22 April 2022
Comment: The future of ETF use - lessons from the past
Channels: Risk, SAA/ALM, USA focus
Companies: Bridgeway Analytics
People: Amnon Levy
Since the financial crisis and the advent of low interest rates, insurers have adopted a broad set of investment strategies that include increased exposure to higher yielding private credit, and more active management of their liquid portfolios. ETFs facilitate this latter opportunity, with their use increasing noticeably over the last several years, as highlighted in ETFs in Insurance General Accounts – 2021.
Favorable regulatory and accounting treatment, and general familiarity with the asset class has had insurers incorporate ETFs into various parts of their evolving investment mandates. ETFs are often used as low-cost vehicles allowing for immediate market exposure and yield generation, essentially liquidity sleeves that get whittled down as insurers' asset managers invest available funds. Their use in tactical asset allocation is less common, in part, limited by fixed income ETFs being generic; BondBloxx only recently introduced industry segmented fixed income ETFs to the market. Whether industry or other segmentation taxonomies, the liquid nature of ETFs allow for tactical rotation, rebalancing and overweighting higher yielding or higher total return segments.
Why it pays to lend ETFs finds securities lending is an increasingly popular ETF income generating strategy, that can produce north of 50-100 bps of additional income for some ETFs and varies with the market environment.
Securities lending has a complicated history with the insurance industry. AIG's poorly managed, and high risk, lending program was partly responsible for the Federal Reserve's need to step in during the financial crisis. With subsequent revisions to reporting and regulatory standards, the NAIC now views securities lending as a potential low-risk investment strategy in its Securities Lending Primer and an effective way to obtain additional yield income.
There are natural questions regarding liquidity of corporate bond ETFs, and their use in securities lending, acknowledging the illiquid nature of the underlying bonds. Fixed income ETFs trade on stock exchanges, and generally exhibit bid-ask spreads that are much tighter than the underlying bonds, with larger AUM ETFs exhibiting spreads that are orders of magnitude tighter. Meanwhile fixed income ETF premia or discounts relative to their NAV are often cited as evidence of their illiquidity. Blackrock's paper, Lessons from COVID-19: ETFs as a Source of Stability highlights those premia and discounts are more related to illiquidity of the underlying bonds and uses March of 2020 to highlight market dynamics and the price discovery process.
The paper describes investors as having sold ultra-short and floating-rate fixed income exposures to raise cash, leading to a reduction in liquidity and bond prices.
The largest US floating rate bond ETF closed at a discount to its net asset value (NAV) on multiple days, hitting 8% on 8 March. The paper argues the price of the ETF that was heavily traded on the exchange, better reflected the floating-rate note market; many of the underlying bonds had not been traded, resulting in the NAV not representing market conditions. The fund was acting as a price discovery vehicle.
The insurance industry is expected to continue with expanding its use of ETFs given its ongoing need for increasingly efficient investment vehicles. By some measures, ETF use is at its infancy, accounting for under 1% of industry holdings. If history is any indication of what the future has in store, expanding use is generally accompanied with innovation, which should be approached mindfully. So far that seems to be the case. Leveraged ETFs, for example, designed to deliver returns that are multiples (e.g., 2x or -2x) of an index (e.g., S&P 500), often using leverage and derivatives, have not been embraced by the industry, with the NAIC and state insurance regulators limiting their use through appropriate accounting and capital treatment.
Written by Amnon Levy, CEO at Bridgeway Analytics.