The United States exchange traded fund (ETF) market has shown rapid growth in both assets and new listings in the past 14 years. This underscores the importance of indexing as a winning long-term investment strategy with important opportunities for insurance products, especially variable annuities.

Consider: Nearly 16% of all U.S. equity assets (almost $1 trillion) is invested in ETFs and open end index funds. They’ve had an 11-year percentage compound annual growth rate of about 13%. Furthermore, numerous studies continue to show that in the long-term, indexing usually outperforms active management. These trends suggest that ETFs might be the solution variable product insurers have been looking for to provide low-cost, efficient and diversified investment options.

Why? Because ETFs can offer precise strategic broad market or market segment exposure tailored to client investment goals, risk tolerance and time horizon. They are also ideal for use with sophisticated portfolio management techniques–e.g., tactical asset allocation, sector rotation strategies, hedging strategies, cash equitization, portfolio completion, account transitioning and more.

The VA market, in particular, can benefit greatly from ETFs’ attributes. Today, about 70+% of all VA and variable life asset flows are directed toward strategic asset allocation (SAA) funds-of-funds–either risk-based or life-cycle oriented. This has allowed variable contract holders to diversify risk across multiple asset classes with one investment. It has also benefited the insurers by allowing them to better price and hedge guarantees.

That is why integrating ETFs into the VA market is a natural fit. Here are 4 primary benefits to this integration:

o ETFs are designed to track benchmarks that are published daily. This makes their allocation very transparent to investors. ETFs either replicate indexes entirely or construct optimized portfolios, investing in a representative sample of the stocks in the underlying index. With ETFs, investors know exactly what they own.

o ETFs can improve insurers’ ability to create low cost, transparent strategic asset allocation portfolios with easily priced and hedged risk/return characteristics. The average expense ratio for equity mutual funds (domestic and international) is 1.59% (according to Morningstar Principia) versus the current average expense ratio for all ETFs of 0.42%. Such differences represent a significant opportunity to decrease the fees VA customers pay for financial products and services.

o ETFs can be used to implement tactical asset allocation (TAA) strategies that produce higher returns than a basic ETF purchase with less risk. These strategies are customized to the insurers’ actuarial requirements. How so? The TAA manager dynamically shifts ETF holdings among asset classes to gain greater exposure to those that are more attractive at a given moment. To date, most insurers have not incorporated fund options in products using TAA. But when ETFs comprise the underlying fund option, slight modulations of the TAA can help drive additional performance with less risk to contract holders.

o Like stocks, ETFs trade throughout the day and are priced and re-priced in seconds. Also, the ETF creation and redemption process increases and decreases the number of outstanding shares as dictated by demand. This virtually eliminates premiums and discounts to ETF net asset values as well as capacity concerns in all asset classes.

ETFs do present potential drawbacks when used in insurance products, however. For instance, they are still a new strategy, so there is not a long track record of ETF performance in the VA space. However, given the positive investor and insurer benefits of well-constructed ETF portfolios overall, insurers are very likely to incorporate future ETF products.

Another factor to keep in mind is that the proliferation of ETFs over a very short period of time means there are multiple products and pricing structures to evaluate. The ETF portfolio manufacturer will need to be well versed and have ample experience in choosing “best of breed” underlying ETFs from a sea of choices.

How do Tactical Asset Allocation ETF products fit into the traditional insurance program? Done properly, they should complement existing strategic asset allocation models. Every TAA strategy starts with an optimized strategic allocation. The TAA ETF models therefore mimic the strategic asset allocation model allocation; additionally, they dynamically, or tactically, shift asset class allocations within set tolerance ranges to take advantage of bullish and bearish economic trends.

The bottom line? TAA ETF products are the next generation of investment options within variable insurance policies. Investors will now have 2 investment options: actively managed funds within a relatively static strategic allocation portfolio or ETFs within a robust tactical allocation portfolio, making for the best of both worlds.