Institutional managers key to ETF growth: Study

If exchange traded funds are to capture more market share from traditional mutual fund trusts, they will need to make inroads with institutional money managers, according to a report on the U.S. market by State Street.

The firm’s VisonFocus report says a higher adoption of ETFs by funds and institutions will go along way to legitimizing ETFs in the eyes of all investors.

Through the first three quarters of 2009, ETFs accounted for 33% of all U.S. stock trading volume and, as of the end of September 2009, global ETF assets under management (AUM) had grown 31% to $933 billion, but that amount is spread across 1,819 products.

Further, in the U.S., 17 of the 20 largest mutual fund complexes and 15 of the 20 biggest hedge funds invest in ETFs. All of the largest university endowments — some of which were early adopters of ETFs — now include ETFs in their top-10 holdings.

“Although most investment managers plan on expanding their use of ETFs, lack of familiarity with all of the new products and confusion over how best to use ETFs in their portfolios is causing some hesitation,” the report says.

State Street says investors are only now beginning to recognize the breadth of strategies and asset classes that ETFs can cover, usually at a lower cost than actively managed portfolios with historically similar returns.

Apart from core index products, the last year has seen a surge in the number of ETFs focused on commodity and niche products, the report says.

“As the ETF market continues to grow, investment dollars are flowing into fixed income, commodity, international and specialty ETFs. With stock markets in Brazil, China, South Korea and Taiwan showing some of the greatest gains this year, there has been a significant resurgence in demand for emerging market ETFs in particular. Gold has also been a market favorite in 2009,” the report says.

“Fixed income captured the attention of investors this year. Representing various maturity ranges, bond ratings and liquidity characteristics, 15 new fixed income ETFs have been introduced in the U.S. in 2009 alone. Fixed income ETFs now account for 13% of the ETF market and may be poised to draw assets from fixed income mutual funds, which currently account for a considerably larger 28% of the mutual fund market.”

The fixed income space represents a growth opportunity for ETFs, in part because low returns in the bond yields make management costs much more important.

“ETFs don’t incur shareholder recordkeeping costs, and fund trading costs are reduced because of ETFs’ special creation and redemption process,” the report points out. “Fixed income mutual funds, for example, charge an average management fee of 0.99 percent, while fixed income ETFs cost on average just 0.25%.”

Achieving scale

So far, an explosion in product offerings has not resulted in an explosion in assets. The report does emphasize that the majority of ETF assets are consolidated amongst a minority of mandates. The growth of the ETF business will require niche products to achieve some level of scale that allows providers to earn a sufficient income off of the fees.

State Street pegs the break even point for most ETFs at $80 million. Below this asset base, mandates face an uncertain future. In Canada, it’s a much smaller market, so niche ETFs taken on even greater risk of not achieving a sufficient AUM.

“More than half of U.S. ETFs have less than $100 million in assets. Together, these 454 ETFs hold only 2% of total ETF assets. With the break-even point for most ETFs at $80 million to $100 million, many smaller ETFs are unprofitable and face uncertain futures unless they grow,” the report states. “Though quite a few of these ETFs may have bright futures, in 2008, 50 ETFs shut down, tying up uninformed investors’ funds as they were dismantled. Investors need to look beyond AUM to decipher which products offer the best long-term prospects.”

State Street suggests average daily volume is a good indicator of mandate strength.

“To get an accurate sense of an ETF’s true liquidity, investors must also consider the liquidity of a fund’s underlying securities. For example, a thinly traded ETF that comprises liquid underlying securities can be efficiently utilized by clients who work with Authorized Participants (Designated Brokers) who are able to create or redeem shares of the ETF,” the report says.

U.S. 401(k) plans change the game

The report says the true potential of ETF growth in North America, has yet to really open up, because investors are still not able to use ETFs in their 401(k) plans. If this market opens up, ETFs could achieve be massive scale.

This would provide incentive for more mutual fund companies to offer fund of ETF products for 401(k) investors and come in at lower price points in a more fee-conscious environment.

“Mutual funds of ETFs are in the earliest stages of development. Their primary use may be in 401(k) plans; however, regulations governing 401(k)s were designed to accommodate mutual funds, not ETFs. As a result, logistical and legal asymmetries must be resolved,” the report says. “Some areas where 401(k) requirements differ dramatically from ETF offerings include pricing, market access and reporting procedures. Besides these issues, pension managers are hesitant to allow employees to use the brokerage window for ETF inclusion due to fiduciary concerns.”

(01/13/10)