Knight Capital Group’s hire of 15 exchange-traded funds traders and salespeople last month from Newedge USA, the U.S. arm of the big French derivatives and commodities brokerage, speaks to the lasting growth and popularity it sees in ETFs.
The giant market maker has seen a tidal wave of volume and liquidity in the ETF space. But they’ve also taken note of the rise of a new ETF customer base: traditional asset managers.
"We’re seeing more traditional mutual fund managers converting more into ETF format for the lower cost structure and transparency that ETFs provide," said Reginald Browne, co-head of the ETF team at Knight Equity Markets.
And converting more mutual funds into ETFs will be a lasting trend in the mutual fund industry, Browne added.
Knight isn’t the only beneficiary. Traditional asset managers’ ETF use has grown steadily over the past few years, industry execs said. They’ve been using them for quick exposure to the market and hedging.
"We’re seeing an increase in [ETF] usage among of more traditional asset managers, such as long-onlys and registered investment advisers–and it’s been steady over time," said Matt Duffy, director of U.S. ETF trading at Citi. "They use them for core holdings, beta exposure, alpha generation, various hedging strategies. Whether you’re bottom-up or top-down, they can be very useful."
Since their creation in the early 1990s, ETFs have long been popular with retail customers because of their tax advantages over mutual funds. Hedge funds and global macro funds led the institutional charge into the space.
The reasons ETFs have attracted long-only managers are the same ones that drew in hedge funds and other early adopters: their structure. ETFs are similar to index-based mutual funds, but trade on exchanges like stocks.
Also, highly-liquid ETFs offer the flexibility to get in and out of big positions during times of uncertainty. And because they’re index-based, they’re more transparent and allow for easy diversification.
"Most of them are very liquid," said Andrew Silverman, global co-head of Morgan Stanley electronic trading. "So as people need to hedge their risk, it’s immediate and it’s fast."
As an example, a traditional asset manager with money for a new account may want to be invested right away. Simultaneously, he also wants to wait two weeks to do some research on some stocks. While doing that research, he can invest the money in a value ETF and, at least, get the exposure until he has the individual stocks he wants to buy.
"ETFs generally provide market participants with very low barriers to a broad spectrum of asset classes and levels of diversification," Duffy said. "They make it really easy for anyone to attain index exposure."
But asset managers are also using ETFs for hedging. And the volatility of the past 10 months, or so, provides the proper impetus for that strategy.
Volatility leads to increased ETF trading volume. From last September through this May, ETF average monthly consolidated volume doubled from the previous nine months–December, 2007 through August, 2008–according to New York Stock Exchange data. And it jumped almost 140 percent from the same period a year earlier.
From September through May, ETF consolidated volume averaged almost 49 billion shares a month. That compared to almost 20.5 billion a month on average from the same period one year earlier.
And in the most recent nine months for which the NYSE has numbers, ETF consolidated volume on average doubled from the previous nine months–December, 2007 through August, 2008–when it averaged almost 24.4 billion shares traded.
As volatility increases, correlations across all equities tend to increase, whether stock to stock or sector to sector, Duffy said. And this lends to more ETF trading, he added.
"Single-stock correlation goes up because people start trading indices more; they need to start hedging more; they need to unwind risk more," Duffy said. "You’re not as worried about single-company exposure. You’re looking for that diversification. You’re looking for that hedge."
More institutional players can only be good for ETF volumes, according to Ira Walker, a senior portfolio manager and wealth manager at UBS who invests solely in ETFs. This is because more participation in ETFs means greater ETF volume.
"It’s like any other stock," Walker said. "If a stock is thinly traded, we would prefer to have more volume so we can trade bigger size."
