Attributed to Mark Johnson, head of iShares UK
While historically insurers have only used ETFs when they want to achieve specific tactical objectives, they have gradually begun to apply these vehicles to accomplish more strategic ends. Given the large size of insurers’ holdings, the liquidity, low cost and tradability features of ETFs ensure that they can often be the vehicle of choice. For example, insurers can use ETFs to manage cash flow and liquidity, implement a diversified asset allocation strategy or minimise investment costs.
Traditionally, insurers have found ETFs useful for managing cash flow and portfolio liquidity. When faced with an unanticipated claim, non-life insurers might not wish to disinvest and modify their core asset allocation. If cashflows in and out of the portfolio are large and frequent, substantial transaction costs associated with the bid/ask spread of trading individual positions can be incurred. To avoid disrupting the portfolio’s positioning and extra transaction costs, insurers may choose to put in place a liquidity sleeve. A sleeve is a part of a portfolio where the core asset allocation is replicated with liquid instruments, such as ETFs. This can be used as a buffer to absorb cashflow, rebalance the portfolio back in line with its targeted asset allocation and pay any unanticipated claims. In addition, a liquidity sleeve of ETFs can enhance the ability of institutional funds to implement large trades at a ‘fair’ price in difficult market conditions. This ability can be particularly attractive in asset classes such as the Over-The-Counter (OTC) fixed income market. For example, during times of extreme market stress, such as in 2008, corporate bond ETFs were in demand as investors were attracted to their on-exchange liquidity.
Many insurers use ETFs to implement dynamic asset allocation. Typically, European insurers had limited international diversification outside domestic equity and fixed income markets. However, the breadth and depth of the ETF marketplace enables these investors to enhance their asset allocation strategies using these vehicles. For example, in a low yield environment and volatile market conditions, there is a strong incentive to approach fixed income with a more flexible strategy than the traditional ‘buy & hold’ approach. Dynamic asset allocation can be implemented using the fixed income ETF offering available across different sectors, duration and quality exposures. Currently, given that nominal rates are at near all-time lows, short duration ETFs can be an attractive option for insurers seeking to protect their portfolios against any further increases in yields.
Insurers are also increasingly using ETFs for obtaining shorter-term beta exposure. Being out of the market even for short periods can mean a performance shortfall in times of rising markets. ETFs can help fund managers offset the negative impact on performance of unexpected cash inflows by providing instant exposure to a specific index. This allows them the time to research appropriate investment ideas by reducing the risk to their performance figures of sitting in too much cash. Although other instruments can be used for cash equitisation, ETFs are operationally efficient being funded and intra-day traded.
Furthermore, ETFs can be used to implement asset allocation adjustments. Asset class weights are fixed regularly, but there is often some flexibility versus the targeted allocation. Asset class weights may be allowed to fluctuate within a set band of plus or minus x% of the target. This enables fund managers to position investments to capitalise on short to medium term beta opportunities. The low cost and operational simplicity of ETFs ensures that they can be used to take advantage of these opportunities.
Insurers need to consider a number of variables when comparing the investment costs of ETFs with other beta vehicles. It is not sufficient to focus solely on an index fund’s Management Fee (MF), or an ETF’s Total Expense Ratio (TER). For example, the on-exchange liquidity of an ETF can lead to its entry/exit costs (spreads) on the secondary market being lower than the entry/exit costs of the underlying securities in the primary market. Index funds operate in the primary market, but their higher entry/exit costs compared to ETFs can be partly offset by lower holding costs (e.g. MFs). In general, if an insurers holding period is shorter than a certain length of time, the savings generated by an ETF’s lower trading costs can outweigh the savings made by the lower holdings costs of an index fund.
To summarise, the liquidity, tradability and low cost structure of ETFs can greatly contribute to the management of insurers’ investments. They are highly efficient tools for both implementing strategic allocation, and engaging in efficient portfolio management functions. Having already gained traction with institutional fund managers, ETFs are now also playing an increasingly important role in the design and implementation of insurers’ portfolios.
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