Liquidity and cost trump all other benefits of exchange-traded funds for institutional investors. Yet the basic attributes of this rapidly growing category of products also have large investors shying away from most areas of index and asset class innovation — where costs are higher and trading is lower.
But those areas are where ETF sponsors have focused in recent years.
In 2012, that divergence became clear as the pace of ETF closures accelerated, despite a net 5% increase in the number of exchange-traded products to 1,443 in the $1.34 trillion U.S. market, according to research firm XTF Inc. Net new flows into ETFs were $169 billion through Dec. 17.
Maturation of the U.S. exchange-traded product market has turned into a battle over indexes and basis points largely between The Vanguard Group, the iShares unit of BlackRock Inc., and State Street Global Advisors, which collectively control 84% of assets. Exchange-traded products include exchange-traded funds, exchange-traded notes and exchange-traded commodities.
In October, the iShares unit of BlackRock, New York, significantly decreased expense ratios on 10 products it sees as core portfolio building blocks. Vanguard, Malvern, Pa., countered with a cost-reduction measure that shifted several products to FTSE international indexes and domestic indexes from the Center for Research in Security Prices at the University of Chicago Booth School of Business. It had been using MSCI indexes.
Boston-based State Street Global Advisors, which manages or markets the two largest exchange-traded products in the world — SPDR S&P 500 and SPDR Gold Shares — has been steadfast in its fees, instead shifting the conversation to one of total cost, including expense ratio, trading spreads and premiums/discount.
"This price competitiveness helps when comparing ETFs to separate accounts and collective investment trusts,” said Onur Erzan, a partner at McKinsey & Co. in New York.
“ETF management fees are converging toward those of index funds,” said Anthony Christodoulou, principal at WorldTrack, London, who advises institutional investors on the use of ETFs. “The total cost of ownership, including trading flexibility, may well have already surpassed them,” he adds.
While a recent BlackRock survey claims that 15% of institutional investors have never used ETFs in their investment strategy (compared to 30% two years ago), those investors are primarily sticking with index exposures in domestic and international equity to manage liquidity.
The greatest growth in 2012, however, in both products and assets has been in fixed income, with investors adding $53 billion in net new flows, 90% higher than the last year's pace. Equity ETPs, on the other hand, had only increased flows of 50% with no net product growth.
Top among new asset classes was emerging market fixed income, with 11 funds attracting nearly $6 billion in net new flows, led by the iShares J.P. Morgan Emerging Markets Bond Fund at $2.8 billion and PowerShares Emerging Market Sovereign Debt at $1.3 billion.
Dustin Lewellyn, president of of San Francisco-based Golden Gate Investment Consulting said he has seen clients gravitating to ETFs only in areas of the market where the cost to transact is cheaper than for the underlying assets, specifically in emerging markets and high-yield debt. In fact, the two ETFs gathering the most assets in 2012 were Vanguard and iShares funds tracking the MSCI Emerging Markets index, at $10.5 billion and $8.6 billion respectively.
Vanguard's transition to the FTSE index, both how the company manages the transition within the fund as well as how it communicates the new index to institutional investors, could be a key driver of flows in 2013. The early response has been a decided shift back to iShares despite a sizable cost difference, with the Vanguard fund losing nearly $890 million and iShares gaining $6.9 billion since October.