Traditional firms face a number of cultural challenges in their efforts at increasing their distribution. Some are not keen to develop strategies designed to appease the market, so expanding board education on ETF distribution trends can be a useful measure to address reluctance about launching the funds, according to Ryan Sullivan, vice president of global ETF servicing at Brown Brothers Harriman.
“What we’re seeing is sort of a fundamental shift in the outlook of ETFs at large,” Sullivan said in an interview with Money Management Executive.
Sullivan stresses that product providers have to be better at adapting to the market, adding that board education on ETFs — in-house or by commissioning third party consultants — is just one of the possible ways of starting the conversation.
“Look at the cost factor,” Sullivan notes. “What does that mean; not only offering those products at a competitive rate for investors, but what does that do to your margins internally and how do you ensure you’re not cannibalizing?”
How has the industry trend to passive investment products affected your product line?
What we’re seeing is sort of a fundamental shift in the outlook of ETFs at large.
What I mean by that is I think five years ago you had a population of asset managers who maybe would’ve given ETFs the stiff arm, had you asked them what their strategy was — that would say it’s just a passive vehicle for low-cost managers, or, “We’re an active shop, and that’s not for us.”
I think more recently, over the last year or two, you have really seen a groundswell with large traditional active managers’ shops that have had a tremendous amount of success in gathering and managing assets over decades, have now come to the conclusion that ETFs are a critical part of their investment menu.
I think that shift has gone from viewing ETFs as a wrapper for low-cost passive strategies, and now the consensus seems to be that they’re really a low-cost wrapper for active or passive strategies.
So, it’s not so much about passive only, but more about the structural benefits the product can provide.
Does this change the way your firm’s products are developed?
There are a couple nuances as firms look to the market, or look to bring ETFs online. When thinking of organizations that would be doing so for the first time, perhaps they a have got a large mutual fund complex, mutual fund managed account or maybe collectives.
ETFs do present nuances to them, and I think many firms may get caught up in the operational nuances voicing concerns such as; “What is a portfolio composition file, or PCF? I don’t need that for my mutual fund, but all of a sudden that’s a new requirement post-NAV for my day-to-day processing. What’s the capital market’s role? What are EPs and market makers? What do you mean there’s a primary and secondary market?”
That’s one of the easiest solutions from our perspective that we can offer, because it’s really things we eat and breathe every day as a custodian and fund administrator to the ETF market.
Those are avenues where we can really tailor and help educate folks in designing what that offering model looks like — highlighting elements that are very standardized and fairly vanilla across all ETF sponsors, and those that allow for a little bit more customization in where they might be able to tailor that to be able to meet their existing options environment.
I think there’s a natural lens on that if you’re an asset manager, especially if you’re under the chief operations officer staff, or working on the treasurer’s team, and you’re focused on NAVs and pricing, and corporate actions in the back and middle office. Day in and day out, you’re going to have a laser-light focus on that.
If you expand that view a little bit, there are nuances around distribution; there are nuances around product development, around the cost that these particular products have.
Distribution, in it and of itself; I think you run into issues and we’ve heard increasingly from managers entering the ETF market that there’s a very real concern about how they incentivize their sales team to promote ETFs when they might be more comfortable doing something with their mutual funds. Is it education or is it compensation based? How do you solve that and how do you think about it as a manager offering now another product wrapper on your shelf?
And look at the cost factor — what does that mean; not only offering those products at a competitive rate for investors, but what does that do to your margins internally and how do you ensure you’re not cannibalizing, especially if you’re launching a strategy in an ETF that may be found elsewhere that may be similar to something in a mutual fund or a collective How do you manage that cannibalization in those competing interests?
Can you speak about the cultural resistance? I’m assuming some traditional product providers might find it distasteful figuring out the ‘hot strategy’ as it may run against the way things may have been don’t traditionally?
That’s always the interrupting dynamic. I would say the onus tends to fall by and large on the product development team and the product strategy group to really make the case internally for why these products are needed. It can be, perhaps, the most challenging.
I mentioned that distribution definitely is a very large concern and there are hurdles to overcome for some organizations, but even building that internal consensus can be a very daunting task, especially if you’re an active manager that’s been around for decades and done things a certain way and had a great deal of success doing it that way.
Understanding some of the headwinds they now face, some managers — whether it’s through outflows, performance or more demographic shifts that are rising as the investor population that wants a lower-cost product — building that case are finding that it can be a challenge.
Anecdotally, how we’ve seen shops overcome that, it can be through things like the board education, where they may be partnering or bringing in a third party subject matter expert to help consult with the board on why the board should really give open consideration for entering the ETF market.
There can be an element of “ETF 101” in that, but it also becomes more macro-related; I’m talking about both the role of ETFs and maybe headwinds that would apply to that manager’s particular sector or peer group, and showing the board that other managers may be going through the same issues, or encountering the same headwinds of what the other shops are doing. And then even outside of the board, working with executives across the organization to help build that consensus becomes a very large task for the alternative product development or product strategy person.
Ironically, I would say some of the larger shops that have multiple business lines, and may be affiliated with broker-dealers and large distribution affiliates, where they may be promoting third party products and sort of have an open architecture approach.
I would argue that they may actually have an easier hurdle to overcome in terms of building consensus because I think folks across the organization are going to see how other firms’ ETFs have sold through that complex. But as a standalone asset manager who may be focused don managed accounts, mutual funds or institutional accounts in mutual funds, showing them the success that ETFs have had can be a more daunting task.
I think maybe to bridge my previous response regarding some of the due diligence that they can do, I think it’s important that they arm themselves as a product development person, to build that consensus that they can show their clients want these products and want their strategies in that wrapper. That is one of the best case scenarios — to have that arrow in your quiver, so to speak, when you go to your CEO or the management committee or executive committee to make the case, showing them what their investors want, and that it’s an ETF with their strategy, that goes a long way.
Who still needs an ETF refresher course?
When you ask who needs it, I think it’s an interesting group, and I’m thinking of just a few off hand here.
You still have distribution channels that survey after survey are saying we still need to learn more about ETFs. You have RIAs, who have been one of the quickest inductors of ETF usage by and large over the last couple of years — yet you still see pockets where it may not be “ETF 101,” but increasingly it becomes more of a master’s class in ETF trading.
They really want to better understand the market dynamic on the exchanges, the differences in the exchanges — whether it’s NYSE Arca, Bats or Nasdaq — and how listing on those exchanges may present nuances. They’re not all identical in the rules they have on a day-to-day basis. This got a lot of attention last Aug. 24.
But it’s better understanding those nuances, the circuit breakers’ trading holts, what’s causing the spread between the bit and the ask for the ETFs, and really focus on that masters level data set. So, they’ve sort of evolved from that “101” education to more of that deeper dive.
Institutional buyers that seem to be emerging — and I am thinking of insurance companies, pensions, endowments foundations. The strategies they tend to be using, especially within maybe the pension or insurance companies, has historically been more tailored around fixed income.
They’ve begun to move into broader equity asset classes, some of which are core holdings for portfolios, whether it’s an insurer building a VA product around ETFs.
They’ve begun to engage more with the sponsors directly on portfolio composition — how those products will play in a structure like a VA or in the pension plan, itself.
Really, it’s getting a better handle on what the adjustment is to the risk return profile, the risk premium the ETFs may prevent or detract, and how that works from their asset allocation strategy. That becomes part of the education component.
I mentioned boards earlier, but we need to think about managers who are now entering the market for the first time and really get a better understanding that, “OK, my board handles 40-act open-end funds right now, so what’s the same and what’s different?”
From their fiduciary standpoint, and their responsibility to their shareholders, what do they need to know? What do they need to arm themselves with to provide better oversight, better governance for a brand new precut.
Some of them might be too hesitant or reluctant to improve.