Editor’s Note: This article is the fourth in a five-part series addressing the distribution challenge across the ETF ecosystem, from issuers to advisors to home offices and end investors. Jillian DelSignore is principal at Chicago-based Lakefront Advisory, a firm focused on improving and scaling distribution strategies in the ETF industry.
ETF distribution and access can be difficult for ETF issuers and advisors alike, as we’ve covered so far in this series. (See Distribution Challenge ETF Issuers Face and When Advisors Can't Access Your ETF.)
Home offices, too, play an important role in this challenge. In this context, we are referring to wirehouse and broker dealer firms like Merrill Lynch, Morgan Stanley, LPL, Raymond James as well as custodians like Schwab.
There are three important factors driving the way these firms engage with issuers, and how they structure their platforms—the increased usage of ETFs relative to mutual funds; the evolution of the product landscape; and the changing advisor business models.
We have all been witness to the growing trend in buying behavior showing investor preference for ETFs relative to mutual funds. Sure, there are some asset classes where mutual funds continue to grow, but as shown by the many traditional active mutual fund managers entering the ETF industry, the ETF vehicle is the one that will drive future growth.
This shift has impacted industry participants differently, but the bottom line is, it has meant a significant change in economics and it has impacted revenue. This is particularly true for home offices.
In a world where mutual funds rule the day, there is a very clear way to generate revenue from the fund companies simply by the vehicle structure—the 12b-1 fees. By design, however, ETFs don’t provide that same revenue to these firms. This shift in advisor investing and buying behavior has led to the great search for missing revenue.
Data: Costly Gold Mine
The question has become how to make up for that shrinking revenue; how to monetize the ETF business. The short answer is in what you have of value for issuers that they’d be willing to pay for: access—that word again. Access to the advisors is also very valuable, once an ETF is available for sale on a particular platform.
What’s even more valuable? Data on which advisors do what type of business, how much business, in which products, etc. It’s gold. The home offices have it, and the issuers want it.
A way to package these things up is in the form of partnership agreements. Issuers pay either explicitly or through revenue sharing (yes, revenue sharing on ETFs) In return, they get access to branch offices, conference sponsorship and the most important thing of all—the data that home offices have. The specific structure of each agreement is going to differ depending on the firm, but it generally remains the same.
While the data is incredibly valuable to issuers, the cost to participate in such agreements is high. More recently, this has grown into simply the cost of doing business with some platforms, as revenue sharing has become a requirement to have active ETFs available for sale. This is a very real challenge for many issuers that just can’t afford such an arrangement in what is already a margin-constrained environment.
Changing ETF Landscape
The second factor to consider is the evolution of the ETF product landscape. Couple with that the number of ETFs that continue to come to market, and ETFs continue to evolve beyond market-cap-weighted equity index strategies. They run the gambit from index- to factor-based (smart beta) to active across a host of asset classes. Performing due diligence on active ETFs in particular requires a different process, and can take longer than on index funds.
The work that goes into providing advisors with a curated list of vetted ETFs is understandable, but it perpetuates access and distribution challenges. Advisors can’t access all ETFs, and issuers can’t distribute them to those they may want to. This challenge will only grow as more and more active ETFs enter the space.
That takes us to our last factor: changing advisor business models. Over the last number of years, there has been a large shift to fee-based business for advisors at wire house and independent broker-dealer firms; meaning, they charge their clients a fee on assets under management instead of commissions.
Why does that matter? Mutual funds have an embedded fee that pays advisors, while ETFs don’t. If you, as an advisor, didn’t have a fee-based business, that begs the question: How do I get paid? ETFs lend themselves to the fee-based business model, and it’s no surprise that the increased usage of ETFs by these advisors has gone up as the approach has shifted.
Home Offices Step In?
This should sound familiar, as it circles back to the changing economics for the home office. Something else that has occurred during this shift in business models is advisors becoming portfolio managers. While that could be appropriate for some advisors, in many cases, advisors are instead best suited as wealth managers and financial planners.
Imagine for a second that we are the home offices trying to address the fact that thousands of our advisors are now acting as portfolio managers, and we may or may not think that this is best for any one of them. What do you do? Protect them from themselves?
This is just another motivation to filter out the available products that can be used by advisors, making sure the approved products aren’t best handled by professional money managers. This is a broad brushstroke, because this means that some ETFs are being kept out of the hands of many who are more than capable of using them appropriately. But it’s happening.
All of these factors create hurdles and have a major impact on adoption, because they drive which ETFs are available for advisor usage. Yes, an advisor may be able to use an ETF that is not approved on what some firms call an “unsolicited” basis, but it’s not scalable, and from advisors I’ve talked with, not worth the hassle.
This is all changing rapidly, as more active ETFs come to market, and it’s an understatement to say it’s all happening in real time. Frankly, some of the details relating to revenue sharing agreements—especially with active ETFs—could change from the time of my writing to the time we go to print.
But the gist remains that home offices are trying to figure out the best path forward in light of these factors. Regardless of the decisions made by the individual firms, they will no doubt continue to impact the access and distribution challenges facing advisors and issuers.
In our final article in this series, we will explore the growing world of model portfolios and how they play a role in addressing, in part, these very challenges.
I’d love to hear your thoughts and concerns about ETF distribution throughout this series. Reach out to [email protected].