Exchange-traded funds have become the new "it" strategy for institutional investors, signaling a shift in the 20-year-old investment product's take among the sophisticated investor class.

Last month, Moody's Investor Services noted the increased demand from institutional investors for ETFs is credited to the investment product's extreme liquidity and low cost, but also to a helping of exotic exposures not usually on the menu.

The report, titled: ETFs: Increased Liquidity and Product Range Drive Institutional Participation, highlights that the product held only 9% of total assets within the overall U.S. mutual fund sector. Traditional mutual funds still maintained 88% of the pie at the end of 2012. Closed-end funds and UITs made up the rest.

Over the 2007 to 2012 period, ETFs maintained a compound annual growth rate of 17.07%, which surpassed mutual fund's asset growth of 1.68% during the same timeframe.Of the top five most liquid ETFs and 20 largest ETFs, Moody's reported that institutional ownership averaged 83.1% and 64.07%, respectively.

Institutional investors are defined by Moody's as pensions, endowments and sovereign wealth funds, active hedge funds and mutual funds.

"As liquidity developed more and more, it became more of a viable product for institutions," said Stephen Tu, vice president and senior analyst of Moody's Managed Investments team. "That is where an investment vehicle jumps the line from just being a one use product for gaining passive exposure to an asset class to something where you can use it for risk management uses and hedging uses."

Average expense ratios for traditional mutual funds were situated at about 1.33%; the ETF held a 0.44% marker, according to Financial Industry Regulatory Authority data.

But as U.S. ETFs have grown to more than $1.4 trillion in August, there has been a more than $250.5 billion increase from last year's high, the Investment Company Institute said.

In total, ICI said there were around 1,260 ETF funds available for investors in August. There were 728 total ETF funds in the nation in all of 2008, however.

New York-based BlackRock, and its iShares business comprise 270 funds for U.S. investors. As of June 30, the firm had roughly $774.3 billion in iShares.

Daniel Gamba, head of iShares Americas Institutional Business at BlackRock, explains the increased surge in institutional support has varied as investors have reported differing needs. "Transparency of holdings is important for all ETF investors," Gamba said. "We are increasingly seeing institutional investors use fixed income ETFs due to the transparency of the products that are critical for institutional investors of fixed income."

With over 150 ETFs listed globally and total franchise assets at $85 billion, Invesco PowerShares Capital Management has become a major player in the field. Ed McRedmond, senior vice president of Portfolio Strategies at the Invesco subsidiary, said that increased usage among institutions "is driven by many of the same benefits that are driving increased ETF usage among financial advisors and retail investors."

"The benefits of the ETF structure and some of the potential advantages are obviously the transparency of ETFs," McRedmond explained. "Knowing what your exposures are on a daily basis, the daily liquidity feature, particularly for some institutional investors like hedge funds who value the ability to get in and out, and the ability to gain exposure to various asset classes via an ETF where a few years ago you couldn't, like bank loans, broad commodities and other areas of fixed income, all have helped drive ETF usage among institutional investors," said McRedmond.

ETFs to replace MMFs?

As the Federal Reserve plans to maintain a quantitative easing (QE) program, proving to tie down current traditional long-term bond funds but gradually raise interest rates in the future, regulation pending fromtheSecurities and Exchange Commission includes another possible boon for nimble ETF fund managers planning to capitalize on cash needs.

Money market fund (MMF) regulation proposed by the SEC focused on ways to safeguard this large mutual fund grouping that is required by law to invest in "low-risk" assets associated with short-term interest rates. In September 2008, the Reserve Primary Fund "broke the buck," and the SEC has been looking ever since to implement reform.

The proposal identified two options for MMFs: one would be a requirement for a floating NAV, and the second focused on using liquidity fees and redemption gates when the market is stretched thin.

Various institutional investment players have sent comment letters to the SEC. Some of these included the likes of Securities Industry and Financial Markets Association (SIFMA)and the National Association of State Treasurers.

SIFMA was against dual implementation of the MMF proposals. Timothy Cameron, head of SIFMA's Asset Management Group, added in a Sept. 18 statement, that fewer cash investment choices could be a direct result. State treasurers also agreed that these reforms could harm state and local government investment pools.

Overall, the nearly $2.6 trillion money market fund industry could see some change. This is why the Moody's report highlights that there is a possibility for ETFs to capitalize in cash alternative ETF funds. However, the ratings and analysis company warns that this could only happen "gradually" because of the small market for these types of funds.

"The question is we don't know what money funds are going to look like respectively so ETFs could be a really good option, but that would imply a very significant change to money funds as we know them today which is an open question at this point," said Dan Serrao, associate managing director of Moody's Managed Investments team.

While Gamba preferred not to comment directly on the MMF reform, the investment decision maker has seen movement. Gamba noted big shifts among fixed income ETF investors where "roughly $40 billion of ETF flows has moved into shorter duration ETFs year-to-date."

McRedmond said he has witnessed similar ETF flows to the specialized rate product."Obviously, ETFs are not a money market by any shape or form, but some investors seem to be using very short duration ETFs as an alternative."

"If you look at filings from some of the larger fund companies, you'll notice that a lot of them are for short or ultra-short duration fixed income products, that some may view as alternatives to invest cash," McRedmond said. "It seems like they are positioning to at least have that option if they should decide to."

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