The Challenges—& Successes—Of Running An ETF Biz

We take a closer look at the growing pains of an ETF issuer rising in the ranks.

The bulk of ETF assets in the U.S. today sits in the hands of only three issuers—iShares, Vanguard and State Street. These firms dominate asset flows as well as headlines most of the time. But it’s the smaller, up-and-coming providers that are seeing the more impressive relative growth.

In 2016, Northern Trust’s FlexShares saw its ETF assets grow 56% in 12 months, one of the strongest AUM jumps last year among the top 20 issuers. The gains came on the heels of net asset losses of about 7% the year before, making 2016 a stellar year for the firm.

Known for its objectives-based and alternatively weighted strategies, FlexShares launched its first ETFs, including the FlexShares Morningstar Global Upstream Natural Resources Index Fund (GUNR), in September 2011. Today the company commands $12 billion in ETF assets spread across 25 funds, making it the 14th-largest ETF issuer in the country. Shundrawn Thomas, who heads the company’s ETF and mutual funds, tells us how it’s been growing an ETF business, and what trends he sees forging ahead.

ETF.com: What worked so well in 2016 to push FlexShares ETF assets up some 50% in one year?

Shundrawn Thomas: I would say a couple of things have been consistent with respect to our experience over time, and then there’re some things that were the benefit of catching certain trends. All those things came together to drive 2016.

If you look back at 2015, one of the biggest things to impact us was the sell-off in commodities and natural resources. We had a roughly two-year period where we saw many assets move away from that. And one of the first funds we introduced was our global upstream natural resource fund [GUNR]. GUNR is our most successful strategy in terms of asset flows. It has $3.6 billion in assets. We felt that downside in 2015.

But in the past several months, we found many investors who held natural resources as their core holding liked our unique approach there. We don’t skew towards energy, but we allocate to energy, ag, metals, timber and water. We have benefited from demand for long-term portfolios that are balanced for inflation.

Another thing we do well in our alternative weighting schemes is factor-based strategies—another trend that benefited us. And a lot of the funds in our suite were launched in December 2012, so we hit our three-year track record at the end of 2015. As you know, that’s when you move past just your early adopters, because now you're coming up on screens and people are looking at these funds. It's the first time you can get ratings from things like Morningstar. All of that came together in 2016.

And from an overall perspective, our investor-centric approach is embraced by advisors as well as investors. I’m referring to the fact that FlexShares is not product-focused. Rather, all of our funds are specifically designed with the real-world goals of investors in mind. As such, each fund seeks to meet one of four core or fundamental investment objectives—capital appreciation, risk management, income generation or liquidity management. This aligns our value proposition with the needs of investors and the advisors that serve them.

ETF.com: Beyond hitting that three-year mark, what’s the biggest challenge to growing advisor acceptance of an ETF strategy?
Thomas: For many advisors, whether you're dealing with an active strategy or an index strategy, the actual performance history matters. We're in an investment business. So for a lot of advisors, looking at both three- and five-year histories is going to matter.

Our experience has been this: Because the ETF space is newer, there's a fair amount of innovation there. What you’ll find is that there’s a certain percentage of the advisor community that I would describe as early adopters. They have both the willingness and the ability to assess newer strategies. They’re not the majority, and there’s no question that having a strong brand helps with early adoption.

When you, the issuer, get the acceleration and move past having just the early adopters, that’s when you start to get to the belly of the curve and reach a broader set of investors.

ETF.com: Is FlexShares’ ETF asset growth new money coming in, or are these assets coming from other products within the firm?
Thomas: Much of our growth is driven by net new flows. Part of it’s market appreciation. What we're really seeing when dealing with advisors—and it can be a long sales cycle—is that we often have success when they're at the point of making another asset allocation decision. That’s because we're focused on long-term investors. Our approach is not to try and find a hot strategy, or what we call the “hot dot,” but to focus on long-term investment portfolios.

We haven't really seen significant shift in any meaningful way from one of our funds to another one of our funds in terms of driving assets. We're seeing more new flows.

ETF.com: Do you expect this rate of growth for companies like Northern Trust to continue? Or was 2016—with 50%-plus growth—an outlier year?

Thomas: There's a law of large numbers. We've been moving our way up the league tables, but as you get larger, we’d expect the percentage growth to change, because you're growing off a bigger base.

Still, the opportunity for us is significant. From a flows perspective, consider that, coming into 2016, we ranked 15th in terms of assets in the U.S. ETF industry, but in terms of flows, we ended the year ranked 8th. We're taking market share.

ETF.com: Asset growth is great, but our data show that revenue growth is lagging, be it due to fee wars or due to investors’ focus on cost. Is running ETFs not much of a moneymaker? Is that a concern for an investment business like yours?

Thomas: It's important for people not to confuse the fees with the profitability. So I think one of the misnomers about ETFs is they're not a profitable business. I can assure you that leaders in the ETF business are profitable.

Without getting into too much detail, the reality is ETFs have a different cost structure than, say, mutual funds. There are certain costs to distribution and things like that you would associate with other structures that wouldn't go with ETFs. While there are a lot of new players who haven't gotten up to scale, I wouldn't characterize the business as being unprofitable, although I would say, on a fee basis, you have relatively lower fees when you're comparing to other kinds of structures.

Yes, there’s been fee competition, but it's been concentrated in what I would call the more traditional, or core, benchmark indices. Our product lineup—every single one of our ETFs—is an alternatively weighted or a nontraditional index, so our experience has been different.

ETF.com: What hasn’t worked well in your experience as an ETF issuer?
Thomas: We're long-term-oriented. To date, we have not closed a single fund, because we look at every one of our funds as having attractive long-term potential.

But we've learned there are parts of the market that take longer to gain adoption. Let me give you an example. There's a lot of understanding around quantitative index approaches on the equity side. Less so on the fixed-income side. We’ve learned that you can't just develop an innovative product. You have to be prepared for a sales cycle and an adoption cycle for certain strategies in fixed income to take longer than on the equity side.

ETF.com: What’s your outlook for ETFs and the ETF industry?
Thomas: We're seeing a lot more of the share of ETF flows go to fixed income. I don't think that's solely about people's concerns about risk, because it's across the risk spectrum in fixed income. It’s demand for fixed-income strategies that are innovative, that are built around empirically grounded and quantitative research—smart-beta strategies. That’s a trend we’re watching.

The second trend I see across asset management—not just unique to ETFs—is a push towards sustainable or impact investing. Exposure to what people refer to as ESG [environmental, social, governance]. We’re going to see two things on this front: First, there’ll be more and more interest in ESG-type strategies. Secondly, we’ll see more integration of ESG in other strategies. ESG may soon no longer be its own bucket in investor portfolios, but may be incorporated into new strategies everywhere.

The last thing in terms of the overall business is that we're at a point now where we've moved from what I would call the clear innovation stage to the growth phase. We're maturing as an industry. I would expect to see some consolidation and more shake-out. We’ll still see new entrants, but the barriers to success, different than barriers to entry, are high. The marketplace is becoming more discerning and increasingly competitive.

The good news is that we know people both on the advisor side and the institutional side are using ETFs more and more in a long-term fashion.

Contact Cinthia Murphy at [email protected]