ETFs' siren song still lures managers

As a new crop of money managers and investment banks enters the hot market of exchange-traded funds, the challenge has already proven too much for some in a sector where scale is key.

Already, a few carcasses have been left along the way as firms such as Northern Trust Corp., AXA Investment Managers and London & Capital PLC withdrew in the past year after unsuccessful attempts to kick-start ETF businesses.

Still, ETFs are luring heavyweight managers including Pacific Investment Management Co. LLC, T. Rowe Price Group Inc., Goldman Sachs Asset Management and Russell Investments.

“There's no doubt growing an ETF business right now is very challenging,” said Ted Hood, CEO of Source, which launched last summer in Europe to offer ETFs to a largely institutional market. “It's not an immature market, and there are well-established incumbent firms that are good at what they've done to date.”

“So the way we've approached (the market) is with the aim to grow the size of the market, so that we can participate in that growth,” said Mr. Hood, whose firm is owned by Bank of America Corp., Goldman Sachs Group Inc., Morgan Stanley, JPMorgan Chase & Co. and Nomura Holdings Inc. Source had $3.6 billion in ETF assets under management as of Jan. 31.

Global ETF assets surpassed the $1 trillion mark at the end of last year, up a whopping 45.7% from a year earlier, according to an annual ETF industry review published earlier this month by BlackRock Inc.'s ETF research and implementation strategy team in London.

In 2010, ETF assets are predicted to increase by 20% to 30%, according to the report.

The trend is driven by stronger investor demand for “easy, transparent and inexpensive” exposure to beta, said Adrian Valenzuela, London-based managing director and co-head of equities distribution at JPMorgan for Europe, the Middle East and Africa.

Firms that have jumped on the ETF bandwagon or plan to do so include:

• PIMCO, Newport Beach, Calif., gained about $418 million in asset inflows as of Dec. 31 within months of launching a series of fixed-income ETFs, including actively managed strategies, in the U.S.

• Jefferies Asset Management LLC, a division of Jefferies & Co. Inc., New York, introduced several ETFs that invest in commodities-related companies. The firm has about $100 million in ETF assets under management.

• T. Rowe Price in 2009 filed with the Securities and Exchange Commission to offer active fixed-income and equity ETFs in the U.S. The application is still pending.

• Goldman Sachs and its asset management subsidiary, GSAM, also have applied to the SEC to manage equity, fixed income and blended ETFs in the U.S. That application also is still pending.

• London hedge fund manager Marshall Wace LLP is introducing an ETF that physically tracks an index based on the firm's market-neutral investment strategy.

• Russell, Tacoma, Wash., hired away two top iShares executives — James Polisson and Andrew Arenberg — in January as managing directors to launch an ETF business. Russell spokesman Steve Claiborne declined to provide details, but hinted the firm will pursue active ETFs.

• ETF Securities Ltd., London, in November launched ETF Exchange, a global platform backed by a consortium of banks that includes Bank of America, Citigroup Inc., Rabobank International and Barclays Capital. Barclays Capital is a subsidiary of Barclays PLC, which only last year divested its ETF division iShares as part of the sale of Barclays Global Investors to New York-based BlackRock. Separately, ETF Securities also launched in the U.S. in July, and has gathered more than $1 billion in assets nationwide.

Charles Schwab Corp. and John Hancock Funds LLC are among firms in wealth management that are taking the plunge into ETFs.

“ETFs are basically a distribution channel at the end of the day — one that investors like. Having an ETF platform can help prevent leakage of assets under management. For some managers currently entering the market, it's one way of retaining assets,” said Christos Costandinides, ETF strategist at Deutsche Bank Securities Inc. based in London. “In the short term, however, those providers are really not going to be a threat to the top five (ETF providers).”

BlackRock alone boasts 47% of the global market share with $489 billion in ETF assets under management as of Dec. 31, followed by State Street Global Advisors' 16% market share, with $161 billion.

Vanguard Group Inc., Lyxor Asset Management and Deutsche complete the top five, which has 80% of the market share among about 110 firms, according to the BlackRock report.

While scale is needed, the ETF market still has plenty of room for growth, and some firms are banking on higher-margin specialized strategies.

“Specialized products that are more expensive to structure also mean more room for profit,” Mr. Costandinides said. “What will differentiate each player as they attempt to gain market share is their ability to capitalize on the different and existing strengths, as opposed to being everything to everybody.”

For example, Jefferies has provided commodity-linked financial products based on futures to an institutional client base since 2003.

“What we saw developing over the past three or four years is a significant inflow of investor assets into a variety of commodity ETFs, many of which demonstrated significant tracking error to underlying spot commodity prices,” said Adam De Chiara, co-president of Jefferies AM.

At Marshall Wace, officials expect to initially raise at least $400 million later this quarter when they introduce the first ETF to track an index based on the firm's six existing proprietary hedge fund strategies.

“We wanted to create an ETF based on a market-neutral index for our clients, since (most ETFs currently available) track indexes that are backward looking and long only,” said Anthony Clake, partner at Marshall Wace.

Of the specialist ETFs being introduced to the market, active ETFs have been causing the most stir. Loren Fox, senior research analyst at Strategic Insight, a consultant to mutual fund companies based in New York, said: “It's too soon to tell whether active ETFs will gain traction, but if they do, it will open (the market) to many more firms built on their expertise in active management.”

For example, Grail Advisors LLC, was among the first in 2009 to offer active ETFs in the U.S. The firm had $24.8 million in ETF assets under management as of Jan. 31. PIMCO followed suit later that year. In addition to T. Rowe Price, GSAM and Russell, Boston-based Putnam Investments is another manager considering entering the active ETF market.

“You don't need to be among the top three to have a viable and profitable ETF business,” Mr. Fox said. “It's pretty inevitable that the market will reach $2 trillion over the next few years, and even if you capture just 1% or 2%, you could build on that foundation.”

Competing in the ETF industry requires not only the ability to introduce viable products, but, more importantly, marketing and distribution capability.

Several ETF players have since thrown in the towel. In January 2009, Northern Trust executives shocked analysts when they announced plans to shut down 17 ETFs less than a year after making a grand entrance into the business. At the time, Northern Trust had $33 million in ETF assets under management.

Officials said in a statement the decision was made after having considered “market conditions, the inability of the funds to attract significant market interest since their inception, their future viability as well as prospects for growth” in the foreseeable future.

Later that year, London & Capital executives also decided to shut down the company's SPA ETF series. AXA IM followed suit in May by transferring its stake in the EasyETF joint venture with BNP Paribas Asset Management to its partner. At the time, AXA IM had e1.3 billion ($1.8 billion) in ETF assets under management in commodities, real estate, credit and infrastructure strategies.

“The fact that these firms have dropped out speaks to the fact that it's not easy to compete in the ETF market,” Strategic Insight's Mr. Fox said. “There are a lot of wheels to keep spinning, and it may not make sense for some firms to enter at all.”