Morgan Stanley steps into ETFs, with indications green for growth

Participants in the no-frills exchange-traded fund business tend to be realists, grounded in the economics of cheap beta and low switching costs. But even the most down-to-earth attendees at the recent Exchange: An ETF Experience conference in Miami can be excused for seeing ghosts.

Years after its involvement in some of the first exchange-traded funds, Morgan Stanley is gearing up to enter the ETF business, leaving some at the conference wondering how big of a player the company could have become if it had built on earlier work.

Via an internal announcement, Morgan Stanley Investment Management said it was building out an ETF platform, hiring Anthony Rochte from Goldman Sachs Asset Management and Allyson Wallace from BlackRock Inc. They will help the $1.6 trillion asset manager shape its own offerings in the crowded and competitive ETF market, lorded over by passive giants BlackRock and Vanguard Group Inc., but recently welcoming active managers such as Capital Group Cos. and T. Rowe Price Group Inc.

Twenty-six years ago, Morgan Stanley was instrumental to the launch of the World Equity Benchmark Series, 17 country index funds managed by Barclays Global Investors. The funds, which eventually became part of the iShares franchise of ETFs, were based on equity indexes developed by MSCI Inc.

Now (and then) a market leader in global benchmarks, MSCI was 96.6% owned by Morgan Stanley when it first filed for an initial public offering in 2007. The other 3.4%: Capital Group International, a unit of Capital Group.

An entry into ETFs will give MSIM the opportunity to get its brands, research and expertise in front of financial advisers, its own and others. According to Morningstar Direct, Morgan Stanley brokerage accounts (both advised and self-directed investors) held $223 billion in ETF assets across 1,650 products through Dec. 31. At that level, ETFs accounted for 4.5% of year-end wealth management client assets reported by Morgan Stanley in its 2021 annual report.

Morgan Stanley declined to comment.

Despite a late start, Morgan Stanley will see plenty of opportunity. Eighty-four percent of global ETF investors surveyed by Brown Brothers Harriman & Co. said they plan to increase their ETF allocations this year, up 12 percentage points from 2021. That's welcome news for a product category that just topped $10 trillion in global assets under management at the end of March, according to research firm ETFGI LLP.

Even more compelling for name brand ETF issuers is the opportunity to have their products included in ETF model portfolios. Seventy-two percent of global ETF investors surveyed by BBH said they source their ETFs from model portfolios, either affiliated/proprietary models (16%), models built by third parties (22%), or those published by ETF issuers (34%).

Affiliated asset managers and wealth managers, however, are engaged in a delicate dance of fiduciary duty and the disclosure of conflicts of interest. Deftly and appropriately managed, the relationship can be a boon for all sides, including clients, but scrutiny of such arrangements is high. Fortunately for Morgan Stanley, the path forward has been forged by the likes of Charles Schwab Corp., Northern Trust Corp., Goldman Sachs Group Inc. and J.P. Morgan Chase & Co.

Over the past 13 years, these companies (and others) have introduced ETFs that have been utilized by both their wealth management clients and other investors, including pension funds, foundations and endowments.

Still, the extent to which an ETF is owned by a large owner (regardless of whether the holder is affiliated with the issuer) can impact its broader marketability. At the high-end, affiliates can end up owning more than 99% of an ETF's outstanding shares. Of 24 J.P. Morgan Asset Management Inc. ETFs for which J.P. Morgan is the top holder, the average holding rate is 65%, according to data compiled for Pensions & Investments by FactSet Research Systems Inc. Of 17 Goldman Sachs Asset Management ETFs for which Goldman Sachs is the top holder, the average holding rate is 42%.

"That affiliated wealth manager has to be considered the same as the largest institutional client," said Jillian DelSignore, managing director, head of advisor sales for FLX Networks, a community platform modernizing the engagement experience for asset and wealth management firms and financial advisers. Ms. DelSignore was previously head of ETF distribution for J.P. Morgan Asset Management.

Amrita Nandakumar, president of ETF subadviser Vident Investment Advisory LLC, cautions that a new issuer such as Morgan Stanley can't overlook the challenges of building out unit staffing and investment, including adequate working capital and compliance support.

"If you are bringing your research and intellectual property into a new market, you have to be able to demonstrate your differentiation," Ms. Nandakumar said. "This includes brand communication and voice." She added that established firms, compared with new asset managers, take on the additional risk of "distracting too much from the core business."

Morgan Stanley Investment Management includes products and portfolios offered under Morgan Stanley's own brand, as well as those of Eaton Vance Corp., Parametric Portfolio Associates LLC, Calvert Research and Management and Atlanta Capital Management Co. LLC.

Regardless of the asset manager's capabilities and past performance in other investment vehicles, how potential clients view the ETF offerings will be critical to their success. Experienced ETF investors understand that ETF liquidity is dependent upon the liquidity of its underlying holdings, but "the perception of ETF liquidity is that it is measured just as it is for stocks by trading volume" said Phil Bak, founder and CEO of atNAV, an early stage capital markets technology company.

"This perception of liquidity is by far the biggest challenge for new issuers to attract assets, regardless of firm size," said Mr. Bak, who previously founded ETF issuer Exponential ETFs and served in ETF listings sales for the New York Stock Exchange.