Higher costs and limited liquidity are the two main obstacles preventing a wider take-up of exchange-traded funds (ETF) by Australian institutional investors, according to a Russell report.

Although ETFs have been embraced by the retail market because of their lower costs in comparison with those of managed funds, institutional investors often have access to index mandates at lower prices.

The cheapest price level for an Australian equity ETF was around 15 basis points, while institutional investors could secure index mandates with their existing managers at just a few basis points in fees, Russell ETF director Amanda Skelly said.

But Skelly also argued that part of the low take-up was a lack of knowledge about the use of the products.

"Market liquidity is one of the biggest concerns that institutions noted throughout the research. They just don't see a lot of liquidity here in the market and they are right: there isn't compared to the rest of the world. We are at very earlier stages here," she said.

"But because of that there are other ways of accessing liquidity here. You can go direct to the brokers and get immediate access to the underlying liquidity and they can negotiate commissions directly with the brokers. That is what we encourage."

When ETFs were first introduced to the United States, institutional investors were the first to take them up, but this was largely driven by hedge funds, which used them to get a quick exposure to an asset class.

In Australia, institutional investors were more likely to use futures or low-cost managed funds instead of ETFs for this purpose, Skelly said.

Yet, this approach had its downsides, she said, because taking exposures via futures for longer than three months often incurred rollover costs, while investors also lost out on franking credits.

"It is clear we need to continually educate the market on ETFs to ensure investment decision makers are properly evaluating the role they could play in their businesses," she said.

The research, which was conducted by Deloitte Actuaries & Consultants for Russell, showed that although many institutions said ETFs were a retail product, 40 per cent of respondents had used ETFs in the past.
 
Also 30 per cent of Australian institutions were considering using ETFs in a "significant way", it said.

"This is a positive sign for the industry, although there is still a lot more we could do to help drive growth through product innovation and education," Skelly said.