Markets are constantly evolving, and institutional investors continually adapt to those changes. Derivatives have long been the default tool among institutional investors for a wide range of functions.

But no longer.

In recent years, these investors are increasingly turning to exchange traded funds (ETFs), using them as financial instruments for a host of purposes, including rebalancing, price discovery, liquidity management and tactical or strategic exposure. This is a significant evolution of the investment landscape – and it is making investors reconsider what the ETF can do.

For example, many insurance companies are now using long ETF positions to help manage liability risk and improve liquidity profiles; hedge funds are using the instruments in alpha generation strategies, both long and short; and asset managers are deploying them in a range of ways to potentially benefit from their liquidity and cost efficiency. A liquidity sleeve using ETFs, for instance, offers efficient benchmark exposure while minimizing cash drag, which is especially significant in a zero-rate environment.

Index futures, total return swaps and ETFs each have a role in institutional index allocations. When choosing the right investment, cost, liquidity and exposure must all be considered. The most liquid vehicle may also be the most expensive; the lowest cost may not track the preferred index; and the one that has tracked best in the past may not do so in the future. Such considerations require a level of customization that increases with the size and complexity of the exposure.

As of last year, 58% of institutions planned to use these securities to replace a derivative product, ¹ reflecting an accelerated investor appetite in ETFs used as financial instruments – specifically ETFs that are typically large and liquid and often used interchangeably with derivatives. During market stress in 1Q20, many fixed income ETFs offered deeper liquidity and tighter bid-offer spreads than the underlying bond market.

“Sometimes it’s just simple math,” says Ravi Goutam, Head of U.S. & Canada iShares Institutional Sales. “Pricing favors some ETFs over derivatives, and that cost efficiency is attractive to clients.”

The Line-Up

ETFs join futures, CDX contracts, swaps and options, in addressing similar functions, while potentially providing superior efficiencies and cost, which is a key determinant in vehicle selection.

ETFs vs. Futures. Futures contracts are no longer the default tool for gaining broad market exposure and hedging against risk. Many institutional investors find they can sometimes get more effective beta exposure from an ETF vs. a future, particularly as the number of ETFs has grown to cover less liquid markets.

A rise in ETF adoption has created a virtuous circle. The inflows encouraged by broader coverage have increased liquidity, which has led to the compression of bid-ask spreads and lower management costs (particularly when compared to the price of rolling futures contracts).

ETFs vs. CDX. A buyer of investment-grade or high-yield corporate bonds who is attuned to the risk of exposure mismatch may be drawn to an ETF as opposed to the typical OTC trade of a credit default swap. The products in the CDX suite come in a number of tenors, of course, but because the five-year is by far the most liquid, there may be risk of duration mismatch.

ETFs can help address this mismatch by holding hundreds of bonds of different durations in one wrapper. Doing so essentially smooths out these varied durations, leading to a more balanced average (3.12 years for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), 9.78 years for the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) ² ). This makes it easier to access beta exposure.

"Although CDX liquidity is large, credit ETF trading volume continues to grow relative to CDX volume," explains Josh Penzner, U.S Head of Institutional iShares Fixed Income ETFs. "We believe this is being driven by investors who may benefit from considering an instrument that may more closely track their benchmark or ultimate investment objective."

ETFs vs. Swaps. In a total return swap, the counterparty agrees to deliver the total return of an index precisely, including any income it generates via dividends or interest payments. Offloading trading and pricing to a third party that can guarantee such tight tracking of an index incurs costs, however, which are expressed via the funding spread.

Funding spreads, as quoted by swap dealers, may be higher or lower than ETF management fees depending on the demand for the exposure and supply of bank balance sheet available to meet it.

ETF Options vs. Index Options. Options on ETFs have grown in popularity as institutional investors look to gain temporary exposure – or to hedge – in various positions, from commodities to emerging market equities. According to the Options Clearing Corporation, options on ETFs have accounted for 39.1% of total U.S. volume through June 2020. That same figure was never higher than 31% before 2010.

Settlement remains a major distinction between options on ETFs and options on indexes. The former settle American-style, meaning the underlying shares must be delivered, as opposed to European-style, which settle in cash. Unlike options on indexes, options on ETFs can be settled early, which may be an advantage for certain trading strategies.

Unbiased Tools

Liquidity and transparency are the cornerstones of effective financial instruments. Following those principles, BlackRock has developed two new tools to help investors make comparisons and spot opportunities.

For institutional equity investors, BlackRock launched Delta One in November 2019, designed as a neutral framework to estimate total costs for ETFs and equity index futures. In a comprehensive window, Delta One employs four lenses to compare and contrast exposure, cost, performance and liquidity. The goal is to provide an intuitive user experience to help investors arrive at the optimal vehicle for any particular transaction.

“Our users will not want to take a total cost chart at face value, and we want to be as transparent as possible to provide comfort,” says Brendan McCarthy, Co-Head of the U.S. iShares Institutional Client Business. The application therefore breaks down the costs and provides supporting analytics to help clients apply their own due diligence to validate final numbers.

To support tactical decision-making, users may wish to log into Delta One each quarter. Clients can access the tool using BlackRock login credentials on the iShares website.

Delta One helps clients select the optimal product – whether futures or ETFs – for their fluctuating needs. Impartial access to analytics will inform their conclusions, with the answer customized to each client’s preferences and priorities.

ETFs may at times prove a better choice than derivatives, although not always. The types of vehicles are by no means exclusive, but are each a distinctive tool in the kit. The current gap in the marketplace reflects an inefficient lack of overall adoption and awareness. “As every vehicle plays a role for a particular purpose,” adds Goutam, “and increased exposure to ETFs broadens the choice set for an optimal solution.”

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Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective. Investment comparisons are for illustrative purposes only. To better understand the similarities and differences between investments, including investment objectives, risks, fees and expenses, it is important to read the products' prospectuses Derivatives information is for educational purposes only. BlackRock is not offering to implement a derivatives strategy. Short-selling entails special risks. If the fund makes short sales in securities that increase in value, the fund will lose value.

Any loss on short positions may or may not be offset by investing short-sale proceeds in other investments.

Buying and selling shares of ETFs may result in brokerage commissions. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

No proprietary technology or asset allocation model is a guarantee against loss of principal. There can be no assurance that an investment strategy based on the tools will be successful.

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of "Characteristics and Risks of Standardized Options." Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500, Chicago, IL 60606 (1-888-678-4667). The document contains information on options issued by The Options Clearing Corporation. The document discusses exchange traded options issued by The Options Clearing Corporation and is intended for educational purposes. No statement in the document should be construed as a recommendation to buy or sell a security or to provide investment advice. If you need further information, please feel free to call the Options Industry Council Helpline. They will be able to provide you with balanced options education and tools to assist you with your iShares options questions and trading. The Options Industry Council Helpline phone number is 1-888-Options (1-888-678-4667) and its website is www.888options.com.

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The tool is provided on an "as-is" basis. BlackRock expressly disclaims all warranties, express or implied, statutory or otherwise with respect to the tool (and any results obtained from its use) including, without limitation, all warranties or merchantability, fitness for a particular purpose or use, accuracy, completeness, originality and/or non-infringement. In no event shall BlackRock have any liability for any claims, damages, obligations, liabilities or losses relating to the tool including, without limitation, any liability for any direct, indirect, special, incidental, punitive and/or consequential damages (including loss of profits or principal).

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[1] 8^th Annual Greenwich Associates Institutional ETF Study, 2018. Based on 106 U.S. responses. Usage figures come from a survey of asset managers, insurers, consultants and institutional funds.

[2] Source: BlackRock, as of August 2020. Duration is subject to change.

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