Teaching Old Dogs New ETF Tricks

As asset managers feed their hunger for exchange-traded funds, order management system providers step up their game.

Are order management systems too mature, too sedate, too underpowered to improve the buysides ever-growing hunger for exchange-traded fund transactions? Not at all, say industry observers.

Of course, no OMS provider would admit that its tools are not ready for prime time, but there are more than a few reasons why ETFs may be pushing the trading capabilities of buyside firms. First, the growth in institutional investors and asset managers trading ETFs in some form or fashion since the 2008 financial crisis has been nothing short of phenomenal. According to figures published in Greenwich Associates 2014 report, ETFs: An Evolving Toolset for U.S. Institutions, the global ETF market has grown a whopping 800 percent since 2008.

The Investment Company Institute, the buyside industry organization based in Washington, D.C, cites a 19 percent growth rate in all of the combined assets for U.S. ETFs, to the tune of $1.9 trillion in November 2014 compared to $1.6 trillion in November 2013. Although domestic equities ETFs represent the lions share of the total at $1.2 trillion, global/international equities ($434 billion), bond ETFs ($296 billion) and the modest hybrid ETFs ($3 billion) also had a good year, with each category growing approximately 22 percent, 10 percent, 113 percent and 20 percent, respectively.

This growth is not set to change. Lisa Kealy, an EMEIA wealth and asset management ETF leader at consultancy EY, foresees ETF growth continuing globally in 2015, buoyed by stable financial markets and strong equity performance.

“Barring any major market disruption, we predict growth of 10 to 15 percent in the U.S. markets, 20 to 25 percent in Europe and 25 to 30 percent in Asia,” she wrote in a recent report.

As more asset managers become familiar with ETFs, they realize that this asset class offers benefits such as an easy way to enter and exit positions and exposure to asset classes for cash equitization purposes, according to officials at State Street Global Advisors. The complex instruments offer the buyside ways to over- or under-weight market segments based on short-term outlooks; gain exposure to a difficult-to-reach market segment; increase liquidity within asset allocations without changing allocations; and increase the speed and efficiency of rebalancing across asset allocations, as well as an easy method for changing credit exposure to meet specific targets.

Kevin McPartland, principal and market structure and technology analyst at Greenwich Associates, estimates that 21 percent of U.S. institutions use ETFs in their investment strategies, compared to 11 percent who did so in 2011. He told Traders that he expects that usage to increase as investors continue to focus on management fees.

Of the 201 institutional ETF users who participated in Greenwich Associates 2014 ETF study, the report’s author, Andrew McCollum, found that 46 percent allocate 10 percent or more of their total assets in ETFs. Further, approximately 30 percent allocate from 10 percent to 25 percent of their total assets in ETFs, and approximately 20 percent allocate more than 25 percent of their assets in ETFs.

The real test for ETF traders will come during the next market shock, when some of them may have to do a redemption by buying the instruments behind the ETFs, according to McPartland. There is still a lot of unknowns in those regards. Under the current environment, it feels like ETFs will continue to grow, he told Traders.

Too Mature?

Trading ETFs is not as simple as trading a cash equity, which is the problem when seeking ETF-related trading innovations from OMS providers. Equities trading is the most mature asset class when it comes electronic trading maturity, which makes introducing innovation an uphill battle.

Additionally, buyside firms are not making large investments in their equity trading desks, according to McPartland. Of the roughly $4.5 billion that buyside firms plan to invest in their trading desks in 2015, only 12 percent will find its way to the equities trading desk. Meanwhile the lions share, 60 percent, of the budget will be spent on fixed-income trading desks. This is good news for bonds but bad news for ETFs.

McPartland attributes this allocation to the equities markets maturity in terms of electronic trading and the market-structure changes happening within the fixed-income market. “There is less tweaking and improving of equities trading systems at this stage, and the spending on them does not need to be quite as extensive as the spending on electronically traded fixed-income desks, where a lot of firms are starting from scratch, he said.

Even though ETFs trade similarly to cash equities, thats where their similarities end.

An ETF might look like a single line item, but it isn’t, McPartland said. “It is everything that underlies the ETF. In some ways, the thought process is no different than if the investor were holding a mutual fund, he said. Their transparencies are different since investors have real-time mark-to-market quotes, which mutual funds do not. Investors need to compare an ETFs derived price to the markets quoted price, and this where the complexity comes in.

Its Not Always About Trading

Rob Agne, director of the product management group at Eze Software Group, is first to admit that not many clients knock on his door asking ETF-related questions.

We support them largely with our current, configurable feature set, he told Traders. We hear chatter about fixed-income and derivative instruments much more than ETFs. This doesnt mean our clients are not trading ETFs. They certainly are.

From the trade-execution perspective, vendors like Eze Software often partner with the sellside to bring innovation into ETF trading.

We are a facilitator through which brokers can distribute their ETF-oriented algorithms, but we are not developing the proprietary logic ourselves, said Agne, adding that ETFs depth and dimension outside the trading environment has necessitated some growth in OMS platforms.

Where OMS providers can help their ETF-trading clients is through improved compliance offerings and tighter integration with back-office reporting systems. This will keep clients from running afoul of the Investment Company Act of 1940, Agne suggests.

“We are aware that clients have ownership concerns around these dimensions of ETFs,” he said. “Particularly when users have large positions on their books, they need to be aware of their percentage of ownership, for example, in certain issuers or regions.”

Eze Software clients can use Eze OMS’ basket-trading and compliance capabilities to create an accurate, real-time aggregate view of the issuers they possess by examining the “rolled up” instruments as well as the basket of securities underneath them. As a result, the platform can notify clients at the point of trade entry if they are about to breach an important threshold.

In addition to regulatory requirements, firms are also monitoring limits from their own investors, according to Agne: “We have a robust set of rule libraries, which we continue to extend, that help facilitate this look-through analysis from a regulatory and compliance stance.”

Eze Software also includes the libraries with the execution and portfolio management components of its buyside product suite.

The vendor has additional modules that users can layer on top of the OMS as their trading become more sophisticated and their reporting obligations become more complex.

Another aspect that Eze Software has been working on continuously for the past few years is improving the integration among its front-, middle- and back-office platforms. Such integration is already paying off for Eze OMS users trading ETFs in back-office situations, according to Ange. Clients can use the platforms programmatic interface to create and then populate benchmark tables with ETF-trading data that will help clients better understand the ratings of their ETFs.

Eze Software is also working to further automate its OMS report manager feature. Eventually, Ange would like to have it capable of automatically filing a firms Form PF and CPO-PQR reports.