asset manager. As author Sebastian Mercado writes:
Institutional ETF assets grew by $213bn and reached $1.44 trillion in 2016: As of the end of 2016, almost 3,500 institutional investors held more than $1.44 trillion in ETF assets accounting for about 59% of all ETF assets. Investment Adviser remained as the dominant group with $813bn representing 33% of all ETF assets. Meanwhile, Private Bank/Wealth Management followed in a strong second place with $372bn in ETF assets or 15% of total assets.
Why the rush into ETFs among institutions? Because as DB explains "from an ETF user perspective we see investment advisers, and private banks/WM as asset allocator investors, brokers and hedge funds as liquidity seekers, and insurance companies, pension funds, and mutual funds as need-based users."
And while the entire report is a must read for anyone obsessed by the "passive" revolution, what caught our attention was the dramatic upswing in ETF usage by those who are most vehemently opposed to passive investing: hedge funds themselves. To wit: "Hedge Funds recorded the strongest relative growth in assets with a 77% from a year ago." However, virtually every other institutional class saw an uptick in ETF usage with the exception of pure-play brokers:
Similarly, Insurance Companies and Mutual Funds also recorded strong relative asset growth with a 43% and 38% increase from 2015, respectively. On the other hand, Pension Funds were practically flat on growth, and Brokers saw the only decline (-4%) which is consistent with an effort from Banks to free up balance sheet on the back of recent regulation regarding capital requirements.
Some more details from DB:
From a historical ownership perspective, Investment Advisers have steadily gained ETF ownership market share for most of the last 14 years. Private Bank/ WM have seen a similar trend of market share gain, but faced a small set back in 2016. Meanwhile, Brokers have been yielding market share steadily since 2007 which is consistent with our previous findings 2 that ETF assets are mostly held by investors increasingly using ETFs for asset allocation purposes. Outside these three major groups of investors, we highlight the sustained market share gains of Mutual Funds and Insurance Companies, and last year's significant rebound for Hedge Funds; while Pension Funds have recently slowed down in their usage of ETFs relative to the other minor groups.
As per historical growth trends, ETF assets held by institutions and the number of products used by them have both grown more than 7 and 8 times in the last 10 years, respectively. Similarly, the number of different institutional investors using ETFs has almost double during the same period.
While hedge fund usage of ETFs has surged in relative terms, however, in absolute nominal amounts it remains relatively modest compared to the other biggest holders of ETFs. According to DB, the top institutional ETF users by assets held mostly belong to the Investment Adviser and Private Banking groups, with some large Brokers making the top 20 also. Overall, institutional ETF assets are highly concentrated with the top 20 owners accounting for 40% of the institutional ETF assets, and the top 250 institutions accounting for about 80% of those assets.
As the charts below show, leaving Brokers aside, Pension Fund and Insurance Company have the largest ETF allocations per institution; while Hedge Fund has the smallest ETF asset allocation per institution
So going back to the one most notable result that emerged from this report, namely the disproportionate increase in Hedge Fund allocation to ETFs, Deutsche Bank confirms that "recent ETF ownership data suggest that more and more hedge funds are finding value in using ETFs."
Why the dramatic jump of 77% in allocation to ETFs among the 2 and 20 community? DB responds: "our data suggest that hedge funds use ETFs for gaining quick and efficient asset class access both on the long and short side, similar to futures contracts." This confirms a long-running observation: for all intents and purposes, ETFs are now merely traded as derivativs by the HF community, with no regard for their disconnect to the underlying, a disconnect that is the biggest red warning, not only in theory - as per Howard Marks - but in practice, as the market "anomaly" August 2015 showed.
Readers may find it ironic that the one instrument considered "liquid" would, and has, become the most illiquid one during the next market "event", however that is the topic of another post, so we continue with DB's findings:
In addition, some can hold ETFs for very long periods (>1 year), while many others may hold them for less than 1 day. Nevertheless, the main requirement is enough liquidity (on the long and short side) and size to be able to execute large trades without major market impact, particularly on those asset classes that may be harder to access. Cost is usually not the main criteria for product selection. Finally, the presence of highly liquid products among the top 30 covering diverse asset classes such as equities, fixed income, and commodities supports these views. Particularly, high positions in Gold, Gold miners, High Yield Credit, EM countries, sectors and industries further confirm the efficient access product thesis."
While for now the jury is out on how systematically risky ETFs are/will be during the next market crash, here is the answer to the question which are the Top 20 hedge funds by ETF assets. In top spot, perhaps not surprisingly, is the world's biggest hedge fund Bridgewater, with some $8.7 billion of its holdings in ETFs.
And a follow up chart: the top 30 ETF owned by hedge funds.