ETF Providers – cost cutting and market share

The Global ETF market is dominated by three industry giants, iShares, State Street and Vanguard holding 38.7%, 17.6% and 12.4% respectively. This top three positioning and the fact that the top 10 products – largely within the stable of these providers – account for 90.6% of the total show a remarkable stability at the top of the market.

When we look to the regional provider tables we see that iShares is the firm that has established a significant foothold in all the regions but it is notable that the other giants of the industry are ramping up their global ambitions and challenging iShares on its home turf with Vanguard taking a further 2% of the market while iShares declines to 40.7%.

It is likely therefore that we will see some movement in the relative size of the industry heavyweights and while performance, liquidity and fund structure will continue to be key, price will be an increasingly important component.

The physical v synthetic “war” that has raged in the European ETF market over the last 3 years has benefitted the physical providers though the moves by the synthetic providers to adapt their models to address regulatory concerns and their effective highlighting of the counterparty risk in physical funds securities lending activities means that the parties might now be seen to be fighting on a level playing field.

The U.S. regulators do not however permit full replication synthetically so the driver for competition has revolved around performance and more importantly cost. In the cost model Vanguard is typically significantly less expensive while their ownership model – they are owned by the funds – means they do not have the shareholder ownership pressure that mitigates against pricing discount model. The fund flows

It is a truism that in economic terms what begins in the U.S. ends up here – though we should be proud of our own home-grown Euro crisis – and it is likely that the pricing war we see being fought in the US – will spread to Europe.

For the investor then it is important to look at the cost of investing in an ETF.

ETFs, underpinned by their principles of transparency, are far ahead of their mutual fund rivals in disclosing total cost of ownership with a flat fee rate the norm, from which all administrative costs are deducted and a factory gate pricing model that rules out intermediary commission.

The management fee charged by the promoter is not however the sole consideration for the investor who could more meaningfully look to the total cost of investing in the product. This figure should equate with the performance difference between the fund and the index so for example to refer back to the US example we saw huge outflows from iShares EM into Vanguards equivalent offering which was both cheaper in terms of the management fee and performed better so that the implicit costs of investing against the anticipated return was significantly lower for the lower management fee fund. This of course may not always be the case so a lower management fee synthetic fund may have significant costs associated with the cost of the swap while the low cost physical fund may have higher rebalancing costs. The investor in considering the implicit costs can also consider the impact of tracking difference which is broadly speaking lower in synthetic funds and higher in physical especially for emerging markets and more highly optimised funds and also the positive returns that securities lending can deliver back to a fund.

Finally, for the secondary market investors it is important to to consider the spread on the investment itself and ensure the optimal execution point.

So, for the investor and understanding of total costs of investing in the fund is key. For the industry the experience of the US suggests that as the large providers grow in their global ambitions the stage is set for increasingly competitive pricing – a development likely to benefit the end investor.

August 2012

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