New Exchange-Traded Product launches are off to a strong start in 2014. As the industry matures, it has become increasingly difficult to launch an ETP that can build assets quickly. Before launching a product, providers need to understand that the factors that drive short-term asset gathering success are not necessarily the same as those that drive long-term success.
Product innovation and market timing drive early ETP success. Product innovation or differentiation results from offering unique features that fill an unmet demand, such as exposure to an asset class or strategy previously not available through an ETP vehicle or a substantive improvement on an existing product. True product innovation is rare, but these products command premium pricing compared to the lowest cost ETPs. For instance, SPDR Gold Shares GLD gathered $3 billion in less than a year and fundamentally changed the way investors buy gold. It is still the most successful commodity ETP around and charges more than its closest peer, iShares Gold Trust IAU. Similarly, product innovation drove success for several ProShares products and the firm remains one of the largest providers of ETPs. PIMCO Total Return ETF BOND offered several innovations, such as access to a star portfolio manager in Bill Gross within an actively managed ETF, for a lower in price than retail mutual funds of essentially the same strategy.
It has become increasing difficult for an ETP to reach at least $200 million in assets one year after launch, but more likely that a new ETP will languish with less than $20 million. But even without substantial innovation, ETPs can gain assets quickly if they take advantage of current market trends. Given the lead time required to bring an ETP to market, it is hard to predict what market conditions will be like when an ETP is finally ready to launch. But that has not stopped product developers from trying. A good example of fortuitous timing was the launch of low volatility products just at the time when investors were interested in returning to the stock market, but where wary of market turbulence. Likewise, bank loan products launched when investors were looking for better yielding fixed income products with less duration risk.
In addition to innovation and market timing, partnerships offer a path to gathering assets. Partnerships may be strategic, such as the many symbiotic partnerships that have evolved between Fidelity and Blackrock, or they may be more opportunistic, such as the way that Flexshares has launched ETPs, which have an in-house demand from existing NorthernTrust clients. Clearly, many of Schwab's ETFs have gained assets primarily as a result of the relationship with Schwab's brokerage platform, as have those ETFs that participate in commission free trading arrangements.
Liquidity is yet another key success factor for new ETPS. Liquidity tends to attract assets, which further enhances liquidity in a virtuous cycle. Two products can offer identical exposure, but traders often gravitate toward the more liquid product, lowering trading costs for long-term investors further enhances liquidity. Scottrade's FocusShares offer a great example of this. Many of these core equity ETFs boasted some of the lowest expense ratios available at the time, yet without liquidity, they withered in less than 18 months. Due to its liquidity advantage, SPDR S&P 500 SPY continues to hold the lion share of ETF assets tracking the S&P 500 Index, even though both iShares Core S&P 500 IVV and Vanguard 500 ETF VOO have lower expense ratios and have outperformed SPY.Brand awareness may also help drive early success.
A strong brand, either at the fund provider level or at the index level fosters the confidence of early adopters. Of the recently launched ETPs that have reached one year in age, those from firms such as PIMCO and Vanguard were able to gather assets more quickly than ETPs from lesser known providers such as AdvisorShares or ALPS.
But even in the long-term, they may not be sufficient to maintain a large asset base. Ultimately, investors want good performance and a suitable investment experience that meets their expectations. For traditional index products, one of the biggest predictors of performance is cost. So for a plain-vanilla ETF to be successful in the long-term, it has to be low cost. Core funds that are suitable for a wide swath of investors that are easy to use and low cost are more likely to endure than tactical funds that require rebalancing or periodic updates to an investment thesis.
For example, of the 290 or so ETPs that have closed, the majority have come from alternative or sector category groups that tend to be suitable for a narrower segment of investors than ETPs in the U.S. equity or taxable bond category groups.
While liquidity is great for short and long-term success, many funds that were once the most liquid have slowly lost market share to similar, but less expensive alternatives. For example, SPDR Gold Shares GLD lost market share to iShares Gold Trust IAU, and SPDR S&P 500 SPY lost market share to iShares Core S&P 500 IVV and Vanguard S&P 500 ETF VOO. The clear long-term winner is Vanguard.
While not always the most innovative, well timed or liquid out of the gate, its simple menu of low cost funds is easy to use and have built liquidity over time.
These funds enjoy good records and stewardship. While Vanguard is dominating fund flows, iShares has taken note and launched a low cost core series of ETFs, which have been successful. This competition should continue to benefit investors.
Michael Rawson is an analyst at Morningstar.
