The Passive War
After a prolonged Hawaiian vacation, Paul Yook was finally ready to make his comeback.
His sojourn in paradise was always going to be temporary, but he needed it. Yook had managed a health-care portfolio at the Galleon Group LLC for five years until 2009, when the New York-based hedge fund became the target of an insider-trading investigation. Eventually, the company’s founder, Raj Rajaratnam, was convicted. Yook was never charged. But he took a chunk of time off in New York after Galleon shuttered and then, in 2011, moved his family about as far away from the turmoil as possible. After two and a half years, however, he was ready to say goodbye to the Aloha State.
He had a big idea—one that, in hindsight, seems like the perfect culmination of his studies at the University of Pennsylvania, where he’d majored in economics and biochemistry. “Imagine a 19-year-old manipulating DNA in a laboratory,” Yook, now 42, says. “That got me really excited.” So did making money. The combination helped him land investment banking jobs at Goldman Sachs Group Inc. and UBS Securities LLC before he moved to Galleon as an analyst.
At first biotechnology exchange-traded funds figured only into his presentations; by the time he was managing a portfolio, though, he’d begun investing in them, relying mostly on the two largest funds—IShares Nasdaq Biotechnology ETF (IBB) and SPDR S&P Biotech ETF (XBI)—to gain short-term exposure and to hedge. He also felt the products were far from perfect. Some of the ETFs were exposed to specialty pharmaceutical companies; others lumped risky early-stage companies with more established ones into a single ETF. The characteristics were so dramatically different, Yook says, it didn’t “make sense to put those companies in the same fund.”
Returning to New York in 2014, he decided to turn his big idea into a reality by designing biotechnology ETFs on his own. Yook took his idea to Andrew McDonald, who in 2010 had co-founded LifeSci Advisors, a life-sciences investor-relations consulting company. They decided to join forces and introduced a pair of ETFs that December. BioShares Biotechnology Products Fund, or BBP, looked at established companies that had already received approval to market a drug; BioShares Biotechnology Clinical Trials Fund, or BBC, focused on young companies that were testing drugs in human clinical trials. The funds were equally stock-weighted to avoid missing out on exposure to smaller companies. At the time, ETFs and the biotech sector were both booming. Yook was confident investors would flock to their offerings faster than white-blood cells to an infection.
And that’s exactly what happened, at first. The ETFs benefited from the rally in biotechnology, attracting more than $70 million in total by the end of that July. Then the market turned. By June of this year, neither of his BioShares ETFs had exceeded the $50 million threshold needed to make a profit and attract the big brokerages’ attention. “The asset growth has been solid”—BBP has gathered about $35 million, BBC about $23 million—“but a far cry from what we expected,” Yook says.
In an increasingly crowded market, where more than 2,000 ETFs compete for assets in the U.S. alone, many upstarts face challenges such as Yook’s. More and more firms are shuttering ETFs that fail to accrue assets, resulting in a record 98 closures last year. Others are merging and forming partnerships with larger companies. Jim Ross, who oversees State Street Corp.’s ETF business and helped start the first one in 1993—the mighty SPDR S&P 500 Trust (SPY)—has a blunt message for new issuers. “I talk to a lot of folks getting into this space,” Ross says. “I say, ‘Listen, if you don’t have a strategy to get to your first $50 million, don’t come in. You are wasting your money.’ ”
That’s because the dominance of BlackRock, Vanguard, and State Street is staggering: Together they oversee 83 percent of the ETF market in the U.S. The 50 largest funds in the world are theirs. They also capture more than half the American industry’s fee revenue, despite the bargain-basement prices they charge for many products. “It’s basically a battle between King Kong, Godzilla, and Mothra, with everybody else fighting over scraps and crumbs,” says Eric Balchunas, an ETF analyst for Bloomberg Intelligence.
Indeed, there are more than 70 other issuers in just the U.S., each hawking its indexes with stock tickers in letter arrangements you might expect to see in a spoonful of alphabet soup: SCIF, DZK, EDZ, LABD. The beauty of ETFs is that they let investors buy or sell exposure to an entire sector, market, or country as easily as a stock. And these funds are simple to understand, typically tracking an index that prescribes exactly what a fund can own. An index is a passive investment by definition, even if the securities in the index are more than likely picked by someone (or someone’s methodology). Still, because you don’t really need an expensive manager to make such decisions, ETFs are cheaper than traditional mutual funds. “Because the ETF landscape is so competitive,” Balchunas says, “investors can now get a fully diversified, institutional-caliber portfolio for an all-in fee of less than 0.09 percent.”
To facilitate the slurping of alphabet soup, the most memorable ETFs tell a story. Want to own the S&P 500 (SPY), dabble in cybersecurity (HACK), bet on robots (ROBO), get into bourbon (WSKY), or profit on the obese (SLIM)? And while SPY, HACK, and ROBO have become the stuff of legend, even a good story isn’t always enough. Those latter two ETFs, as clever as they sound, each have market caps under $3 million. In fact, 40 percent of funds manage less than $50 million—that magic number at which the average ETF breaks even.
To put it another way, size matters, and not only for the fund’s internal economics. Pension funds and insurers often require a minimum amount of assets to consider a particular ETF. And many funds are stuck in a chicken-and-egg purgatory, wherein a handful of all-powerful wirehouses—including Morgan Stanley, UBS Group AG, and Bank of America Corp.’s Merrill Lynch brokerage unit—control access to financial advisers that could steer millions into a fledgling ETF. These advisers control much of the money from mom and pop investors that account for about 70 percent of ETF assets, says Balchunas. Yet funds must hit certain milestones to get onto the big platforms at all, with some brokers demanding as much as $1 billion in assets, a three- to six-month track record, and sometimes an access fee.
Nonetheless, the flood of money into passive vehicles can’t be overstated. Passive approaches now account for 35 percent of mutual funds’ stock investments, a figure that Vanguard Group Inc. founder Jack Bogle says could rise to 45 percent over the next five years. ETFs will no doubt continue to benefit if that trend continues, having already jumped from $400 billion in assets a decade ago to about $2.9 trillion today. Active mutual funds, meanwhile, have stalled at about $10 trillion in the U.S.
In other words, an enormous amount of cash is sloshing around when even a modest cup of froth can make an also-ran’s year. The strategies for filling that cup all differ, but sooner or later you need to claim a bar stool and defend it with sharp elbows.
Or maybe a lightsaber. One speaker at a recent ETF award ceremony even likened the industry to Star Wars: Rooting for BlackRock Inc., he said, was akin to pulling for the Empire. That may give BlackRock a little too much credit, though, because the force is also so strong with Vanguard and State Street.
Where will the Resistance go from here?
Jonathan Steinberg is scrappy by nature. He’s been a Resistance fighter for more than a decade, armed with little more than belief and perseverance. And with that he’s constructed a $40 billion ETF business. Yet even he recognizes things are about to get really tough. The novel approach to indexed investing that’s defined his company, WisdomTree Investments Inc., has gone mainstream, with similar strategies accounting for about 70 percent of funds started in 2016. Chalk up a win for WisdomTree’s instincts but hold the applause: Despite overall assets increasing, the company has slipped behind peers. It’s now the seventh-largest ETF provider in the U.S., down from fifth only three years ago. “You are always competing with the world’s largest asset managers,” says Steinberg, an impish 52-year-old fizzing with impatient energy. “It’s not for the faint of heart.”
A wannabe financial media mogul at the height of the dot-com bubble, in charge of a publishing house that hadn’t turned a profit in years, Steinberg realized then what many only now comprehend: ETFs were the future. He knew the likes of Vanguard would use their bulk to dominate. So as the son of Saul Steinberg—a fearless 1980s corporate raider whose audacious takeover bids and a high-rolling lifestyle flirted with cliché—he sold up and got in on the game.
“I invested aggressively,” says Steinberg of the single June day in 2006 when he introduced 20 ETFs. “I was accelerating my losses knowing that I was going to go bankrupt, high probability. So I put a burden on myself to raise additional capital fast, but I knew that this was a race.”
It was. And for a while, WisdomTree held its own, gradually gaining ground amid the behemoths, making its name with so-called smart-beta funds, those that shun traditional indexes tilted toward the largest companies in favor of dividends, value, or growth.
The company’s stable also has some of the most-traded ETFs, which Balchunas likens to beachfront property if the company ever finds itself in mergers-and-acquisitions negotiations. “There will likely be major consolidation in the next 10 years,” he says. “Asset management may come to resemble the media industry.”
Clever ideas may have helped propel Steinberg to date, but they may not be the answer going forward. To that end, WisdomTree has used its funds to create model portfolios that financial advisers can tap into via the company’s website. It’s opened offices in London and Tokyo, hired a new head of client solutions, and bought part of a B2B robo advisory platform to capitalize on a shift toward low-cost, online money management. Sure, the product is just as important as ever, Steinberg says, but “we’re evolving.”
Wisdomtree’s struggle to maintain its foothold and even expand is something Deutsche Asset Management knows all about. Despite success as Europe’s second-largest issuer of exchange-traded products—with backing from its parent, the region’s biggest investment bank—a prized top-10 slot in the U.S. has proved elusive. Deutsche is in 11th place, just ahead of ALPS Advisors Inc. “We’re in mile 4 of a 26-mile race, so we are still early,” says Fiona Bassett, the 43-year-old Brit brought in to shake up the American ETF business in 2014. “Winning in the U.S. is absolutely critical for our global ambitions.”
Within months of trading London for New York, Bassett gave the company a boost by selling its commodity-focused ETFs and refocusing the business on the bank’s international chops via a suite of currency-hedged ETFs. Deutsche is now the third-largest manager of these funds in the U.S., with assets increasing 14-fold, to $13.7 billion, under Bassett’s leadership. The business’s overall ETF assets have grown 38 percent under her.
Not bad, but still not enough. Overseas strategies, hedged or otherwise, remain a small allocation for most U.S. investors. About $9 of every $10 that Deutsche manages is in three popular funds that were among its first currency-protected products.
Like WisdomTree, the company looks to brighten its fortunes by reaching new potential buyers. Deutsche has signed up to the smart-beta craze and is marketing multifactor ETFs that pack several of these strategies into one wrapper in a bid to expand its investor base. It’s also pursuing a share of the fixed-income market by undercutting fees on similar existing products. Its website is dotted with “thought leadership” pieces on how to use these funds.
Deutsche is finding that relationships with clients increasingly determine success. “It’s like talking to your tailor rather than someone who wants to sell you a suit,” says Reinhard Bellet, the company’s head of passive asset management and Bassett’s boss in Frankfurt. “You cannot just issue a product and say, ‘Good luck!’ You have to be there, and you have to be a partner of the client, and I think that’s the future of passive: providing service.”
It takes more than smarts to succeed in the crowded ETF market. You need a game plan that will persuade buyers to place bets with you. “You do have to get smarter in thinking about distribution,” says Marie Dzanis, head of intermediary distribution for Northern Trust Corp.’s FlexShares-branded ETFs. “It’s almost like matchmaking. You can date anyone, or you can be very thoughtful about who’s going to appreciate this exposure, this experience.”
That’s something Charles Schwab Corp. has mastered. By channeling the techy vibes of its Silicon Valley neighbors, the San Francisco-based company has built 21 funds into the fastest-growing ETF business in the U.S. How? With innovative distribution, not product.
Schwab has set up an ETF superstore, letting clients compare more than 200 ETFs (including its own funds) from 16 providers. The company’s own offerings on its commission-free platform are mostly plain vanilla—a large-cap stock ETF or a product that invests in the broad market—but they come with perks. Buyers can get a stamp of approval from Schwab’s advisory services unit, for example, or a low-fee portfolio-modeling service on the side.
So that’s a Schwab-approved ETF, issued by Schwab, bought via a Schwab platform, for a portfolio designed by Schwab? Right.
“We have our own proprietary asset management and a huge open architecture platform where clients can choose among every ETF in the industry,” says Jonathan de St. Paer, senior vice president for strategy and product at Charles Schwab Investment Management Inc., or CSIM. “The Schwab platform is a microcosm of the industry.” This has given CSIM a unique insight into which funds succeed and how investors act, helping it develop a $75 billion ETF business based on economies of scale.
Thanks to the wide distribution its ETFs get on Schwab platforms, CSIM can afford to offer funds for next to nothing. Half of the 10 cheapest U.S. ETFs are run by the company, which has offered them free of commission from the outset. That’s elevated Schwab to the fifth-largest ETF issuer, up from 10th three years ago. “Every investor gets our best price,” Walter Bettinger, Schwab’s chief executive officer, said on a call to shareholders in April. “We talk about disruption. This is a classic example.”
The numbers suggest Schwab’s strategy is succeeding. Investors poured more than $11 billion into the company’s ETFs in the first five months of the year. That’s more than the funds from both State Street and Invesco PowerShares, two providers that tower over Schwab in terms of total assets.
And the money is sticky. Clients who’ve invested in the asset management arm or used their portfolio solution services on the platform are the largest holders of 13 Schwab ETFs. Robo advisers have also enthusiastically adopted Schwab’s low-cost funds for their low-fee (or often no-fee) investors. “We’re not going to build niche products for one client set,” St. Paer says. “We’re going to build foundational products.”
While Schwab has thrown everything but the kitchen sink into making its ETF business work, others have found success—and assets—another way. At Goldman Sachs, it took only 11 people to pull off one of the most successful startups in ETF history. The investment bank’s money-management arm came out with three ETFs in late 2015, ending two decades on the sidelines; in less than a year, those funds had $2 billion.
The Goldman secret sauce? Packaging existing strategies and existing clients into the must-have product of the moment. “ETFs give us another solution for our clients,” says Michael Crinieri, 52, who moved from Goldman’s securities division to head ETF strategy in July 2014. “People are using ETFs in active strategies. We’re focused on offering those building blocks.”
Goldman Sachs Asset Management (GSAM) was an unlikely candidate to broach a new passive frontier. Its battalions of doctorates specialized in crafting active strategies, but then came the financial crisis. Investors shunned stock pickers for low-cost indexes, and Goldman suffered three straight years of outflows through 2012. Something had to give. It resolved to halt the exodus, beef up its flailing unit, and create a one-stop investment shop.
And that meant introducing ETFs. From 2011 to 2015, Goldman went on a buying spree, acquiring 12 companies—including Westpeak Global Advisors LLC, an expert in quantitative analysis that became the backbone of Goldman’s ETFs. “When the ETF business was about traditional indexing, GSAM really didn’t see a fit,” Crinieri says. “As investors were more interested in products differentiated from traditional market-cap-weighted indexes, all of a sudden GSAM decided that this is what we do, this is what we’re good at, and we can really add value.”
Goldman hired industry experts from BlackRock and Pacific Investment Management Co. And Goldman’s established divisions, including its investment research team, gave GSAM its winning formula—or a version of it—to create products such as an ETF that tracks the hedge fund industry or a fund that buys short-dated Treasuries.
It worked. Existing clients jumped at the chance to get a Goldman strategy for a lower fee, providing an early boost to assets that helped the products take root, according to people familiar with the matter. Goldman’s largest ETF, a smart-beta fund that selects stocks by calculating their value, momentum, quality, and volatility, can be yours for just nine basis points, less than SPY charges for tracking the S&P 500. The company’s ETFs saw record inflows in April, lifting assets to more than $4 billion.
Goldman won’t corner the ETF market; that’s not its ambition. Rather, it wants to satisfy current clients and give previously underserved investors, such as registered investment advisers, a chance to buy the Goldman brand. “We’re probably never going to be a Vanguard or IShares,” Crinieri says. “We’re not going to have hundreds and hundreds of products. We’re focused on taking some of our best ideas and turning them into ETFs.”
The meteoric success of Goldman and Schwab shows that there’s still room for newer entrants to make it big in the ETF market, Balchunas says. It’s not easy, but with the right strategy, issuers can carve out a profitable business away from the Big Three. “Goldman Sachs is a great example of a company that successfully made the transition to ETFs—they hired a few industry veterans, did their homework in picking which products to launch, and then hit the streets to make their presence known,” Balchunas says. As for Schwab, it’s “a technological marvel how they can offer up such cheap funds,” he says.
So bioshares, take heart.
Yook certainly isn’t giving up. After the wirehouses ignored their funds, he and McDonald teamed up with a larger asset manager to get the big bucks rolling in. Their ETFs will be sold through that money manager’s distribution arm, leveraging its existing relationships with big brokerages and financial advisers.
Yook declined to provide more details about this new partnership because the deal hasn’t closed yet. But when it does, he expects the number of sales professionals selling his ETFs to hit 50 eventually, up from just a handful today. That could be the game changer. “We realized distribution in a big way is important,” Yook says. “What we really need to do is have multiples of what we have.”
Or so hope the Resistance fighters.
Evans covers ETFs in New York. Burger covers cross-assets in New York. Willmer covers asset management in Boston.