Assessing Issuers' Commitment To ETFs

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Benjamin Lavine, chief investment officer for 3D Asset Management.

One of the leading exchange-traded and mutual fund providers, Invesco, recently announced the closure of 42 ETFs with a cumulative total of over $1 billion assets under management (AUM).

Through a series of acquisitions (PowerShares, Guggenheim Funds, OppenheimerFunds), Invesco has become the fourth-largest ETF provider, so it should not come as a surprise that the company “rationalizes” its product line as it refines its market strategy to institutional and retail investors.

List Of Gullivers & Lilliputians

We are all aware of the growing asset concentration among the largest ETF issuers where BlackRock’s iShares, Vanguard and State Street Global Advisors comprise over 80% of the $4.3 trillion in U.S.-listed ETF assets (ETF.com’s League Table as of 12/11/2019). Invesco currently sits at No. 4.  

The top fund providers argue that “scale” is of increased importance in order to remain competitive in the areas of expense ratios, intellectual property, trade execution and brand awareness.

But the industry still remains supportive of much smaller niche players able to navigate a sea of big box fund providers. Despite the AUM concentration at the top, there are over 120 distinct ETF issuers, with 86 of those having just over $50 million in AUM.

Perusing the list, many of the smaller ETF providers are positioning themselves as niche providers for specific strategies. The ETF ecosystem seems to be able to support big box as well as boutique fund providers (for now).

Unlike other industries where there is significant enterprise risk for going with smaller vendors, there is relatively less risk when investing in smaller funds that face higher closure risk.

That’s because when a fund liquidates, the cash proceeds are returned to the investors’ cash account. Ultimately, the main risk with investing in smaller funds is tracking error, or the risk of performing differently from the asset allocation benchmark.  

Revisiting 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—such as Invesco’s latest move—is yet another reminder that ETF issuer evaluations remain a critical part of the due diligence process.

Our firm’s fund due diligence process can be summarized as follows:

1. What are you investing in? (i.e., investment design and holdings-based analysis)
2. How is your investment being managed? (i.e., portfolio/index construction)
3. What are you paying to invest in the fund? (i.e., expense ratios for the intellectual property being delivered)
4. Who are you investing with? (i.e., ETF fund provider due diligence)

That fourth one 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 assess, 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:

1. 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?
2. Raison d’etre for offering a specific ETF strategy
   • Why offer this specific strategy (i.e., chasing a hot fad, 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-size fund providers need not “stay in their lanes,” but they must 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.

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.

Disclosures:

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 is 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 Dec. 16, 2019 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.