BlackRock's launch of low-cost ETFs seen as smart move
By Timothy Pollard | October 29, 2012
BlackRock (BLK) Inc. (BLK)'s strategy to offer 10 low-cost exchange-traded funds for buy-and-hold investors will cost it revenue at the outset, but analysts say the effort to reclaim business and market share it has lost in recent years is generally positive long term.
Management has said the estimated cost to BlackRock's revenue will be about $35 million to $40 million annually. That figure, however, only accounts for the revenue on the six funds whose expense ratios were reduced. Analysts' estimates vary — from an amount in line with management's estimate to nearly $90 million in annual forgone revenue, when all 10 are included.
A fee-reduction analysis by Keefe, Bruyette & Woods, New York, found that - based on Sept. 30 assets under management figures — BlackRock will forgo $37.9 million annually on the six ETFs on which the firm cut fees. KBW's analysis also found that BlackRock stands to forgo almost $52 million in annual revenue related to the four new funds that began trading on Oct. 22, assuming 20% of assets flow from BlackRock's pre-existing ETFs into the new, cheaper alternatives.
Taken together, the $89.5 million in potential forgone revenue would represent 4.1% of the total revenue the iShares business generated in 2011, and 1% of BlackRock's combined operating revenue for 2011.
Despite that potential hit, Greggory Warren, senior stock analyst who covers BlackRock at Morningstar Inc., Chicago, said the cost of BlackRock's move to lower-fee ETF options is likely to be offset by the company's launch of its own internal trading platform.
The announcement on Oct. 15 unveiled a new strategy to drive global and U.S. growth for its iShares exchange-traded-funds unit. The company launched a suite of 10 ETFs, which it's calling “core” offerings, that will be priced in line with lower-cost providers. The Core Series includes four new funds that are lower-cost versions of international equity and short-term U.S. bond funds on which the company did not reduce expenses. The firm is also initiating a global branding campaign and combining the sales forces of its iShares and U.S. BlackRock retail units.
Increased flows expected
Despite the revenue hit, most analysts believe the lower pricing and new ETFs eventually will lead to increased flows over time and help plug some of the “leakage” to lower-cost competitors such as The Vanguard Group and Charles Schwab Corp.
During the three-year period ended Sept. 30, the Vanguard funds saw net inflows of $50.9 billion, vs. outflows for the iShares funds of $703.6 million; and over the five-year period, Vanguard inflows were $66.3 billion compared with iShares inflows of only $5.9 billion.
However, Morningstar's Mr. Warren noted in an interview that even before the cost cuts were announced, iShares generated its largest quarterly flows since 2009 during the third quarter of 2012, with $25 billion.
During the company's third-quarter conference call, BlackRock President Robert S. Kapito said that over a multiyear horizon, BlackRock executives believe iShares can achieve double-digit organic growth from the new strategy.
In an interview, Daniel E. Gamba, managing director and head of iShares Americas institutional business at BlackRock, said that such growth will largely be centered around three themes: fixed-income ETFs, global expansion, and innovative ETF use among institutional investors “particularly for derisking, large transitions and using ETFs more strategically.”
Mr. Kapito also outlined BlackRock's three distinct groups of ETF users in the U.S.: active capital markets participants; investors seeking precise and specialized exposures; and buy-and-hold investors seeking broad, beta exposure to the markets. BlackRock, he said, has a very strong position with the first two segments, and the new core offerings will target the latter group.
Mr. Kapito cited iShares MSCI Emerging Markets Index Fund as an example of an ETF sought by active market participants and those seeking specialized exposure, highlighting its deep liquidity, tight spreads and that it's the only “highly liquid emerging markets product pegged to MSCI, which many institutional clients use as a benchmark for emerging markets.” The fund has an expense ratio of 0.67%.
In comparison, the new Core MSCI Emerging Markets ETF has an expense ratio of 0.18%. This fund will track the MSCI Emerging Markets Investible Market index, or IMI, rather than the non-IMI index, which excludes small-cap stocks.
In the firm's marketing materials touting the use of MSCI investible indexes, BlackRock highlights that non-IMI indexes cover only about 85% of the market. Inclusion of small caps offers broader exposure and greater diversification benefits, according to the materials. A new offering that tracks a greater portion of the emerging markets universe at a cost of 49 basis points less could potentially lead to investors dropping the higher-priced ETF, regardless of its liquidity benefits.
Mr. Gamba said the response from institutional investors has been positive. A major trend of late, he noted, is that ETFs are moving front and center for investors like pension funds, insurance companies and hedge funds, and BlackRock (BLK)'s move was done to attract institutional investors who want a core offering that is competitively priced.
Asked if any investors had inquired why BlackRock simply did not reduce fees on all existing products, he said no concerns had been raised; rather, clients have been inquiring how they can maintain exposure to MSCI indexes.
Investors appear split on the importance of pegging to a brand-name index. In an unscientific poll posted on Pensions & Investments' website, 52.8% of respondents indicated it does not matter if passive money managers benchmark against brand names indexes. But Mr. Gamba said institutional investors are very careful about selecting indexes that are strict in their construction and that MSCI is considered the gold standard for international equities. He said he does not see that changing over the next five to 10 years.
This article originally appeared in the October 29, 2012 print issue as, "BlackRock giving up a little now to gain later".