Dominance of ‘Big Three’ forces wave of innovation

Three big problems confront asset managers looking to establish or expand their operations in the rapidly growing exchange traded fund industry: BlackRock, Vanguard and State Street Global Advisors.

These behemoths together control more than two-thirds of the ETF industry’s global assets and in 2015 grabbed 55 per cent of the new cash allocated by investors to ETFs, according to ETFGI, a consultancy.

But there was plenty for other managers to fight over given the ETF industry’s record inflows of $372bn last year.

ETFGI data show that some of the notable beneficiaries of investors’ growing interest in ETFs include WisdomTree and Deutsche Asset Management, which both saw inflows to ETFs more than triple in 2015 compared with the previous year. Daiwa, the Japanese fund house, registered a sixfold increase in net inflows.

Investors have ploughed around $1.5tn into ETFs over the past five years after growing dissatisfaction with the high fees and widespread underperformance of actively managed traditional mutual funds.

The large cash flows are attracting new competitors. A record 43 managers launched ETFs for the first time in 2015, including high profile entities such as Goldman Sachs and John Hancock, the US arm of ManuLife, the Canada-based financial services provider.

However, latest research from ETFGI shows that 276 managers globally now participate in the ETF industry, raising doubts about just how many can prosper in an increasingly competitive industry.

“The barriers to entry into the ETF industry are low but the hurdles to achieve success are getting higher and higher,” says Lee Kranefuss, executive chairman of Source, the London-based ETF provider.

Attempting to compete purely on costs is widely seen as a thankless task as BlackRock, Vanguard and State Street have already slashed fees on some of their most popular funds in a cut-throat price war.

The competition on pricing is so intense that midsized managers are trying to find a niche by focusing on new ideas, such as smart beta ETFs, even though the largest providers are also trying to innovate.

“It is far harder to create a hit in the ETF industry than in the music business,” says Mr Kranefuss.

Sub-scale unprofitable funds abound across the ETF industry. ETFGI estimates that more than 6,100 ETFs are now available to investors globally, but around 70 per cent of those funds have less than $100m in assets, the minimum level generally regarded as necessary to break even. Just under 2,000 ETFs have less than $10m of assets, effectively making them uninvestable for many institutional managers.

Mr Kranefuss points out that greater size generally brings important liquidity benefits, allowing investors to buy and sell more efficiently. “Investors need to know they can get out as well as into an ETF,” he adds.

Christos Costandinides, founder of BlueHarbor, a US-based investment consultancy, says providers need to gain size quickly to counteract the ETF industry’s intense competitive pressures.

While Mr Kranefuss and Mr Costandinides believe the industry is ripe for consolidation, there have been few mergers and acquisitions.

Just last month, however, Legg Mason bought a stake in Precidian Investments, a New Jersey-based boutique that has developed an innovative active ETF structure.

BMO Global Asset Management, the Canadian investment manager acquired the UK fund house F&C in 2014 using the deal as a launch pad to enter the European ETF market last year.

Marc Knowles, a director at BMO Global Asset Management, says there is no point in launching “me-too products” to compete against the well-established ETFs of the big three providers.

“Providers have to strive to be different. It is vital to have the right products in an increasingly crowded market place, to build ETFs that meet specific client needs,” he says.

Striving to be different seems to have paid off for one provider. WisdomTree, the New York based manager, runs a pair of currency hedged European and Japanese equity ETFs that were two of the fastest growing products globally in 2015.

Nizam Hamid, head of sales for WisdomTree Europe, says smaller and nimble players can compete effectively against the industry’s Goliaths. “Clients do want to see providers that offer something different and who can bring some extra value to their portfolios,” he says.

Deutsche Asset Management is already thesecond-largest player in the European ETF market, according to ETFGI, but it too is looking to differentiate itself as it expands its US operations.

“We will not attempt to compete on vanilla [traditional] index-trackers in the US. Our focus is on more sophisticated products,” says Reinhard Bellet, head of passive asset management at Deutsche Asset Management.

He emphasises the importance of helping clients understand how to use these more sophisticated products in their portfolios.

Providers, says Mr Bellet, must also be able to quickly read shifts in market conditions so as to better understand the needs of clients.