Despite the phenomenal rise in ETF adoption over the past few years, they still account for a relatively small portion of pension funds’ portfolios. As a recent survey by TrackInsight confirms, ETFs have room to grow with these institutional investors as they fit well with the dual nature of their mandate: meeting short-term liabilities while maximising long-term returns. 

Despite the phenomenal rise in ETF adoption over the past few years, they still account for a relatively small portion of pension funds’ portfolios. As a recent survey by TrackInsight confirms, ETFs have room to grow with these institutional investors as they fit well with the dual nature of their mandate: meeting short-term liabilities while maximising long-term returns. 

In this context, the recent TrackInsight Global ETF Survey shed some interesting light on the behaviour of professional investors in ETFs around the world, including pension funds. 

Though the number of pension fund respondents was quite low the data we gathered, combined with our own insights gained from conversations with pension funds and others in the ecosystem, indicates there are some key differences in how pension funds tend to use ETFs right now, compared to the wider group of professional investors.

Short-Term rather than Long-Term Holdings
While the majority of other professional investors use ETFs for long-term strategies, what pension funds really seem to value in ETFs is the wrapper’s tradability, tending to favour short-term uses.

In particular, they use ETFs for tactical asset allocation – a dynamic strategy shifting the portfolio’s exposure as market conditions change. Because ETFs offer a low-cost, quick and easy way to get in and out of an asset class or a market segment, they are ideal building blocks for adjusting a portfolio’s asset allocation. 

This has become even easier to do effectively as the number of ETFs has risen rapidly in recent years, from fewer than 800 ETFs in Europe in 2010 to over 2,600 today. Products now cover a wide range of sectors, countries, risk factors and other thematic investments, allowing for an almost infinite number of portfolio configurations.

Pension funds also often use ETFs for liquidity management. This comes as no surprise as ETFs’ enhanced liquidity makes them a perfect instrument to help pension funds meet their cash flow requirements. 

Most common uses of ETFs

Last but not least, as with other professional investors, pension funds use ETFs in their strategic asset allocation. Not only are ETFs cheap to hold, all the evidence shows that they also outperform their active counterparts in the long run, especially in the large-cap segment. This, in particular, should encourage pension funds to increase their adoption of ETFs in the future. 

Sophisticated Selection Metrics for Sophisticated Investors
We find that two metrics stand out for pension funds when selecting ETFs: tracking difference and tracking error.

Tracking difference is the cumulative performance gap between an ETF and its underlying index over a given period of time. It encompasses the ETF’s total expense ratio as well as other sources of replication discrepancy and helps pension funds measure to what extent their portfolio fulfills their long-term return objective. 

In order to get a better picture of the overall cost of their investment, sophisticated investors such as pension funds consider the total cost of ownership rather than total expense ratio. Our research suggests that both tracking difference and total cost of ownership are more important to pension funds than total expense ratio.

Tracking error measures the volatility of the daily excess return of the ETF versus its benchmark. This metric is critical when pension funds make tactical bets using ETFs or when they need to sell them quickly to meet cash-flow requirements. According to results from our survey, tracking error is a major point of attention for pension funds in their ETF selection, while it is not for the rest of professional investors. This can be explained by their increased focus on the use of ETFs in dynamic asset allocation.

Smart-Beta and Risk-Based ETFs are Sought After
Even though ETFs currently represent a minor allocation in pension funds’ portfolios, this proportion is likely to grow. Indeed, the majority of the pension funds we spoke to plan to increase their allocation to ETFs from 5% to 20% in the next few years. 

Unlike other investors, where demand is for a broader range of ESG and thematic funds, it appears that most of pension funds’ future flows would be directed towards smart beta and risk-based ETFs. These funds are expected to suffer lower drawdowns than market-cap weighted products in the event of a market sell-off.

“Risk-based strategies seek to avoid bear markets that can prove fatal to investors who solely focus on static portfolio diversification, potentially leading to unacceptable levels of loss” said Philippe Malaise, the chairman of Koris International, a quantitative institutional investment advisory firm. These strategies rely on a quantitative, dynamic and systematic approach centred on the notion of extreme risk, which makes them particularly attractive to pension funds constrained by short-term liabilities. 

“Pension funds also often use ETFs for liquidity management. This comes as no surprise as ETFs’ enhanced liquidity makes them a perfect instrument to help pension funds meet their cash flow requirements”

Although these strategies can be implemented with vanilla ETFs through an active mandate, the development of a wider range of risk-based ETFs could provide easier access to these strategies for pension funds. 

Room for Growth
It is clear that ETFs still have room to grow in pension funds’ portfolio allocations. As the industry matures, ETFs are becoming more and more attractive to pension funds, with tactical asset allocation and liquidity management being the primary focus today. The development of smart beta as well as risk-based ETFs could be the catalyst that sparks a broader use of these investment vehicles by pension funds, leading to a greater allocation in their portfolios, in particular as part of their strategic long-term asset allocation.