Institutional investors are flocking to new kinds of low-cost ETFs

Consumers have piled into exchange traded funds, and institutional investors are following suit, with growing numbers buying hybrid “smart beta” funds

Stock market traders

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There is a dramatic shift happening in the way institutional investors manage money and the average investor would be wise to take notice.

According to a new report by Greenwich Associates institutional investors are integrating exchange traded funds into their portfolios at a frenzied pace. In Canada, 28% of institutional investors plan to increase their ETF holdings over the next year. This is part of a global trend towards ETFs as the limitations of these products falls by the wayside.

There are three main drivers for this shift and they are just as relevant to the average investor as they are to large institutions: ETFs are low-cost, effective and easy to use. In fact, 85% of institutional investors cite ease-of-use as the main reason why they are using ETFs more.

This shift will continue to fuel the explosive growth in ETFs. Over the past 10 years Canadian investors have increased their assets in ETFs from $15.1 billion in ETFs at the end of 2006 to an estimated at $120 billion, according to report from the Canadian Exchange Traded Funds Association. That’s a whopping 22% annual growth rate for the past 10 years. By 2021 BMO estimates the Canadian ETF industry will grow to $250 billion.

Smart beta ETFs

But it’s not just your typical index-mimicking ETF that’s attracting the attention. A new breed of products, dubbed smart beta (which blend active and passive investment strategies), is gaining popularity and it will change the way some investors view ETFs. Nearly a third of institutional investors responding to the survey say they are using them. Of those who are, more than half plan to increase allocations to them in the next year.

“Use of newer types of ETFs like smart beta ETFs are something retail investors should look at,” says Collier. The market is changing so quickly that several types of smart beta ETFs weren’t even on the radar for institutional investors during the last annual study, now half of institutions are using them.

Why institutional investors are shifting to fixed income ETFs

Bond ETFs are another popular vehicle for institutional investors. The report found that 25% plan to put more into fixed-income ETFs. The transition to fixed-income ETFs has been significant. Ten years ago there was a mere $1.7 billion in bond and preferred share ETFs; today that figure tops $37 billion. The current economic environment is only accelerating this trend.

“Liquidity in bonds has gone down a lot, and the cost of getting access to bonds has gone up, so you see institutions using ETFs to get exposure to their bonds instead of individual bonds,” explains Collier, who adds these same pressures apply equally to average investors.

Retail investors haven’t got the message

Yet, many retail investors continue to embrace mutual funds. The Investment Funds Institute of Canada estimates there’s $1.3 trillion assets under management in mutual funds. Why? John De Goey, a portfolio manager with Industrial Alliance Securities, believes embedded commissions in mutual funds are a major factor.

“There’s a very strong preference for advisors, especially among the 90% that tend to be MFDA registrants or bank employees, to prefer to use products that pay in embedded commission. And ETFs generally do not pay in embedded commissions,” he explains.

Many of the advisors retail investors use are only licensed to sell mutual funds, he adds.

This article originally appeared at MoneySense.