Venture cap, merchant banks see gold in ETFs

Private equity and merchant banking firms think there is money to be made in the booming exchange-traded fund business.

Investors hope to find the next PowerShares, which has become the poster child of entrepreneurial ETF success. The firm — acquired for $60 million by AMVESCAP PLC earlier this year — had amassed $9.15 billion in assets as of Dec. 18, about three years since it launched its first two funds.

AMVESCAP's purchase of PowerShares "opened up people's eyes" to the growth potential, said Ben Cukier, a partner with venture capital firm FTV Management Co. LLC, San Francisco. "I have received calls from countless entrepreneurs … who all want to be the next PowerShares." FTV invested $10 million in PowerShares Capital Management LLC, Wheaton, Ill., in 2005.

The global ETF market is expected to hit $2 trillion in 2010, up from $469 billion in June, according to Celent LLC, a New York research firm.

That growth rate has venture capitalists and merchant bankers looking for the next hot ETF provider.

FTV officials expect to announce an ETF financing commitment in early January that will be "similarly sized" to the PowerShares investment, Mr. Cukier said.

Meanwhile, merchant bank Grail Partners LLC, San Francisco, plans to make an initial investment of about $10 million in an ETF provider in the first quarter, said Donald Putnam, the firm's managing director. Mr. Putnam said he knows about a dozen companies in the ETF market considered to be "investment quality." Mr. Putnam declined to name individual firms, but said some include enhanced or "quasi-active" ETF providers, as well as those that offer financial services such as lifecycle or target maturity funds.

GrandBanks Capital Inc., a venture capital firm in Newton, Mass., also has been exploring potential investments in the ETF market, said Charles Lax, managing general partner. And another venture capital firm, Aquiline Holdings LLC, New York, is looking for budding early stage or venture ETF investments, said Steven Spiegel, partner.

WisdomTree Investments Inc., New York, crossed the $1 billion mark in assets under management in November, about five months after its first family of fundamentally weighted dividend ETFs began trading. Before it introduced those funds, WisdomTree had about $250 million under management.

WisdomTree raised a total of $16.5 million in two separate transactions between 2004 and 2005. WisdomTree investors include Michael Steinhardt, chief executive officer; Jeremy Siegel, senior investment strategy adviser; RRE Ventures LLC, a private equity firm in New York; and Quantitative Financial Strategies Inc., an asset management firm in Greenwich, Conn. Calls to WisdomTree President Bruce Lavine and other company representatives were not returned.

If the Securities and Exchange Commission changes rules that currently restrict active management of ETFs, they could pose a competitive threat to mutual funds.

As ETFs become more common, there is a "general belief that ETFs are a very disruptive technology to the mutual fund world," said Grail's Mr. Putnam.

"You will see growing interest in ETFs as a distribution mechanism," said Steven Schoenfeld, chief investment strategist for Northern Trust Global Investments, New York, and author of "Active Index Investing: Maximizing Portfolio Performance and Minimizing Risk Through Global Index Strategies." He declined to comment on whether Northern Trust, which has a substantial indexing business, is considering expanding into ETFs.

ETFs are "too much of a growth factor of the market to be ignored today," added Aaron Dorr, managing director at Putnam Lovell NBF, an investment banking firm in New York. He declined to comment on whether Putnam Lovell is considering financing ETF providers.

The landscape today is dominated by Barclays Global Investors, San Francisco, and State Street Global Advisors, Boston, with ETF market shares of 58.4% and 25.3%, respectively, as of Oct. 30, according to a BGI report. Among other firms, Bank of New York had a 7.2% share; Vanguard Group, Malvern, Pa., 5.2%; PowerShares, 2.1%; Rydex Investments, Rockville, Md., 0.8%; and WisdomTree, 0.2%. Victoria Bay Asset Management LLC, Alameda, Calif.; Van Eck Global, New York; and First Trust Portfolios LP, Lisle, Ill., each has a 0.1% share.

Newer ETF firms tend to have more varied offerings, ranging from ones tracking fundamental indexes to "value-added" services. For example, XTF LP, New York, recently packaged ETFs into six target-maturity portfolios. XTF uses ETFs from the likes of BGI, SSgA and Vanguard in those portfolios.

The firm, which recently raised $9.5 million from individuals, had decided against venture financing, said Mike Woods, XTF's chief executive officer. Company officials weren't happy with giving up board seats, among other things, he said.