As ETFs Grow, So Too Must Risk Models, Pricing Matrixes

Institutional investors represent 36 percent of a total $2.1 trillion US ETF pool.

ETFs performance

A new study by Greenwich Associates shows that ETFs should see continued growth in 2016, and beyond. Anthony says that firms will have to improve their pricing matrixes and risk models if they want to keep up.

Earlier this week, consultancy Greenwich Associates put out a report examining the exchange-traded fund (ETF) market that highlighted the thirst by institutional investors for these products.

According to the study, which was sponsored by BlackRock, institutions represent 36 percent of the total $2.1 trillion in US ETF assets, and 43 percent of institutional users invest 10 percent or more of their overall portfolio in ETFs. And those numbers are expected to increase in 2016. According to BlackRock:

All of the ETF users in the study invested in equity ETFs, with 36 percent planning to increase allocations in the year ahead and 35 percent of those planning to boost allocations by 10 percent or more. 35 percent of fixed income ETF users expect to increase allocations this year, and 36 percent plan to do so by 10 percent or more.

Hands down my favorite feature I put together in 2015 was one that looked at the fixed income ETF space, which has skyrocketed since 2008. The Greenwich report noted that 65 percent of 183 respondents said that they employ fixed income ETF strategies in their portfolios, with more expecting to partake as liquidity in the overall fixed income market has declined ─ hence the desire to bundle these stocks together in an ETF.

It's quite challenging to price fixed income baskets because many of the underlying stocks aren't traded daily ─ and some are only traded a couple of times a year. As a result, creating a pricing matrix to value the ETF on an intra-day basis can be quite challenging.

Additionally, firms have to build out robust risk modeling strategies and find inventive ways of creating and redeeming fixed-income ETFs. And as to the overall ETF market, the modeling and pricing challenges will only become more complex as investors use these products in tandem with derivatives. According to the report:

ETFs are increasingly being evaluated along with derivatives to determine the best tool to hedge or gain market exposure. More than half the institutions in this year's study replaced derivative products, such as equity futures contracts, with ETFs in the last year, and 78 percent of futures users plan to replace an existing futures position with an ETF in the next 12 months.

As firms diversify using ETFs, they'll also need to better understand the underlying factors used in their portfolios, especially for those firms employing smart beta ETF strategies.

While there's a lot of promise in the ETF space, especially as firms look for longer-term, strategic allocations and innovative replacements for bonds and derivatives, understanding these products will take on greater importance. There's a sea of data out there to be mined and plugged into matrixes and models. But it's also easy to drown in that sea, or get lost and lose sight of land. (You keep up with that whole ‘sea analogy' thing.)

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