Growth of ETFs reflects passive shift; 3 largest firms hold 79% of assets

The trend toward more passive investment was reflected in the increase in assets under management in exchange-traded products in 2017, Pensions & Investments' annual money manager survey findings show.

Managers in P&I's survey reported​ worldwide assets in sponsored exchange-traded funds and notes totaling $4.13 trillion as of Dec. 31, up 36.3% from the end of 2016. That's on top of a 23% gain in assets in 2016.

And as is the case with worldwide asset growth, the same money managers — BlackRock (BLK) Inc. (BLK), Vanguard Group Inc. and State Street Global Advisors — continued to manage the lion's share of the overall assets. The three managed 79% of all ETP assets reported in P&I's universe as of Dec. 31, the same as at the end of 2016.

That concentration exists, sources said, because those managers are leveraging their scale and their relationships with existing clients to meet the desire of investors, institutional and otherwise, to reduce costs through the use of passive investment vehicles. The vast majority of ETPs are passive.

The three largest managers "have increased scale," said Alex Bryan, director of passive strategies research, Morningstar Inc., Chicago. "Once that happens, they can improve their capital markets team, their trading desks, improve the cost, and generally make it tougher for others to compete. (Also) a lot of this is inertia. They're increasing their wallet share. An investor might like one fund, and they'll look at that manager's other funds. Ultimately (investors) think of the whole service package. As with brokerage clients, once institutions get a relationship, they're inclined to stick with them because of their service, their liquidity and their all-in costs."

'Pricing game'

"It's a pricing game," said Neil Rue, managing director, Pension Consulting Alliance LLC, Portland, Ore. "If you're comparing one ETF vs. another, generally returns will be the same thing but some will be priced better."

Added Jonathan de St. Paer, senior vice president, strategy and product, at Charles Schwab Investment Management Inc., San Francisco: "What we're seeing across all segments of the industry is that the use of passive investing is a rising tide, with ETFs as well as passive mutual funds. Institutions in particular are also using a lot of indexing. If I'm a (defined contribution) plan, I'm typically using mutual funds; but if I'm virtually every other institution or (a registered investment adviser), I'm looking at ETFs."

While the top three managers held fast to their perches atop the list of largest ETP providers, other firms in the top 10 saw larger percentage increases, like Invesco (IVZ), up 49% to $171.4 billion; Nomura Asset Management Co. Ltd., up 54% to $122.9 billion; Schwab, up 66% to $99.1 billion; Nikko Asset Management Co. Ltd., up 64% to $57.7 billion; UBS Asset Management, up 61% to $51.5 billion; and Amundi, up 78% to $51.4 billion. DWS Investments had the lowest percentage increase among firms ranked four through 10 in 2017, although it still increased assets 37% to $94.9 billion.

Mr. Rue said those percentage gains show there's still a market for exchange-traded products in asset classes beyond the traditional passive equity and fixed-income funds dominated by the top three. BlackRock (BLK)'s ETP assets increased 36% in 2017 vs. 40% for Vanguard and 24% for SSGA.

"There are a lot of ETFs," Mr. Rue said. "The question is whether the marketplace is getting saturated. There's still a notion of demand for some solutions that ETF providers can target."

At Invesco, which ranked fourth in the survey, investor demand for smart-beta products helped the increase, said Daniel Draper, Downers Grove, Ill.-based managing director, global head of ETFs. "Now that we're seeing the interest rate cycle change and higher levels of valuations, factor ETFs are coming back. That's our wheelhouse," Mr. Draper said. "We've had organic growth, especially in the U.S., with institutions in the education and use of factor investing. We've also seen growth in intermediate retail and wirehouse business."

Invesco also added $29 billion in assets through its acquisition of European ETF provider Source, which closed in August, Mr. Draper said. That acquisition helped boost Invesco's institutional ETF assets, as Source ETF assets are about 85% institutional, he said.

Where it comes from

At Vanguard, the lead driver of asset inflows has been business from financial advisers through banks, broker-dealers and registered investment advisers, said Richard F. Powers, Malvern, Pa.-based head of ETF product management. However, the firm also has seen assets increase from institutions — mainly money managers, insurance companies, endowments, foundations and not-for-profits — and direct retail through Vanguard's platform.

Mr. de St. Paer said Schwab has benefited from both the search for lower-cost products and investors seeking to concentrate on core strategies. "Despite the wide variety of ETFs out there, the money is still going to a few low-cost core strategies," he said. "That's why the big firms keep getting bigger. Even with sophisticated investors on the institutional side, there's been such a proliferation of ETF products that have just a slight tweak here and there, it's hard to be an expert on new approaches. It's important to (the investors) to concentrate on where to use their risk budget in their core portfolios."

Schwab has 22 ETFs covering broad-based U.S. and international equity, domestic fixed income, and fundamental index or smart-beta ETFs, he said.

While sources said the search for lower-cost core products has been a big reason behind the overall ETP asset increases, demand specific to institutional investors in the past year has targeted the use of ETFs as a replacement for derivative investments and for investment vehicles easier to trade than individual securities.

ETFs "are being used as replacements for futures contracts," said Morningstar's Mr. Bryan. "It's a trend that we've seen, because of ETFs' lower cost, ease of use, there's no slippage associated with contango or anything like that. Plus, you own the underlying security with an ETF. And trying to take the macro view, there's no worry about manager selection, they can be used for transition management, and there are more institutions using ETFs in active ways, like to mitigate interest rate risk or to short long-term corporates. They're very liquid, and the cost of trading (with ETFs) is often lower than trading individual securities."

Added Vanguard's Mr. Powers: "We're seeing more replacement of separate accounts and more use in the insurance general account space. Changes in (U.S.) tax treatment allows fixed-income ETFs to be on the books as a substitute or complement to an individual bond portfolio."