The 20th anniversary is fast approaching of the launch by State Street Global Advisors in 1993 of the first investment fund that could be traded throughout the day like a stock.
Today, $1.3 trillion in assets are held in more than 1,455 exchange-traded funds and other exchange-traded products. That is still dwarfed by mutual funds, which hold roughly 10 times as much. However, ETFs are on pace to set another record with $135.2 billion in net inflows so far this year, according to the ETF Industry Association.
That could eclipse the previous record year, when $175.7 billion was pulled in during 2008. Money still flows into ETFs nearly every week exit mutual funds that invest long-term in stocks. “ETF providers are becoming more attuned to the needs of their clients and have been adjusting their offerings to win new assets and trading volumes,” said Deborah Fuhr, co-founder and managing partner of ETFGI, a Londonp-based research and consulting firm.
But the ETF market is not wide open. The top three firms—BlackRock’s iShares, Vanguard and State Street’s S&P Depositary Receipts (SPDR) ETF unit—control around 70% of ETF assets worldwide. And investors new to placing assets in ETFs can be confused by the hundreds of smaller ETF firms that operate at a much smaller scale.
Here, Money Management Executive provides three perspectives from three players in this fast-growing market. One, the view from the top (BlackRock); two, an upand- comer (Charles Schwab & Co.); and three, a firm that has retreated for now (Russell Investments), but reserves the right to mount a comeback.
The Heavyweight—BlackRock’s iShares
Through the end of September, more than one-third of the $135 billion that have gone into ETFs this year, or roughly $50 billion, has flowed into iShare’s ETF products. The firm’s share of global ETF assets is more than twice that of its secondplace rival, State Street’s SPDR ETFs, according to global data from ETFGI.
Indeed, BlackRock’s ETF assets exceed those of its next seven rivals, combined, ETFGI’s count says. Is BlackRock’s dominance and growth sustainable? And does the firm have a strategy for the next rounds of the competition for new assets?
“Absolutely,” said Mark Wiedman, Managing Director and Global Head of iShares. “We feel very strongly that the combination of our iShares Core Series, which targets buy-and-hold investors and a campaign to refresh the powerful iShares brand are key components of our broader plan to drive even stronger growth in the U.S. and globally.”
Under the new initiative, launched in mid-October, iShares created iShares Core Series, a group of 10 lower-cost ETFs specially designed for the needs of long-term investors. BlackRock is hoping the ETFs in the Core Series—composed of four new and six existing iShares funds—will attract investors by offering lower fees than other firms, and frankly, other iShares products.
For example, the fees on the iShares Core S&P Total U.S. Stock Market ETF were slashed to 7 basis points, from 20 basis points before the initiative. The cost-cutting initiatives came just a week after rival Vanguard enacted its own some pricing cuts, moving away from using its long-timer supplier of investing benchmarks, MSCI,to a new provider.
iShares also plans an advertising blitz, including television ads, to target smaller retail investors and educate them about the uses of ETFs in their portfolios. All of this is designed to build on the firm’s strength in the sector, Wiedman explained. “As investors seek core portfolio products they can buy and hold for the long term, price sensitivity has become more important in this section of the ETF market” he noted. “By taking price off the table, the adjustments we are making allow our core building-block products to compete on quality alone.”
The move was a smart one for iShares because even a champion has to defend his belt if he is going to remain relevant, analysts said. “Total costs and performance are important but they only tell part of the story,” said ETFGI’s Fuhr, adding that ETFs have to satisfy investors’ desired product characteristics, such as benchmark, trading exchange and tax structure.
That doesn’t mean iShares is rope-adoping and assuming its dominance will not face challenge or that its approach to bringing in assets does not need to change. But when you’re the size of iShares, you have to find prime-growth areas on which to focus to keep its numbers strong. Wiedman thinks he knows that answer to that one too. “Fixed income, fixed income, fixed income,” he said.
“As investors continue to grapple with low yields and volatile markets, a growing number are beginning to realize that the bond strategies of the past are just not behaving the way they used to.”
Wiedman believes global industry growth will be primarily driven by institutional and retail investors embracing passively managed fixed-income ETFs. “At iShares we like to call it a ‘quiet revolution,’” he said.
It’s not a bad bet—fixed incomefocused ETPs currently represent less than one-fifth of all ETP assets, despite the fact that in the non-ETF/ETP world, the bond market is about three times the size of the equities market. That is room for growth, Wiedman said, it’s not a new story for the firm, which created the first fixed income ETF nearly a decade ago.
“By offering price transparency at the ETF level and a liquidity layer that can exceed the underlying over-the-counter market, we may be creating a reference market of the future [in fixed-income ETPs],” Wiedman said.
Up & Comer: Charles Schwab
Schwab is also a player in lower-cost ETFs. In late September, Schwab cut its annual expense fees on its 15 ETFs, in some cases by as much as 60%. For example, the Schwab’s U.S. Mid-Cap ETF (SCHM) saw its fee cut in half, to 7 basis points from 13 basis point. With the lower fees, Schwab undercuts the competition. For example, its U.S. Large Cap Fund (SCHX) now charges 4 basis points compared to 10 basis points for the Vanguard Large Cap Fund (VV) and 9 basis points for SPDR’s S&P 500 ETF (SPY).
Schwab’s moves actually led a new round of expense cuts. Within weeks, both iShares and Vanguard followed suit with price-cutting initiatives of their own. John Sturiale, head of ETF product management at Schwab, explains that the beating heart at the core the firm’s cost-conscious strategy is its three-pronged distribution channel that serves customers that come in from its retail outlets, its online site, its affiliated registered investment advisers and 401(K) plans that offer its products.
Schwab’s distribution channel, which included 8.7 million active brokerage accounts and total client assets of $1.89 trillion at the end of the third quarter, allows the San Francisco-based brokerage to be aggressive when it comes to pricing and fees.
Schwab’s theory may well be proven right. At the end of the third quarter, ETF assets at Schwab reached $146 billion, up 35% over the past year and slightly above the level of ETF industry growth of 34%, according to research firm Strategic Insight.
Schwab’s ETF group is comprised of 12 to 15 product managers, client advisors and portfolio managers, which work with the indexed mutual funds too, as the indexing team. Sturiale said the firm added three or four new professionals in 2012, and plans to add more in 2013. “It’s a growing area for the firm,” he said.
Schwab’s strategy to compete on price has won over some industry experts “Do I think Schwab is someone to watch in the ETF space—absolutely,” said Daniel Weiskopf, co-portfolio manager at Forefront Global ETFs.
The firm’s wide distribution, Sturiale said, allows Schwab to offer: (i) the lowest operating expense ratio in each respective Lipper category of ETFs; (ii) commission free trades; and (iii) an aggressive bid/ask spread that often offers further savings to investors. “All three of these factors allow Schwab to cut costs for customers,”
Sturiale explained. “And as you can tell, costs are important to us.”
But if the firm’s ETF growth is fed by lowering its expense ratios and offering free trading, what has the firm truly accomplished at the end of the round? Can it make a profit in ETFs?
To hear Sturiale tell it, plenty—in an environment that, in fact, may be the new normal, returns are being squeezed and thus, value and low-cost offerings takes on paramount importance, he said, adding that in this diminished-return paradigm, it may be easier to find 20 basis points of lower cost than it would to find a bump of 20 basis points of return.
“I think the general trend for prices is to go lower,” Sturiale said. ‘Investors are realizing that indexing is a commodity, and a cap-weighted, beta-indexed ETF needs to attract on cost. The question is, how low can it go?”
That lower-cost ETFs are potent weapons for Schwab is important because the firm may not be able to compete on sheer size or the number of ETFs offered—yet. “Schwab is certainly not the biggest in the ETF market, and we’re not going to be,” Sturiale explained. “Our value and our attraction is in finding lower costs for our clients. The cuts we made strengthened that position, and we’re going to stay competitive.”
Down, Not Out—Russell Investments
In mid-August, Russell Investments announced it would shutter its family of 25 passively-run ETFs. It looked as if the firm, which is a big supplier of the indexes that passive ETFs are based on, was throwing in the towel.
The move came little more than a year after Russell stepped into the ring. The funds had amassed only $310 million in assets, as of the end of July, and were wound down by October 24, with investors getting their money back.
ETF analysts and advisors speculated that it was this lack of asset accumulation that had doomed Russell’s fledgling effort. And Russell wasn’t alone—FocusShares, the ETF unit of brokerage firm Scottrade, scrapped its 15 ETFs, just 18 months after launching them.
Russell said 30 employees in the ETF division were laid off, and Jim Polisson, CEO of Russell’s ETF business, left the firm to pursue other opportunities. Despite all this, few expect Russell to be gone for good. “I would call what Russell did a ‘tactical retreat’,” said Jim Pacetti, an ETF industry consultant with S*Network Global Indexes, a New York-based index provider. “They came out with a good product, but the firm’s timing was off—had the equity market rebounded, thenthe wind would have been at their backs and it would have been a different story.”
Some of the shuttered ETFs were relatively popular. For example, the Russell 1000 Low Volatility ETF (LVOL) and the Russell Equity Income (EQIN) were the firm’s most popular ETFs, amassing $69 million and $50 million before being closed.
Interestingly, Russell kept one of its ETFs in the group alive—the Russell Equity ETF (ONEF), which was the only actively managed ETF of the group. The Russell Equity ETF is benchmarked to the Russell Developed Large Cap Index, and has just $4.3 million in total assets.
Actively managed ETFs have garnered fewer assets and less respected than the cheaper passively managed ETFs, which often out-perform their actively managed counterparts, analysts said. At just under $5 million in assets, ONEF holds less than the industry standard for start-up seed money, though.
“The decision to liquidate the passivelymanaged ETFs was driven by a range of strategic factors, including to more fully reaffirm our focus on our core competency— delivering multi-asset solutions—and it frees us from needing to dedicate the attention and resources toward building distribution and scale for a stand-alone ETF business,” said Steve Claiborne, a Russell spokesman, in an email.
Obviously, Russell is a big name in the ETF industry in another way—indexing, a fact the firm is eager to underscore. “Russell serves as the underlying index provider for many passively-managed ETFs around the world, which have more than $80 billion in assets under management, and we aim to continue our strong partnership with each of these ETF sponsors.”
But can Russell parlay its ETF-indexing business, which represents just a fraction of its overall indexing business, into another foray of ETF creation and management? “I think Russell will be out of the market temporarily, say like a year or longer, and come back in when they see the opportunity,” S*Network’s Pacetti said.