Book Review: The Institutional ETF Toolbox
ETFs are taking over the world. Last year, according to ETFGI, a research firm, ETF net inflows were $372 billion, representing 10% growth versus 2014. Today, ETF assets stand at ~$3 trillion, a figure that is slightly larger than the entire hedge fund industry. While mutual funds are still out in front, with ~16 trillion in assets, the balance of power is changing rapidly.
There are good reasons for these trends. ETFs provide a host of advantages (e.g., tax-efficiency, transparency, and lower-costs) when compared to alternatives, and these advantages accrue to anyone, from the smallest retail investor, to the largest institutional behemoth.
Given the tiny allocations institutions currently make to ETFs, it seems that these investors either 1) don’t care about ETFs or 2) don’t know much about ETFs. This is somewhat puzzling because 1) ETFs provide some compelling benefits to investors and 2) thanks to a new book, there is a good resource to learn a lot about ETFs. “The Institutional ETF Toolbox,” a new book by Eric Balchunas, a Senior ETF Analyst and Funds Product Specialist at Bloomberg, provides a great introduction to ETFs and how sophisticated investors can use these products in their portfolios.
The book offers a soup-to-nuts overview of ETFs, from a discussion of their history, and their structure, to how they can be used, and how to evaluate them. In short, the book is roadmap for understanding not only why, but also how investors should consider integrating ETFs into their portfolios.
What I like about the book
One thing I enjoyed about the book was that in addition to its impressive scope, it offered good depth across many areas. A few years ago, when our firm was thinking about launching an ETF, I looked around for good ETF books and was disappointed. Some covered ETFs very broadly, but only at the most superficial level, while others provided too much detail on oddball areas and had huge blind spots. This book strikes a nice balance.
Balchunas begins with a review of the reasons behind the appeal of ETFs, which offer a way to access a variety of asset classes, countries and strategies, at low cost, and in a liquid, tax-efficient, and transparent wrapper governed under a fiduciary standard.
For the sophisticated investor, these are compelling benefits.
Next is a discussion of the history of ETFs, including how the system of commodity warehouse receipts inspired “in-kind” trading for stocks, and the basic ETF mechanics of creation and redemption.
The ETF offers tremendous flexibility, and the core of the book is how institutions can use ETFs. For instance, ETFs offer liquidity benefits—to “equitize” cash (and eliminate cash drag), as a placeholder to stay invested when switching managers or when rebalancing, or as a “liquidity sleeve,” providing rapid access to cash needed for operations. ETFs are also a powerful shorting/hedging tool to adjust overall market exposure, or achieve targeted exposures. There is a section on enhancing returns through securities lending, and a section on tax-loss harvesting.
The book includes a review of due diligence considerations, including how to think about an ETF’s holdings, index weighting, expense ratio, tracking error, and bid/ask spread and impact cost factors. There’s a nice section on liquidity, and why the liquidity of the underlying portfolio, or “implied” liquidity, matters much more than trading volume. It continues to stun me how few people understand this critical issue.
The book is divided into two sections, and the second section is more in line with generic ETF books that are already out there.
There’s a review of U.S. stock ETFs, including small/mid/large cap, and some of the big index categories (S&P 500, Russell, Nasdaq, etc.). There’s also a review of sector and industry ETFs, thematic ETFs, and also more exotic/nichey stuff (MLPs, gold miners, covered call ETFs, etc.). There’s the obligatory section on “smart beta,” and some discussion of international/global products, including currency hedging. Finally, Balchunas addresses fixed income, managed futures and other “alts,” leveraged, inverse and VIX ETFs, and active ETFs. There’s lot of neat material here. Thinking about capitalizing on roll yield by shorting a VIX ETF? Balchunas explains why this may not be such a hot idea.
In the end, the book offers a good overview of the many issues surrounding the ETF, which is a financial innovation that is here to stay.
I realize that earlier I commended Balchunas on his in-depth coverage of many areas, but I still think he skimmed over some important details.
For example, despite the fact that a primary benefit of ETFs relates to how they are taxed, I found the book to be quite light on its discussion of taxes generally. This is troubling to me since the tax efficiency of ETFs is a very important issue for taxable investors. And maybe there are good reasons he doesn’t want to get into a tax conversation (e.g., many institutions are tax-exempt), but if you are looking for a deep understanding of ETF taxation, you are in the wrong book.
There are other areas where detail is lacking. To pick an example, when Balchunas discusses securities lending, he does not address counterparty issues. I would assume any institutional manager would be aware of this issue, but regardless, this is something that absolutely must be addressed if one is considering this strategy. But maybe I am nitpicking here, since Balchunas admits in the beginning of the book that it is meant to have a “conversational and informal tone.” Fair enough.
Pensions, insurance companies, and endowments are increasingly looking to ETFs as low-cost, flexible, and liquid instruments that can meet a variety of their needs, but they are arguably underutilized as an investment vehicle. Anyone who strives to be an educated investor should investigate the ETF structure as a potential investment vehicle, and this book provides a strong introduction to the big picture.
Even though this book has the word “institutional” in the title, and would be useful to many institutional investors, it is also well-suited for individuals. Retail investors can also benefit from understanding ETFs, which allow even the little guy to invest in a wide variety of asset classes at the same low cost as even the biggest institution. Now that is the democratization of financial services in action!
Overall, I thought the book offered a good survey of the relevant issues involving ETFs, and highlights some areas that deserve additional scrutiny. It surely belongs on the bookshelf of the educated investor.
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