Although an oligopoly of three money management firms dominates 84% of the U.S. market for exchange-traded funds, the relative newcomers to this fast-growing investment segment are capitalizing on their brand names and existing strengths as competitive advantages.
Pacific Investment Management Co., Charles Schwab & Co. Inc., Northern Trust Corp. and other investment management firms that compete for the remaining 16% of the marketplace have been able to increase assets by ignoring for the most part the core ETF products following popular indexes that are some of the hallmarks of the top three providers. Instead, the newer competitors have developed their own unique offerings, such as an ETF following a custom index designed to track diversified commodity exposure in the case of Northern Trust or an ETF version of the world's largest bond fund in the case of PIMCO, said Ben Johnson, director of passive fund research at Morningstar Inc. in Chicago.
Mr. Johnson said it would be difficult to compete with the big three on core ETFs.
“They have a stranglehold on those products,” he said.
Total ETF assets in the U.S. are still small, $1.4 trillion, when compared with mutual funds at $9.6 trillion. But for many major diversified money management firms, having an ETF lineup is important, particularly if the segment starts heating up and becomes bigger, said mutual fund consultant Geoffrey Bobroff, president of Bobroff Consulting Inc., East Greenwich, R.I.
Mr. Bobroff said that generally an ETF has to gather between $50 million and $100 million in assets to become profitable. Companies like PIMCO, Schwab and Northern Trust don't break down revenue or profits or losses for their ETFs.
BlackRock (BLK) Inc. (BLK), New York, the largest ETF provider in the U.S. with $566 billion, reported 29.5% of its $9.34 billion in revenue came from its ETFs in 2012. It does not break out ETF profits.
Broadly speaking, ETFs can be more profitable than mutual funds for money management firms, said Jason Weyeneth a New York-based analyst with brokerage firm Sterne Agee Group Inc. Mr. Weyeneth said most ETFs follow passive indexes, so once the index is set up, the ETF does not have the cost associated with paying active managers.
Mr. Weyeneth said Invesco (IVZ) Ltd. reported operating margin in the mid-30% range in 2012 but noted in its financial statements that its PowerShares ETFs achieved or exceeded that operating margin range. Invesco PowerShares is the fourth largest ETF manager in the U.S. with $62 billion in assets.
Another window into ETF profitability can be found by looking at WisdomTree Investments Inc., New York, the sixth largest ETF provider with $26.3 billion in assets under management. It reported net profits of $11 million in 2012.
Mr. Weyeneth said WisdomTree has an operating margin in the mid-20% range, but estimates that if the company can achieve $35 billion in AUM, it can bring profitability up to at least 40%.
PIMCO goes active
Industry observers have paid particular attention to PIMCO's move into ETFs. Its largest ETF, the PIMCO Total Return ETF, is an actively managed product, an exception in a world where most ETF products are passive. It is also modeled after the world's largest mutual fund, the $288 billion PIMCO Total Return Bond Fund managed by William H. Gross, said Morningstar's Mr. Johnson.
“You've got one of the most successful fixed-income managers of all time offering a proven strategy that has outperformed for decades in an ETF wrapper,” he said.
PIMCO enjoys global brand recognition, which helped the firm build ETF assets. It also has not hurt that the Total Return ETF has outperformed the mutual fund with the same strategy, said Deborah Fuhr, managing partner at ETFGI, a research and consulting firm in London.
“All those things have played to their advantage,” she said.
Ms. Fuhr said Northern Trust's success is based on its coming up with a series of smart-beta products “that have been embraced by investors looking for outcome-based investment products rather than market cap exposure.”
Being a trust bank has given Northern the opportunity to cross-sell its ETFs, leveraging its custody and wealth management business, said Shundrawn Thomas, managing director and head of Northern Trust's exchange-traded funds group.
“That being said, if you don't have a good value proposition, it doesn't mean anything,” said Mr. Thomas, saying there are other examples of successful financial companies closing their ETF lines.
Northern Trust was one of them. In June 2009, Northern closed all 17 of its ETFs, less than a year after the funds were launched in April 2008. Mr. Thomas, who did not head the company's ETF operations then, said the funds were launched at the wrong time, at the beginning of the financial crisis.
Northern Trust, which calls its line of nine ETFs FlexShares, has had the most luck with its FlexShares Morningstar Global Upstream Natural Resources Index ETF. Launched in September 2011, it had $1.9 billion in assets as of March 25, according to Northern Trust.
The fund, which uses a custom index from Morningstar, invests in commodities but uses a diversified approach, investing 30% of its assets in agriculture, 30% in energy, another 30% in metals, 5% in water and 5% in timber, with the diversification supposedly offering an inflation hedge and downside protection. “You won't see such a balance (of commodity investments) in any other ETF,” Mr. Thomas said.
Northern Trust is looking for products that will fulfill a market need, “not copycat products,” he added.
Mr. Johnson, whose ETF research division operates independently of the Morningstar division that provides the index for the Natural Resources ETF, said Northern Trust has managed to develop products not offered by other ETF providers.
“Northern has done a good job of nibbling around the edges of the market and finding what little white space is left,“ he said.
While the road to success for most ETF providers is not to emulate the core products of BlackRock (BLK), State Street Global Advisors and Vanguard Group Inc., Charles Schwab has taken a different approach, citing its low-cost fee structure as it attempts to out beat out Vanguard for the claim of being the lowest-cost ETF provider.
Mr. Johnson said some Schwab ETFs are priced as low as four basis points.
“That's as low as it gets in the U.S. ETF market,” he said.
Schwab wants to be known as the price leader in the ETF industry, said John Sturiale, vice president of Charles Schwab Investment Management, San Francisco.
Mr. Sturiale said the company has major plans to build its ETF business even further, including creating an institutional presence.
He said sales representatives are beginning to call on institutional consultants to pension plans, foundations and endowments that the company believes will be attracted to its low-cost ETF options.
Mr. Sturiale said the company's $10 billion in ETF assets are split between direct retail customers and money placed by financial advisers.
Mr. Johnson said he doubts Schwab is making any money on its ETF lineup, given its free commissions and low ETF fees.
“If they are making any money it's awfully small,” he said.
Erin Montgomery, a spokeswoman for Schwab, said the company views its ETF operations, “holistically” and that ETF sales positively affect the profitability of the total client relationship the company has with investors.
Ms. Montgomery would not say if Schwab makes money on ETF sales alone.
Mr. Johnson said investors being lured to the Schwab platform to invest in ETFs can also be converted to using Schwab's investment platform for other products, which ultimately could be lucrative for the company.
Record net inflows in 2012
The successes of PIMCO, Northern Trust and Schwab come as the U.S. ETF industry in 2012 had record net inflows of $191 billion. Despite those inflows, a March 25 industry report by Credit Suisse noted that a record 102 exchange-traded products closed in 2012, almost twice as many as the previous year. A total of 178 ETF products were launched last year, according to ETFGI's Ms. Fuhr.
The number reinforces that it has become “much more difficult to launch a successful product in a market with so many different choices already,” the report noted.
The Credit Suisse report noted that a recognizable brand name might be the most important characteristic going forward in a market where assets are heavily concentrated in the largest providers and success is usually determined within two years, and often one, of a product launch.
PIMCO's and Schwab's ETF inflows make them the 11th and 12th largest ETF providers in the U.S.; Northern is 18th.
This article originally appeared in the April 1, 2013 print issue as, "Big-name firms work to grab snippets of ETF pie".