Fixed Income ETFs: Passing the test and making more sense

Headshot of Bernard Ryan

Stewart: Insurance companies are using ETFs more than ever before. My name's Stewart Foley, this is the Insurance AUM Journal podcast and ETF use in insurance company portfolios is the topic of the day. We are joined by two folks who are experts in the field, David Stack, and Bernie Ryan. Welcome gentlemen.

Ryan: Thank you Stewart.

David: Thank you Stewart.

Stewart: Do you want to give just a little bit of your individual backgrounds and then I want to get right into some of the findings of this recent paper.

Bernie: Sure. Yeah. This is Bernie Ryan. I'm a Senior Relationship Manager for the insurance business at DWS. I also head up our business development efforts for insurance companies in the Americas. I've been with the firm for 14 years and have experience across all asset classes and in all types of insurance companies. But as Stewart mentioned, we have begun to see more and more inquiries and have done more and more work in the ETF space to the point where it's become integrated pretty much into almost all conversations or strategic asset allocation type initiatives with insurance companies. So we'll delve into that today.  Dave, a little bit on your background.

David: Yeah, sure. Thanks for having us again, Stewart. I'm Dave Stack from DWS and I am a Senior Capital Market Specialist within our systematic investment solutions, which is where we house our passive ETF funds. I'm mainly responsible for the U.S. ETF platform and the liquidity that's around it. I work very closely with authorized participants and market makers in supporting them with any questions or how to create or redeem or any of the activity that we're seeing in our funds. I also work closely with their sales and our distribution efforts with the end clients, as they educate themselves around using ETFs, how to think about ETFs, how to trade ETFs. We do a lot from an ETF capital markets perspective, so happy to be here and joining this conversation today around insurance usage of ETFs.

Stewart: It is really timely because Raghu Ramachandranfrom S&P just published his dissertation, if you will, a 60 page paper on ETF use and insurance companies. Insurance companies in the U.S. bought $4 billion of ETFs last year, up 18%.   Yet, not a huge allocation in terms of overall assets of insurance companies. David, can you give me an overview of the state of the ETF market today?

David:  Sure, absolutely. So when we look at the U.S. ETF market, there's roughly about 24, over a little over 2,400 ETFs that are listed, which have amassed 6.4 trillion in AUM. Looking at an asset class breakdown, equities account for 80% of that, fixed income roughly about 18% and the balance is split between commodities and mixed allocations and specialty types of funds. Year-to-date ETFs have taken in roughly about 411 billion of net new assets, with equities really representing the lion’s share of that with 316 billion. Fixed  income ETFs grab 92 billion.  Of the year-to-date net new assets in ETFs,. 57% of the flows have been into funds with a management fee of ten basis points or less. So just looking at those numbers, you can see that ETF flows are highly competitive. One of the other things that we've seen in year-to-date is obviously there's been fee compression.

David: That's something that's been happening in the industry over the years, which is really beneficial to anu investors that are utilizing ETFs In their client portfolios. It was kind of interesting, last year with the volatility that COVID had brought to the market, we ended the year with roughly about 505 billion of net new assets. Here's where it gets interesting, so that was a high watermark for ETFs. You go back since the first ETF was ever launched in 1993, that was a high watermark with net new assets, but we're approaching the first half of 2021 this year and we've already had 411 million in net new assets, which is astonishing. I just think there's just so much education that has happened over the last 28 years with clients. A couple of the things to kind of think about some of the themes that we're seeing year-to-date, obviously there's been lots of talk about a reflation or a value trade.

David: We're seeing clients talk about ESG. We're seeing clients look at a thematic type of funds and these types of themes that we've seen are just top of mind for investors. And that's what's really kind of been driving the flow.  As we're seeing, a lot of the flows here today flow back into equity funds. That's kind of the state of the market. It's ever-changing, it's constantly growing. We're seeing new use cases by clients develop throughout the years. Hopefully that's a good overview of the state of where we are in the ETF market. It's continuously growing:  6.4 trillion, 411 billion in net new assets. It's just been an amazing run.

Stewart: It is an amazing run. And I mean, as we talked about a little earlier before the podcast started, you know, my background is managing insurance assets for the past, what feels like 300 years. And what I've learned is that insurance companies don't buy things they don't understand. Right. So Bernie, what are you seeing in terms of adoption of ETFs by your insurance clients?

Bernie: Thank you, Stewart . And as you mentioned, the insurance industry allocation TTS is really just a drop in the bucket from a percentage of the total general account assets across the board. The key becomes understanding where that adoption is occurring and that's fine, that can be tracked through reporting.  But then there's also the conversations that take place that, that maybe don't result in allocations and the why of that. So maybe I can touch a bit upon that and then also where we see it going. Perhaps at this point, I'll just give sort of a high level and we can dig into some of the use cases in some of the adoption areas for insurance companies. If you look at just pure AUM numbers, obviously the mega companies and the large companies hold most of the ETFs, but from an adoption standpoint or a percentage of the total assets within each of those firms, the usage is much higher with small and medium size firms.

Stewart: And that's a really good point. It makes total sense too, right, because the structure helps those guys get better. It's hard to figure out what the cost of execution is for a smaller company and the structure makes a lot of sense from that perspective.

Ryan: It makes a lot of sense from a diversification standpoint, from a trading standpoint, from a liquidity standpoint, from execution in the marketplace across a large, actively managed investment grade fixed income portfolio right. The trading component is significant and as you're into smaller piece sizes and odd lots, right, the ETF piece or the ETF adoption there makes a lot of sense. It's still been relatively slow as a total percentage, but it is growing and it is growing quickly with the adoption of the look-through treatment from the NEIC a few years back, and then systematic valuation, which we can get into a little bit as well. It assimilates it much simpler for insurance companies in the small space, but it isn't just small firms as well. They do have a higher utilization rate. We do see some.

Bernie: There's really two main areas that insurance companies are utilizing ETFs. One is just tactical allocations. High yield spreads blow out in March of 2020. It's the buying opportunity of a lifetime and everyone's been complaining the markets are expensive and then they're cheap two weeks later. This is a great way to go in and allocate to markets that have sold off and then earn part of that return premium one to six month-type tactical investment. Certainly insurance companies are doing that, that may be more on the larger end, but we do see some of that in the small and midsize as well. The other pretty common use case is as a placeholder for building out inactive, fundamental portfolios. So just using high yield, as an example, mid-size insurance company says they want to allocate $50 to $70 million to BB and single B's.

Bernie: They can go in and buy a high yield ETF for 75 million and then sell it down as they build out their actively managed portfolio and that could be over 3, 6, 9 months. So we do see a fair amount of that. There's also an offshoot of that, where temporary cash infusions that need to be put to work that maybe only have on your balance sheet for 2, 3, 4, or five months ETFs. We do see some adoption there, invested across investment grade ETFs, knowing that that cash came in from a reinsurance commutation or something else. It's going to go back out the door later on. You see that element. We have begun to see some strategic ETF allocation adoption. We did have one large insurance company who we managed for. Who made a very large, longer term ETF allocation. Again, if it's a situation where you're fine with a beta play, so to say, and you can earn a significantly lower fee and you look at what the active fee would be versus the passive fee and the alpha that would have to be generated there.

Bernie: We have seen some of that. I wouldn't say it's widespread at this point, by any means, but it's not without allocation and it's not without merit in the marketplace and it's absolutely happening. And then I would say the other area where we're seeing it is certainly ESG. Dave mentioned that there are ESG specific ETFs. It is a simple way for CIOs and Portfolio Managers who are under a little bit of pressure to have some ESG money in the hopper to make an allocation there. Probably seeing more conversations there than actual allocations, but I would venture to say that, as a lead forward, we will absolutely see some ESG adoption through the ETF sector. And lastly is an area where there's a lot of conversations going  on, not necessarily a lot of allocation for custom development of ETFs to fit a specific purpose, perhaps where an insurance company, an asset manager would partner to seed from a very specific type of funding.

Bernie: So for example, in the high yield space, most of the ETFs go across the rating scale to CCC. Most insurance companies like to be BB, single B. And it's not to say that those ETFs don't exist, but in certain situations, insurance companies are very specific in what they're looking to do. So we do see those types of conversations. There hasn't been a lot of movement there, but I think over time we will see some adoption through custom ETFs that fit a specific need that then can be marketed more widely across the industry.

Stewart: Some of the good news of these podcasts is I always say that I'm the one who gets to learn the most. My hope is that our audience goes, “Man, I'm glad he asked that question. I wanted to ask that”. So here we go. Every presentation I've ever been involved with, with an insurance company at some point, there's a question, “where does this go on my schedule D and how is it accounted for?” So ETFs have this thing called a systematic valuation, which, I don't know,I just frankly don't understand. The other piece of that is that according to Raghu's paper, only about 25% of insurance companies are using it. So can you help us figure out what does systematic valuation mean in an ETF context?

Bernie: I have the same question. Why isn't it more broadly used? It's been around for about four years now, too, so it's not brand new anymore. When it came out in I think the second half of 2017, we got a lot of questions in ‘18 and ‘19 on it. It wasn't widely adopted. I understand that it's relatively new. Insurance companies can be slow to move, insurance accounting departments, sorry to the accountants who are listening, but sometimes can be slow to adopt new principles. I think part of it may have been just, with the pandemic hitting in 2020, it kind of slid down the priority list for insurance companies. But systematic valuation effectively allows you, instead of just taking sort of a mark to market NAV approach to, the BTS are valued that way, but on your books, on the insurance company books, and then actually book it as an amortizing bond that has an initial book over time.

Bernie: So, particularly for the life companies, where it's income oriented and you can adopt a bulk yield at the time of purchase and then make the book value adjustments over time. You're really holding it on your general account on your schedule D as an income oriented bond that you can track from a book yield and a book value perspective over time versus having it just be a mark to market quarterly type valuation.

Bernie: That's the simple explanation for systematic valuation. It would seem to fit for insurance companies very well and certainly the life companies where the adoption has taken place. I think it's about half the life companies do utilize the systematic valuation, which makes sense. And I think the slow adoption, I think part of it was the pandemic last year, and maybe moving down the priority list for insurance companies from an accounting standpoint. I do expect those percentages to increase, but I'm with you Stewart, I'm surprised it's as low as it is because there is a tool available for insurance companies to book ETFs in a very similar fashion to they do to investment grade corporates. But I do expect that to increase over time.

Stewart: It is interesting because 18% increase year over year ‘19 to ‘20, and yet the use of systematic valuation was flat at around 25%. So to me, it's very interesting. The other thing, and this is kind of additional topics that are related to the adoption of ETFs. One of the things that was surprising to me is that there is quite a bit more allocation to equity ETFs than fixed income ETFs and I'm wondering about that. And then the second part of that is, how often are you seeing insurance companies buy a fixed income ETF and take delivery of the bonds? Is that happening at all?

David: If that does happen and it can happen. That's one of the major benefits of the ETF structure, where the client can redeem through an authorized participant and have the authorized participants deliver the underlying basket of bonds. I think when you look at when there's periods of market stress, and they have a challenge of finding the bonds that they're looking for, they can utilize an ETF to take delivery. And that's kind of one of those ideas, and we've seen it in the past. There was a trade years ago in the high yield ETF, and it was like eight or 900 million that was redeemed. And the basis of the story was that the client was looking to receive the underlying bonds. And it was just one of those ways of accessing the cash bond market without actually ever having to go to the cash bond market.

David: They were just buying the ETF on screen. I think that just goes back to, there's so many different use cases and the ETF is so versatile for investors in an investor's portfolio. It is not just an asset allocation tool. It's a hedging vehicle, it's a cash equitization, it's a liquidity tool. People can tactically tilt your portfolio and go back to that S&P report, which I found was interesting, even though it was only 4 billion in net new assets that were gained last year. But I think the report had mentioned a story somewhere around like 63 billion had been traded throughout the year. And that just goes to show you that you have investors that are out there in the insurance industry that are capitalizing on market movements and 2020 was just a perfect opportunity to do that. The market craters in March of 2020, you step into the market, the market rallies back when the Fed supports it, and then they sell out of it.

David: They used them correctly in their portfolio. I think it all goes back to, and also with the systematic value, being roughly about 26% of insurers actually utilizing it.   I think it has to go down to a couple of things that where we sit and what I view as extremely important, is the education around ETFs. Even though ETFs have been in the market since 1993, it really goes down to education. Even with the switch back in, as Bernie said it back in 2017, by the NAIC and being able to systematically value. There's so much education that has to be done with end-clients. You're in a highly regulated industry, like the insurance industry, people need to really, truly understand that. And that's, I think, one of the key drivers, and that's why you're seeing while it's growing.

David: It's definitely a slow ramp up in ETF usage by insurance companies. And I think it just goes to the education around it. Understanding how that fits in their portfolio, how they should think about utilizing it, what's a use case for them in their business. Whether it's from a life insurance or personal commercial, whatever it might be. I think that's where people are starting to go through their education. It takes a little bit of time, but as Bernie said, I mean, 2020 threw a loop to everyone. So that probably slowed down, even though they gained 4 billion in net new assets, it looks like it's going to double over the next five years. I think that's fantastic but it really goes down to the education just around the ETF and how to think about it and utilizing that in a client's portfolio.

Stewart: It's interesting. Earlier you had mentioned the use of passive and fee compression in institutional portfolios. I think that's a trend that's been there and continues. How should investors think of passive and active funds?

David: That's a great question. It's kind of interesting, if you look at some financial media, it's always like one or the other, you get a passive’s attacking active. It's not. Each client has a specific, unique risk profile and have certain needs that they want. A passive fund may work perfectly for one investor, and then there's going to be another investor that, based on their requirements, they’re going to want to try to outperform so they're going to go active. And then you're going to find some investors that can capitalize on utilizing both. They have a passive sleeve and they use that for possibly a liquidity tool. If in the event like something like 2020 last year when the market craters, do you want to sell your active manager?

David: If you've got capital demands and, or do you want to go out and just use the ETF as a liquidity tool? And that's why the ETF is so versatile. It gives you the asset allocation, but also gives you the ability, if in the event you need liquidity, you can just go out and sell it into the market. I think is it active over passive? No, I think it's what the client wants, what they need and what their investment guidelines are and there's going to be a tool whether it's active or passive that they can capitalize on. I don't think it's one or the other, I think it's really down to what clients are looking for.

Stewart: I think that's so important, particularly in the insurance space, which is all its own, as you both know well. With the growth of index based investing, how has the product development landscape changed at DWS?

David: It's been truly amazing to watch. When ETFs first came to market, they were just traditional beta products, which is the S&P 500 ETF.  Then there were a bunch of country ETFs.  I think after that was the Dow Jones. These are like big beta indices that were coming out and it's been just truly amazing to watch. If you think about fixed income in particular, the first fixed income ETF was launched in 2002, and there were only a handful of ETFs, fixed income ETFs, into 2007. And by that time, there was already 300 or somewhat odd products for equities and other types of asset classes that were already in the market. So fixed income was definitely slower to develop than equities, but equities are already, at that point in time.  They were slicing and dicing everything down, going from single factors to multi-factors to country-specific,  all this stuff was happening, but fixed income was very slow.

David: It was only really where we started to see the growth of fixed income start in 2007, which actually was kind of perfect because we were going into the global financial crisis and everything that was happening at that point in time. People started to look for fixed income ETFs because they were trading on exchange during the middle of 2008, when volatility was spiking and you couldn't get bids on bonds, but ETF is still trading. So people were looking at the ETF as a price discovery tool. There's just been so many things that were unique to the product development through the years. When we look at fixed income in particular,  we started with these big, beta type indices that they were benchmarked to.

David: And then, because the fixed income market is opaque, people think that they need active. So then we started to see fully transparent active products come to market. If we're looking at that today, there's roughly about 132 billion in AUM that sits in active, fully transparent, which is just amazing. But interestingly enough, we're starting to see middle ground between passive and active and starting to develop, whether you call it smart beta or a single factor. We're starting to see this area that actually get developed. At the end of last year, there was roughly about fifty or so odd products that we're roughly about 9 billion AUM in this middle category between fully passive and active. And in 2018, we had actually developed two products where we took the high yield beta index that covered the liquid subset of high yield and we further segmented that index by a yield profile while maintaining sector diversification. And this was really to allow investors to manage their high yield exposure with greater precision.

David: So we took the larger index, we divided it into sectors, then we ranked each individual security by yield to worst, and then each sector was divided by its median yield. The higher yielding securities went into our higher beta product, a lower yielding securities went into our lower beta products. And the reason why we chose yield as a metric to slice and dice the index, was we felt that the changes in corporate credit profiles take a bit of time to be upgraded or downgraded, but the markets are constantly moving. So by the time that the rating was actually changed, the market had moved. So we felt that yield was a better proxy of determining credit profiles that are improving or deteriorating. While it's still in the early grounds of this middle, between active and passive, it definitely highlights the work and the product development that has been happening in on the fixed income side. So the product engineers, they're doing a fantastic job. I can't wait to see what the next five years brings between fully passive and active and what that middle ground's going to look like.

Stewart: Very cool. That's some very interesting developments. Bernie, let me go back to you. How should insurance clients be thinking about ETFs in their portfolios?

Bernie: I think first of all,  there still are some insurance companies who aren't thinking about ETFs in their portfolios. So I'd like to see that segment. It's probably less than half at this point that aren't even thinking about it. I would like to see more insurance companies consider ETFs as an option. It doesn't mean you'll ultimately invest, but guideline inclusion is a very important piece of this going forward as well. Not to be underestimated,I think it was mentioned earlier, is understanding the structure itself, particularly investment committees here, and they don't understand it. There's still a lot of education that needs to take place in certain areas of the insurance marketplace. I do think there have been some good liquidity, real world stress scenario cases that have played out, particularly back in March of 2020, that in a bit of a perverse way to help validate the ETF market because there weren't any high profile blow ups.

Bernie: We received feedback from one insurer who was able to liquidate some ETFs in early March of 2020, late February of 2020 and had no issues. Those have helped going forward. I do think, more so as that sort of tactical allocator, I would venture to say that there's going to be more adoption there. I think one of the reasons why insurance companies tend to not take tactical advantage, and I'm not saying all insurance companies, but a large percentage of them is that it's difficult to move in and out of large baskets of bonds or large baskets of equities or large baskets of whatever asset class you're looking to take advantage of an ETF star, a pure and simple way to do that. And with the proliferation of products and strategies out there, I do absolutely think we are going to see more tactical advantage when those opportunities take place, particularly with the low yield environment.

Bernie: CIOs are looking for alpha where you can get it and if corporate yields blow out and we think it's temporary, I'd like to see more insurance companies take advantage of it, even if it's in a relatively small way.  And then I think the second piece that will really play out over the next let's call it two, three, four years is the ESG piece of this. Being able to allocate to ESG product and do it in a simple way and begin to demonstrate to investment committees and regulators in the marketplace that insurance companies are not just talking about ESG from an asset side. I mean, obviously they talk about it from a liability side, but from an asset side that insurance companies are actually eating some of the ESG cooking so to say, and I do think ETFs can play an important role.

Bernie: It's not a complete piece of the puzzle for ESG, but I think it's an early adopter way to make some headway into the ESG marketplace. And then finally the strategic allocation piece I mentioned earlier.  That one I'm less confident on, but I do think that there are possibilities of insurance companies taking a more longer term strategic allocation, whether it's in high yield, whether it's their equity portfolio and being able to access through sector ETF, or strategies like that. And there are some doing that currently. I hesitate to say that that's sort of a larger trend. I would put that third, but I do think it bears watching for insurers going forward.

Stewart: It's interesting that the litmus test that you referenced around the March 2020 market dislocation is something that I've had a number of different conversations and really everybody kind of echoed the point that you made, which was they put a lot of confidence into the ETF structure.

David: If you think about what happened last year, the Fed, when they came in and they wanted to support the market, they chose cash bonds in the credit market, and then they chose ETFs. That just spoke volumes to the ETF structure. For them to be able to buy and exchange and a lot of that goes to the transparency that ETFs provide. You can see the volume, you can see the flows, you can look at an ETF portfolio, you can go to any issuer's website, you can download what they're holding each and every single day, the transparency, the structure, it just speaks volumes. I just thought with the Fed utilizing ETFs last year, I think for every client that was out there, that was kind of on the fence, “Should we use ETFs or not?”, when the Federal Reserve is stepping into the market to support the market, they're choosing cash bonds, and they're choosing ETFs.

David: I just think that's something that, for investors, they really need to think about ETFs in their portfolios. And it really goes back to the education around the structure and understanding what their use cases could be in their insurance business. And like Bernie said, where does it fit? Is it a liquidity sleeve? Is it a tactical sleeve? Is it a strategic allocation sleeve? Wherever it might be, there's going to be a use case behind that and it just goes to the education around ETFs.

Stewart: That's good stuff and I completely agree with you. This is the part of the podcast that nobody's ever prepared for. So David since you went last, I'll just start with you. We have a really huge change in the way that people work due to the COVID-19 crisis and it seems like the landscape has changed. So I want to take you back to a day in your life that I know you remember, which is your college graduation from your undergraduate institution. Now, no matter what stellar celebrations may have taken place the evening before, you are bright eyed and bushy tailed in your cap and gown and there you are waiting for your name to be called. Your last name starts with an S. So you've got some waiting to do, plenty of time, up the stairs you go.   They call your name, crowd goes bananas. You go over, you get a quick handshake and a photo op, get your diploma and you cheer, wave, everything else and down the stairs you go. At the bottom of those stairs you run into David Stack today. What do you tell your twenty-one year old self?

David: Wow.

Stewart: and Bernie has a huge advantage because he gets to listen to your answer.

David: That is a great question. I would say that the path that you're on is the right path. It's going to lead you. You're going to have ups and downs. You're going to learn a lot, but continue to focus on the goals that you wrote down your first day in college and continue down the path and you're going to do just fine. Or give them mega millions or Powerball numbers or something like that. At the end of the day, you get at the path or the goal that originally set out for when I started my undergraduate degree and continue through, and then with my career, I think I would just say, continue down that path. You're doing fine. You can have ups and downs. You're going to learn from it and it's okay to make mistakes.

Stewart: Bernie, what do you think?

Bernie: Well, I was an accounting major, so I hope that the Bernie Ryan of today had told him “Don't be an accountant your entire career!” That absolutely played out properly, no offense to the accountants on the call, but I did work as an accountant. That was actually a great experience. I would say somewhat similar to Dave: make sure you live in the moment and not constantly be re-evaluating longer-term strategic plans for your career and for your job and while we certainly have to have vision in foresight, both personally and professionally, make sure you live in the moment more and enjoy each day, enjoy each moment, focus on what you're working on at the time and if it isn't something that is of full importance, then maybe you should ask yourself while you're working on it in the first place, whether it's personal or professional. If there's one phrase I would say, and I know it's overused, but it's probably under-practiced,  is live in the moment and enjoy each day and good things will happen to you if you live by that credo.

Stewart: Sage advice from you both thank you very much. ETF used by insurance companies with David Stack and Bernie Ryan of DWS. Gentlemen, thanks for joining today. Thanks for listening. We're always wanting your ideas for new podcasts. Please email us at My name is Stewart Foley, and this is the Insurance AUM journal podcast.


Download PDF Reprint

Register for Insurance AUM Journal

Register today to confirm your status as an institutional investor and gain access to the latest thought leadership in the industry.

  • Thought leadership delivered to your inbox
  • Confirm your status as an Institutional Investor
  • Complete CFA Continuous Professional Development requirements

By clicking submit you confirm that you qualify as an institutional investor and you consent to allow Insurance AUM to store and process the personal information submitted above.

Lost password