Institutional demand for exchange-traded funds (ETFs) has increased markedly in recent years, fueling rapid growth of a product originally geared towards retail investment, says Moody's Investors Service in its new special comment "ETFs: Increased Liquidity and Product Range Drive Institutional Participation."

Exchange-traded funds are a form of open-ended mutual fund, and are traded on exchanges much like stocks. Like other mutual funds, they allow investors to gain exposure to a diversified portfolio without having to purchase individual instruments. While still only a small portion—approximately 10%—of the overall US mutual fund sector, ETFS have grown rapidly. During the five year period beginning with the credit cycle peak of 2007, total US ETF assets have grown at a compound annual growth rate of 17.07%.

"ETFs are increasingly attracting flows that once would have gone into traditional mutual funds, or to hedging vehicles such as futures and swaps," said Moody's Vice President Stephen Tu, the author of the report, in a statement. "This institutional participation will likely continue to expand, which is a credit positive for large ETF providers such as BlackRock, State Street and Invesco."

While institutional investors initially used ETFs for simple investment functions such as temporarily investing cash, growing product diversity has led them to use ETFs in other areas, says the rating agency. Moody's notes that institutional investors — including even traditional mutual fund managers — now hold over half of all US ETF shares.

In addition, as liquidity has increased, ETFs have become hedging tools used by sophisticated investors for shorting or tail hedging. Investors are also starting to use ETFs in order to gain access to esoteric markets, or to have access to assets in markets that have been closed or are constrained due to regulation.

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