‘Not’ All Things to All People
Note: an edited version of this article first appeared on ETF.com
One of the leading exchange-traded and mutual fund providers, Invesco, recently announced the closure of 42 exchange-traded funds (“ETFs”) with a cumulative total of over $1 billion assets under management (“AUM”). Through a series of acquisitions (Powershares, Guggenheim Funds, Oppenheimer Funds), Invesco has grown to become the fourth largest ETF provider, so it should not come as too much of a surprise that the fund company ‘rationalize’ its product line as it refines its market strategy to institutional and retail investors.
A List of Gullivers and Lilliputians
Many investors are also aware of the increased AUM concentration among the largest ETF issuers where BlackRock iShares, Vanguard, and State Street Global SPDR comprise over 80% of the $4.3 trillion tracked by ETF.com’s League Table as of 12/11/2019. The top fund providers would argue that ‘scale’ is of increased importance in order to remain competitive in the areas of low expense ratios, intellectual property, trade execution, and brand awareness.
Despite the increasing AUM concentration as fund providers consolidate to remain at the top of the league table, there are still over 120 distinct ETF issuers with 86 of those having just over $50 million AUM. Perusing the list, many of the smaller ETF providers are positioning themselves as niche providers for specific strategies. These may fall underneath the radar or be deemed not worth bothering with by the larger providers.
Yes, ‘scale’ has become increasingly prominent as the ETF industry matures from its early wildcatting days, where $10 million in dealer seed capital was enough to keep a fund afloat. Now, $50 million fund-level AUM is deemed as viable (and most of that is not dealer seed capital), but the industry still remains supportive of niche players able to navigate around a sea of big box fund providers. This is not to suggest that investors should favor one or the other but that the ETF ecosystem seems to be able to support both big box and boutique fund providers (for now).
Unlike other industries (say technology hardware) where there is significant enterprise risk for going with smaller vendors, there is relatively less risk when investing in small funds that may face higher prospects of shutting down (fund strategy execution risk is another matter). When a fund liquidates, the cash proceeds are returned to the investors cash account – ultimately the main risk with investing in smaller funds in tracking error, or the risk of performing differently from the asset allocation benchmark. The barriers to entry for ETF product launches are still relatively low to what you see with other investment products, but the flip side is that the barriers to closure are just as relatively low.
Revisiting the Fund Evaluator Framework
This is not to suggest that ETF investing can be put on autopilot, even when investing with the largest fund providers. The occasional fund closure announcement is yet another reminder that ETF issuer evaluations remain a critical part of the due diligence process. Our firm’s fund due diligence process (DDP), admittedly a common framework for many DDPs, can be summarized as follows:
- Know What You’re Investing In (i.e. investment design and holdings-based analysis).
- How Is Your Investment Being Managed (i.e. portfolio/index construction).
- What You Are Paying to Invest in the Fund (i.e. expense ratios for what the intellectual property being delivered).
- Who You Are Investing With (i.e. ETF Fund Provider Due Diligence)
#4 is arguably the hardest and least quantifiable (as well as least predictable) and is mainly a function of past management behavior, but the investor should strive to determine, with some degree of confidence, the commitment of the fund provider to support and grow its product line. Below is a suggested rubric for arriving at a reasonable assessment of the fund provider’s commitment:
- Raison d’etre for Offering ETFs (as opposed to separate accounts and mutual funds)
- How long has the fund provider been managing ETFs?
- Did the fund provider acquire ETF management expertise, or was it developed organically?
- How do ETFs figure in the fund provider’s overall business strategy?
- Are ETFs marketed separately from the other investment offerings, and are they marketed by ETF specialists?
- Does the fund provider offer ‘free’ ETF model portfolios as a means of enhancing its distribution strategy?
- What is the fund provider’s track record with respect to fund openings versus fund closures when viewed within the context of in- and out-of-favor investment styles?
- Raison d’etre for Offering a Specific ETF Strategy
- Why offer this specific strategy (i.e. chasing a hot dot, a me-too strategy but with lower costs and better trade execution, or filling a niche not presently met by other products)?
- What audience is this strategy trying to serve?
- What is the source of the intellectual property supporting the strategy?
- Does the firm possess the investment expertise underlying the strategy, or is it outsourced?
- What resources (personnel, capital markets, technology, education) are supporting the strategy?
- Why does the provider believe this strategy will be economically viable for the firm and for the fund shareholders?
For the ETF ecosystem to remain healthy and thrive, it needs to accommodate niche offerings or else compromise its breadth and diversity to the whims of the investor masses.
Mid- and large-sized fund providers need not ‘stay in their lanes’ but they must also recognize the limits of being all things to all people.
Niche providers recognize the uphill battles they face when trying to compete against ‘scale’ but should also be realistic as to what the market will bear with respect to fund expenses.
And investors need to focus beyond the net expense ratio to more fully understand what market segments they are participating in and the investment expertise underlying the fund strategies.
The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete.
3D does not approve or otherwise endorse the information contained in links to third-party sources. 3D is not affiliated with the providers of third-party information and is not responsible for the accuracy of the information contained therein.
Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of December 16, 2019 and are subject to change as influencing factors change.
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By: Benjamin Lavine