[This article appears in our June 2021 issue of ETF Report.]
The exchange-traded fund industry started as an innovation—in response to the 1987 stock market crash—so innovation is at the core of the ecosystem.
But over the years, a vast majority of the assets were swept up by a handful of top issuers, leaving small-fry and even medium-sized firms struggling to stand out in the crowded ETF field. The way these firms do it is through pushing innovation.
In any industry, the smaller firms often are the ones that produce cutting-edge ideas, and it’s no different for the ETF ecosystem. Beyond the plain vanilla main benchmark ETFs, many of the popular subindex, packaged investment and thematic ETFs got their start from small companies.
Paul Kim, CEO and co-founder of Simplify Asset Management, who previously worked at Principal Global Investors and PIMCO, says while larger firms are well-resourced, have larger staffs, possess expertise with compliance and operations, and have the ability to scale, it takes these firms longer to bring new products to fruition.
“Innovation often requires imperfect information, a lot of uncertainty and experimentation,” he said. “And that's really hard to do in a big place where you have multiple committees and a lot of cooks in the kitchen.”
Considering how much of ETF innovation stems from unique products, it’s harder for larger shops, especially those with an active mutual fund business to disrupt that existing business line with ETFs, Kim adds.
Differentiate To Stand Out
Andrew Chanin, co-founder and CEO of ProcureAM, which issues the Procure Space ETF (UFO), and who’s launched several thematic ETFs that have gone on to gather assets of more than $1 billion, notes that s there was a “tremendous” success rate when launching ETFs in the industry’s early days.
“Now, how do you differentiate? You have to really demonstrate and prove that you're something different that [investors can’t] access through other existing products,” he said.
Eric Balchunas, analyst at Bloomberg, notes that successful, innovative ETFs will have holdings that are very different from the Global Industry Classification Standard sector or other big benchmarks, and that they have a name or a label that can be easily and quickly understood.
Innovation is the only way around “the Vanguard effect,” Balchunas suggests, referring to the fee compression first started by the fund giant. He adds that being able to reduce fees to such a level where ETF annual expense ratios are only a few basis points each itself was innovative, even if it came from big issuers.
The “Vanguard effect” lowered expense ratios overall, but some smaller ETF shops did their own fee disruption. Because big firms weren’t very active in natural resources, Will Rhind, CEO of GraniteShares, explains that his firm launched commodity ETFs such as the GraniteShares Gold Trust (BAR) at an expense ratio of 0.17% versus the original physical gold-backed ETF, the SPDR Gold Trust (GLD), which has a cost of 0.40%. It also rolled out the GraniteShares Bloomberg Commodity Broad Strategy No K-1 ETF (COMB), a tax-efficient strategy.
“We started with commodities because the big firms didn't really have a lot of exposure, and we felt that the products they had were overpriced and structure hadn't evolved over time,” he said. “Demand was there.”
|UFO||Procure Space ETF||0.75%||4/11/2019||$133.3M|
|BAR||GraniteShares Gold Trust||0.17%||8/31/2017||$1.1B|
|COMB||GraniteShares Bloomberg Commodity Broad Strategy No K-1 ETF||0.25%||5/22/2017||$179.4M|
|LIT||Global X Lithium & Battery Tech ETF||0.75%||7/22/2010||$3.1B|
|PAVE||Global X U.S. Infrastructure Development ETF||0.47%||3/6/2017||$3.1B|
|BETZ||Roundhill Sports Betting & iGaming ETF||0.75%||6/4/2020||$508.1M|
|WFH||Direxion Work From Home ETF||0.45%||6/25/2020||$135.4M|
Risks Of Launching Innovative ETFs
Luis Berruga, CEO of Global X, the ETF issuer offering the most thematic ETFs, notes launching innovative ETFs is how a firm stands out, but that may take time for these funds to catch on. Their biggest ETF is the Global X Lithium & Battery Tech ETF (LIT), at $3.1 billion in AUM. It launched in 2010, but noticeable volume in LIT didn’t pick up until 2017, when interest in electric vehicles rose.
Similarly, it took 3 ½ years for their No. 2 ETF by AUM, the $3.1 billion Global X U.S. Infrastructure Development ETF (PAVE), to see flows snowball. PAVE started to gain attention in October 2020, as investors made bets that an infrastructure plan would happen if Joe Biden were elected U.S. president.
“PAVE was a theme that was not particularly sexy,” Berruga admitted. “But our analysis was that there's always a need in the U.S. for infrastructure investment.”
Like other fund issuers interviewed, Berruga notes that Global X only launches a thematic ETF if it feels the trend will be long lasting. Since it can take time for a theme to catch on, Berruga says Global X has never closed any thematic products since the formal introduction and branding of its thematic suite in 2016.
But not all small issuers have the luxury of waiting for investors to find a diamond in the rough. Todd Rosenbluth, director of ETF research at CFRA, notes there’s a lot of risk riding on these smaller firms to get noticed and have their ETFs be profitable to run from an operational perspective, and for the various brokerage firms to consider adding to platforms.
Small firms can sometimes attract attention when a larger firm launches a similar-sounding fund. When ARK Invest announced it was launching a space fund, Chanin says that UFO saw flows increase at the time of that announcement in February. It went from a $43 million fund at the end of 2020 to $133 million as of the end of April 2021. However, he points out that despite the similar-sounding name, the holdings are much different.
Rosenbluth suggests that a small firm with a hit ETF can launch other ETFs aligned with the original theme, but there’s some risk of becoming defined by early success, too.
That’s something Will Hershey, co-founder and CEO of Roundhill Investments, acknowledges. The firm has several sports- and entertainment-related ETFs, including the $508 million Roundhill Sports Betting & iGaming ETF (BETZ). He says launching a few ETFs on that theme wasn’t intentional, and that they’ve filed for another fund that’s slightly different: “We have plans to expand beyond these particular themes.”
Smaller firms that want to move beyond their initially innovative products need to do so carefully so as not to be seen as diluting their brand. Direxion’s suite of leveraged and inverse ETFs was innovative at its inception, and now Direxion is expanding beyond those core products to other types of strategies, including the popular $135 million Direxion Work From Home ETF (WFH), which offers exposure to technology firms benefiting from a flexible work environment.
David Mazza, managing director, head of product at Direxion, explains the firm thought hard about their expansion: “Our brand is not necessarily the guys with leverage, but it's the way for you to amplify exposures… . Really, it's, how do we apply what we're known for among the trading community and bring that to the longer-term investment community?”
When smaller firms hit it big with innovative ETFs, it encourages new entrants to the field, Balchunas observes, and that keeps the ecosystem fresh. While not every innovative fund will gather over $1 billion, smaller firms that accumulate assets over $100 million are success stories, and it helps to create a “strong middle class” of ETF firms.
“I find there are a lot of products like that, that will have $500 million. That would be a dud for Vanguard,” Balchunas said. “But I think, a strong middle class, the hope of winning the lottery—in that you have a product that just breaks through [to become] a blockbuster—is what keeps innovation alive.”