ETF assets rising, but some find the going tough

The ETF market is a confusing place at the moment.

ETF net inflows are on a pace to shatter the all-time inflow record set four years ago. At the same time, however, more money managers are exiting, and entering, the arena.

Net inflows into U.S. exchange-traded funds totaled $130.9 billion in 2012 through Sept. 24, according to BlackRock Inc.

This surpasses net inflows of $117 billion in all of 2011, $123 billion in 2010, and $119.4 billion in 2009. If the trend continues, 2012 net inflows would break the record of $175.7 billion in 2008, according to data from BlackRock and the ETF Association, Philadelphia.

Yet within a two-week period in August, Russell Investments announced it was closing its 25 passively managed ETFs, just 15 months after it launched the offerings, while FocusShares LLC, the ETF unit of brokerage firm Scottrade Inc., pulled the plug on its 15 ETFs, just 18 months after they were launched. In addition, fund manager Direxion said it would close nine of its 50 ETFs.

None of the shuttered funds had reached the $100 million mark, a commonly used measure of ETF profitability. Russell's suite of ETFs had gathered a total of $310 million, while FocusShares' 15 ETFs had a total of $100 million.

All three firms cited problems getting significant assets as the reason for the closures.

“We are in a difficult financial environment,” said Deborah Fuhr, a principal in the London-based ETF research firm ETFGI. “Look at the bank and brokerage industries and how many people are cutting head count. Financial firms are asking, "Where should I be spending if I have limited resources?'”

Yet others are lining up for their turn at bat. Boston-based Fidelity Investments reportedly plans next year to offer active ETFs based on its “Select” line of industry-focused equity mutual funds.

Fidelity spokesman Jeff Cathie said the company has formed a division to develop investment offerings based on the sector funds, but refused to say they would be ETFs. He said such an announcement would be “premature.”

Still, the new division is being headed up by Anthony Rochte, who, as a senior managing director at State Street Global Advisors, helped run the world's second-largest lineup of ETFs.

Fidelity would be just the latest in the line of large, established money managers that want to enter the ETF business, joining Legg Mason Inc., T. Rowe Price Group Inc. and John Hancock Financial Services Inc., among others.

Two trends are occurring simultaneously: Bigger money managers are staking a claim to the ETF marketplace; and smaller firms are struggling to stay in business, said James Pacetti, an ETF industry consultant with S-Network Global Indexes, LLC, an index provider in New York.

“You are going to have a big shakeout with the smaller guys who have no distribution,” Mr. Pacetti said, declining to name any firms.

ETFGI statistics show the 13 smallest U.S. ETF providers had a combined AUM of $1.073 billion as of Aug. 31, a minuscule number in the $1.178 trillion U.S. ETF industry.

The smallest providers as of Sept. 24, according to the BlackRock report, include tiny firms and global banks. They are AlphaClone LLC, with $3 million; Citigroup Inc., $4.4 million; Huntington Asset Advisors, $13.6 million; Factor Advisors LLC, $15.5 million; and Arrow Investment Advisors LLC, $17.6 million.

But Ms. Fuhr said niche providers have found enough traction with their ETFs to be successful, or are willing to endure money-losing years on the hope of eventually turning a profit.

“Many firms are going to stick with ETFs for the long run, but we are probably going to see some consolidation,” she said.

As the player roster changes, competition also is heating up among the three biggest ETF players — BlackRock Inc., SSgA and Vanguard Group Inc. — which control about 82% of the U.S. market and 70% of the global market, according to BlackRock.

BlackRock's iShares unit, the largest with $528.9 billion in U.S. ETF assets, has been losing market share during the past few years to third-place Vanguard, with $231.6 billion. Vanguard has lower fees on several key products that are similar to iShares' offerings, and on March 1 announced it was cutting its prices even further. State Street Global Advisors with $317 billion in assets is the second largest ETF provider.

BlackRock CEO Laurence Fink said in a Sept. 10 speech that his company would lower fees on some large, liquid-core ETF's probably in the early part of the fourth quarter. The cuts could cost BlackRock $200 million to $300 million in revenue, about 3% to 7% of its overall revenue, said Luke Montgomery, an analyst with Bernstein Research in New York in an interview.

“I fully expect the cuts to have an impact on their bottom line,” Mr. Montgomery said. “I am not convinced that lower fees will result in higher flows.”

Mr. Montgomery said Vanguard has been very successful in the retail market, making it difficult for BlackRock to regain assets on some of its offerings, like the iShares Emerging Markets ETF, which has been overtaken by the Vanguard MSCI Emerging Markets ETF as the largest ETF in that category.

Tracking error issues that started in 2008 in BlackRock's emerging markets ETF also turned off some institutional investors, he said.

Daniel Gamba, New York-based managing director and head of Americas iShares institutional business, said the tracking problems were corrected more than two years ago and the ETF is now closely following the index. He said the ETF has increased the number of local securities it holds and reduced holdings of American and global depository receipts.

Vanguard has been the flow generator this year. Its net inflows in 2012 are $41.8 billion through Sept 24, compared with BlackRock's $33.3 billion and SSgA's $25.9 billion.

Still, BlackRock's 40.5% share of the U.S. ETF market vastly exceeds SSgA's 24.3% and Vanguard's 17.8%.

ETFGI's Ms. Fuhr said it would be extremely difficult for any new entry to gain enough traction to compete against the big three, which have “captured around 70% of the (global) market for a very long time.”

Below the top three, assets of ETF providers in the U.S. drop quickly.

Invesco PowerShares Capital Management LLC, the fourth-biggest U.S. provider, has $75.4 billion in assets or 5.7% of the marketplace, with Van Eck Securities Corp. at fifth, with $27.4. billion, a 2.1% share.

After that, no single provider has more than 1.7% of the marketplace.

Just how much room there will be for new players or for smaller players to increase their AUM is the subject of debate.

Optimistic market forecasters have projected global ETF assets could go to $10 trillion by 2020 from $1.2 trillion now.

Bernstein Research's Mr. Montgomery, however, estimates a 13% compound annual growth rate for ETFs through 2025, taking the industry to $6 trillion.

“Industry growth will disappoint more optimistic estimates and is likely to decelerate beyond the next decade, unless the ETF market can evolve away from its roots as a passive product or break into untapped distribution channels,” he said.

Mr. Montgomery said the most significant new opportunities for the ETF industry, active ETFs and the defined contribution market, are also the most tenuous.

ETFs are transparent by nature and disclose their holdings on a real-time basis, which could be a problem for active ETFs, he said.

“Providers have not fully solved the challenge of offering active management without exposing managers to front-running, and they have yet to convince investors why they need” active ETFs, Mr. Montgomery said.

In the U.S. defined contribution area, he said, 27% of assets are invested in mutual funds, compared with less than 1% in ETFs, which must contend with technical hurdles like the ability to invest contributions in a fractional share.

For now, all eyes are on Fidelity and its expected launch into the active ETF market.

The company has not given specifics, but Mr. Pacetti of S-Network said the success of Pacific Investment Management Co. LLC's move into active management has paved the way for Fidelity.

PIMCO's Total Return Bond Fund ETF, based on its Total Return Bond Fund, the world's largest mutual fund, was introduced in March and already has gathered $2.6 billion in assets.

Mr. Pacetti said he expects Fidelity will be offering clones of some of its sector mutual funds, enabling the firm to use existing investment personnel as well as the company's distribution network.

The growth of the ETF industry also means never say never.

Northern Trust Corp. entered the ETF market in the spring of 2008 with 17 ETFs, including a set focused on developing and emerging markets. Yet, eight months later the company exited the market after gathering aggregate assets of less than $35 million.

Northern Trust is having more luck with a smaller introduction of just four offerings in September 2011, which trade under the brand name FlexShares, and invest in Treasury inflation-protected securities, U.S equities and natural resources.

As of Sept. 15, the combined funds had assets of $1.6 billion, said Shundrawn Thomas, managing director and global business head of Northern Trust's exchange-traded funds group, Chicago.

Russell Investments, Seattle, seemed to leave open the possibility that it might return to the ETF market. In a news release announcing the closings, Russell officials said the market for the new ETFs it launched was still in the early days, and the liquidation of its ETFs “at this time” was in the best interest of the shareholders. n