ETF Seed Money Dries Up

June 14, 2007

I received a note last night from a panelist mentioning that in our FRA conference today in New York, we might want to talk about the issue discussed in Diya Gullapalli's recent WJS article - no seed money for new ETFs - and how that has shifted the industry.

This obviously has been a fundamental change in the industry...and events are rapidly shifting the terrain.  The gist of the situation is that the dynamic in the ETF industry has radically, and I would say ironically shifted.  The mentality now is all about assets, where trading used to drive the industry.

The irony part comes in because ETFs are increasingly criticized in some quarters for being all about trading, while the dynamics now driving the industry are all about asset gathering (even if it's "hot" asset gathering).

Remember that an exchange (the American Stock Exchange) founded ETFs (thank you, Nate Most) to bring increased trading volume to the then-faltering AMEX.  And it worked.  ETFs played a huge part in turning the AMEX's fortunes from the late 1990's through the early 2000's.  Spreads, even on some of the most heavily traded products like QQQ were wide enough for a lot of traders to be making good money.

With the advent of ETNs, unlisted trading privileges and "upstairs" trading (trading among large institutional players off the floor), volumes on the exchanges rapidly fell even as spreads fell.

The result may have looked like an absolute boon to investors, but there have been other issues that have arisen.  One could argue that to some degree innovation could be hampered. With specialists having far less money to seed funds, it became more difficult for smaller funds to adequately seed funds.  On the other hand, it would be hard to argue that there's no innovation going on. The level of innovation from a wide variety of shops is unprecedented.

VC firms have largely stepped in where specialists left off.  And like the dynamic shifting to an asset focus, a key driver in the industry has become the "end game"  There are now a lot of new players looking to get into the business and pull a "PowerShares"  meaning work hard 3 or 4 years and then sell their company for $500 million $1 billion - whatever.

So the result is that the industry looks wildly different than did only a few years ago.  It's all about asset gathering, margin expansion and the end game now.  It seems pretty clear, though, that the pace of current development may begin to outstrip the issuers' expectations in what really had become a bubbly market. 

The gist of it is that those that don't have a tremendous build-it-and-they-will-come product (and how many of those are still out there) or tremendous distribution may be run over.  And they may still be able to sell.  But a "platform" may start looking cheaper than a "successful line of ETFs"

The other huge change is that it remains to be seen how ETFs hold up in a fully non-specialist system, if we go that way.  A very large story that has gone untold in the national media is that NYSE Arca is going to move all of their ETFs from the traditional platform onto the Arca electronic platform...and they plan to make that happen by sometime this fall.

The track record has been mixed in the U.S., because, for example, while the BLDRs opened on the Nasdaq platform with huge streads, it seems like that problem has been fixed...and you have to think that the exchanges would be on it.  In Europe ETFs seems to trade fine - and that activity is all electronic. I know in some instances (in international markets) specialists are paid basis points on trading activity to maintain good markets.  It's unclear if something like that could work in the U.S.  But it does seem like for the very lightly traded ETFs particularly, that having a specialist maintain a decent market is certainly beneficial.  But no one is going to do that for free.  We'll keep our eyes open.

All that said - and that's plenty.  There is absolutely no doubt in my mind that there is plenty of space for more expansion, and that ultimately significant parts of the mutual fund industry are going to be forced into the ETF structure, because, as Burton Malkiel says, they are just a better mousetrap.  ETFs are more cost effective to run, more tax efficient, attractive to more kinds of investors, etc.

The flip side is that while ETFs have sort of the ultimate distribution - open platform - the secondary market - accessible to virtually all (except most of the poor imprisoned 401(k) investors), what they DON'T have generally is heaps of cash and outrageously an compensated sales force.  Or they didn't.  Because of sheer scale, that has started to change.

Look out traditional mutual funds.

One last thing on Diyas piece...which does a good job of getting a story that would otherwise be invisible nationally some spotlight...there are some parts that are slightly off re: the meltdown story w/ the Macro's from December.  The real problem was less about trading that it was about the fact that there was no one there to do creates in the product at the time.  Matt Hougan and I did an expanded story on the Macros here in the Journal of Indexes.

Now, I've got to get back to trying to keep track of everything flying around in the index business... 

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