The ETF Giants Grow

August 09, 2012

Regulatory changes are reinforcing the trend toward the ETF market's domination by a few large firms.


[This article originally appeared on our sister site,]


It’s hard to disagree with the European regulator’s push for greater transparency in index funds and ETFs. But a side-effect of the new rules is almost certain to be the reinforcement of the competitive position of the current industry leaders.

As John Williams pointed out yesterday in his excellent review of the index-related part of ESMA’s guidelines, the potential banning from use in UCITS funds of indices that have “been created and calculated on the request of one, or a very limited number of, market participants and according to the specifications of those market participants” threatens to dampen the current fashion for “smart beta”.

Such a judgement must be music to the ears of firms like Vanguard, which recently warned of the dangers of placing excessive faith in indices that are created on a whim and a back-test, so to speak. But it’s important to remember that creating custom indices is one of the few ways that newer entrants into the ETF market can distinguish themselves. After all, who needs the nth version of a Euro Stoxx 50 tracker?

And it’s proved surprisingly difficult to dislodge larger ETF providers by offering to undercut fees, at least in Europe. ETF investors and traders appear to favour the superior liquidity promised by large, existing funds, even at the cost of higher expense ratios.

Perhaps a happy medium will be reached, where new indices to underlie ETFs will still be permitted, but only after a much more rigorous examination of the benchmark, including the assumptions made for trading and rebalancing costs, the investment concept underlying the index and the independence of the index firm.

These are all things we’ve banged on about as important in any investor’s due diligence process, but they are also areas where regulators have rightly pointed out the inadequacy of the existing information on offer from many providers. On balance, though, it’s fair to assume that it’s going to be much harder to get new a new index fund approved by Europe’s national regulators if “smart beta” is involved.

And all this will surely further concentrate the dominant positions of the leading European ETF issuers, most notably iShares, but probably also db x-trackers and Lyxor. I suggested last week that these two firms, the largest two bank-owned ETF providers, which have been losing market share steadily over the last 18 months, might have been seen ESMA’s guidelines as a respite.

But the competitive landscape is surely getting much tougher for smaller providers, in particular those who haven’t yet reached break-even point in assets under management or fee revenues.

In the last week we’ve seen one ETF issuer, FocusShares, leave the US market after failing to crack it, and Russell announce it’s scaling down its ETF business, also in the US. It wouldn’t be surprising to see some similar announcements in Europe.

As the ETF giants grow, should investors be concerned? In the short term, probably not. There’s arguably still enough competition to ensure that product providers stay focused and that fees remain under downward pressure, particularly with firms like Vanguard making a big push into the region.

From a longer-term perspective, the tendency to gigantism in the financial markets is a worry. Regulators’ interventions since the financial crisis have had the effect of concentrating risk in a few enormous institutions, rather than dispersing it. “Too big to fail” has been enshrined as policy, not done away with. So we should probably all hope that smaller, nimbler operators can continue to keep the largest firms on their toes, and not just in the ETF and index fund market.



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