(Bloomberg Markets) -- Leighton Shantz had barely begun managingpart of the $26 billion pension fund for Texas state employees when hegot a crazy idea.

The fund’s floundering investment-grade bond portfolio wasoccupying his undivided attention, its strategy clearly broken. Nomatter what he tried, the securities couldn’t deliver sufficientyield or liquidity. He knew he had to get rid of them; he justwasn’t sure how.

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The time-tested rules for fixed income, which Shantz had honedfor years as a managing director at Lockheed Martin InvestmentManagement Co. and as a money manager for Tennessee’s retirementsystem for teachers and state employees, no longer seemed toapply.

As he analyzed the broader portfolio over the summer of 2012, itdawned on him that exchange-traded funds, which were becomingincreasingly popular investing tools, might prove useful. Thesefunds needed thousands of securities just to exist. Perhaps theycould take the bonds off his hands?

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Yet whenever ETFs came up in conversation with assetmanagers, they responded how a Texan might react to finding beansin his chili. “Every one of them commented on how stupid bond ETFsare,” says Shantz, 51. That response didn’t sit especially wellwith the contrarian. “I decided that either fixed-­income ETFs weretruly sensationally stupid—which didn’t explain why their assetswere growing so fast—or there was much more to it.”

Shantz and his team of six began studying the funds. What theyfound intrigued them—so much so that in May 2013 Shantz forked over$1.35 billion of debt, or almost 20 percent of the fixed-incomebook, in exchange for shares in two of BlackRock’s investment-gradebond ETFs.

It was a bold move for the Employees Retirement System of Texas,an institution that had only one small trade in bond ETFs under itsbelt when Shantz joined.

When he later explained the maneuver at an industry event, peersand competitors told him that he was risking his reputation andthat he’d gone mad. “They were absolutely convinced that I was afool,” he says. “In a market dislocation, [they said,] these thingswould blow up, leaving me in a smoking heap in the ditch.”

That wasn’t just fear of the unknown. When the U.S. housingbubble burst in the mid-2000s, the price of some ETFs divergedsharply from the value of their underlying bonds. Given that thesefunds had since become more sophisticated and complex, somewondered whether they could walk through the fire of a globalfinancial crisis.

But Shantz and his portfolio have yet to find said ditch.Indeed, they’re both alive and well, with the credit book returningan annualized 5.3 percent over the last three years, beating itsbenchmark by 60 basis points. “It wasn’t until it was all done thatyou could breathe in and go, ‘Well, that was awesome,’ ” hesays.

And the once-esoteric debt ETFs he used? They’re colonizingswaths of investor money that bonds used to rule alone.

In pension plans, endowments, and mutual funds, they’ve grown asliquid alternatives to cash and temporary holding pens for capital,and as trading tools. Bond ETFs around the world are swimming inmore than $700 billion of cash, with about $480 billion of that inthe U.S.

Although those sums are a drop in the bucket compared withequity ETFs, which account for about 80 percent of the $2.8trillion U.S. market, debt funds are growing at a faster clip thanall asset classes other than commodities.

Every bond powerhouse from Pacific Investment Management Co. toDoubleLine Capital has started funds to get in on the action. Moreshares in a BlackRock high-yield debt ETF were traded on itsbusiest day last year than shares in Wal-Mart Stores, Exxon Mobil,or American International Group during the same session. By­contrast, similar bonds typically trade fewer than 100 times aday.

This rapid explosion of “Debt 2.0” has spurred dislocations andmutations in the market. Regulators worry that ETF brokers can’tkeep pace with investor appetite for the funds. Some ETFs flirtwith allowing cheaper assets into their portfolios so they growfaster than their competitors.

And the products are getting more and more complex. But none ofthis has slowed their acceptance by the financial community. “It’sgone viral,” Shantz says.

Turning bond ETFs into the next Grumpy Cat was far fromStephen Laipply’s mind when he got the call from Texas in early2013. Laipply had welcomed Shantz to BlackRock’s San Franciscooffice a few weeks before and was impressed by the fund manager’sthoughtful questions about ETFs. Now Shantz was back with aproposal.

A flood of easy money spilling out from the Federal Reserve hadlifted company debt almost 10 percent in 2012, according to theBloomberg Barclays US Corporate Bond Index. Investors had two waysto join the party via ETFs: They could either buy shares fromexisting owners on the stock market, the way they would with AppleInc. or General Electric Co., or they could ask the ETF manager tocreate new shares for them.

To create shares, an investor could pay in cash or “in kind,”acquiring and delivering an agreed-upon smorgasbord of securitiesto the fund, which the fund would then absorb and use to supportthe issuance. A middleman, usually a bank or broker, facilitatedthe switch.

Shantz wanted to explore an innovative version of the secondroute: using his book of investment-grade debt to buy theshares.

Laipply had seen this type of portfolio trade only once before,nine months earlier, when he’d swapped 4,000 bonds from a largepension fund for shares in BlackRock’s flagship ETFs. He startedpicking through Shantz’s selection of securities to determine whichbonds might fit into their ETFs. “There were hundreds of bonds,”Laipply says. “We went through a process of just looking at thepotential candidates and seeing how they could map onto ourETFs.”

Those names were then sent to BlackRock fund managers, who madethe final call on whether to accept or reject the offerings. Alittle more than half the bonds were a match. Elated, Shantz handedover the debt in exchange for shares in two ­investment-grade ETFs.Just like that, step one was complete.

But for Shantz, that wasn’t the end. The pension plan neededbonds, not these ETFs, and he’d settled on a mix of junk debt andTreasuries.

So after lying low for three months, Shantz quietly arrangedstep two: selling the ETFs in the secondary market to exit hisposition and free up capital.

By October he’d halved his exposure. By December the shares weregone.

Shantz had his cash—and all without roiling the price of theETFs. “We didn’t want to show up every day looking for bids,” hesays. “You can go into ETFs and buy or sell exposure in size andnever tip your hand to anybody.”

That versatility is part of what makes ETFs an attractiveproposition for money managers frustrated with the clubby world oftraditional debt trading. Rules implemented after the financialcrisis have crushed the banks and brokers that previously oversawbond trades, curbing their inventories and manpower and makinglarge trades a laborious process that nimbler competitors canexploit.

ETFs offer a speedier, cheaper alternative. The differencebetween the price at which traders are willing to buy or sell amainstream junk-bond ETF is about 1 basis point, considerably lessthan a spread of about 45 basis points to trade the underlyingbasket of bonds.

The fee to create ETF shares is typically less than $1,000.

In tumultuous markets, the funds are a safe house for investors,allowing them to remove baskets of bonds from their balance sheetsin return for highly tradable equity instruments that they canswitch back into debt when markets calm down.

Others buy ETFs to earn income on capital they’re waiting toallocate elsewhere. And still more follow Shantz’s example and useETFs as a tool to adjust their portfolios. “It’s happening everyday at some level and in some form,” says Damon Walvoord, co-headof the ETF group at Susquehanna International Group LLP. “It stillhas a long way to go before it’s an everyday tool for bondmanagers, but it’s moving in that direction.”

Such a dramatic transformation of the debt market bringschallenges as well as opportunities. Regulators fear that sharecreations could falter if even one or two middlemen who lead thesetrades quit. The Securities and Exchange Commission needs to reviewthe role of these gatekeepers, Commissioner Kara Stein hassaid.

Difficulties sourcing debt to create ETF shares and managingthat risk—particularly overnight—have already pushed some middlemento stick to cash creations or hand over tricky requests to theircompetitors.

The likes of Susquehanna have dedicated bond ETF traders, butdebt and equity teams at some other shops remain divided. Thecreation process they administer—which is unique to ETFs as anasset class—is also fragmented.

Although some bond ETFs demand a basket of securities alreadyfound in the fund, others require a portfolio of debt that’s merelysimilar. The latter makes for a more liquid ETF that’s easier tocreate, particularly for portfolio trades, but it also incentivizessubmitting the cheapest qualifying securities to the fund. ETFmanagers wanting to increase their assets must walk a fine linebetween accepting them and diverging too far from theirmandate.

“We’re evaluating them very closely, but the executionpotentially is not as good as doing it yourself,” says GregoryPeters, who runs the ­Prudential Total Return Bond Fund. “I’mnot an ETF hater by any stretch of the imagination, but those aresome of the challenges we face as an active bond managerimplementing ETFs into the strategy.”

Many other money managers have made their peace with debt ETFsand are weaving them deeper into their books. BlackRock gained 64institutional users of its bond ETFs last year, while almost 70percent of the 100 pension funds, insurers, and ­investmentadvisers surveyed for a Greenwich Associates LLC report lastSeptember said they’d increased their use of the funds over theprevious three years.

Investors that have already embraced portfolio trades are nowutilizing ETFs in lieu of options, swaps, and futures. Instead ofentering total-return swaps, they’re finding similar exposure in anETF.

And rather than using credit default swaps, investors arehedging their debt holdings with help from options on ETFs.Exchange-traded funds have also allowed ­investors to bet againstentire markets rather than short individual securities. The fundsare typically cheaper and require less ­balance sheet space orcollateral than buying a derivative.

All of that seems a world away from the stakes Shantz facedusing ETFs in 2013. Then, his reputation was on the line; now heuses them almost casually to respond to the needs of his­portfolio—instantly boosting exposure to a hot sector or ditchinga clutch of unattractive bonds. “There are some people who aren’tthat bright and would rather fail unconventionally than muddlealong conventionally,” he says. “I guess I’m one ofthose.”

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