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Exchange-traded funds have been hailed for their accessibility, transparency, and, above all, low costs. But the way in which investors are actually able to buy and sell ETFs—and at what cost—runs counter to their promises.
Even the word the industry uses—distribution—obscures the process: ETF providers have to get their products in front of investors, whether that means via a discount brokerage aimed at individuals and registered investment advisors, or on the platforms offered at big wealth managers, or through any other means of institutional trading. How do ETF providers get on these platforms? They pay.
This model, employed by mutual funds for decades, has long been criticized. Mutual funds have share classes—versions of the same portfolio that come with different fees—that facilitate these kinds of payments from the firm offering the fund to the firm making it accessible to the end investor. Known as revenue-sharing agreements, these costs get passed on to the investor. ETFs don’t have share classes, but they are not immune from this sort of pay-to-play way of selling. And it has limited the industry’s growth.
The gatekeepers at the big wirehouses, brokers, and home offices decide which ETFs see the light of day. “The gatekeeper’s job is to identify and confirm the quality of the product being considered for inclusion,” says Paul Ricciardelli, who oversees research and evaluation of investment products and strategies at
Morgan Stanley
.
ETFs usually need the assets and a track record to become firm-approved and placed on a wealth management or brokerage platform.
This may not sound like a high hurdle, but the distributors want to be paid for that distribution. Mutual funds, in this sense, can have an upper hand, because their 12b-1 fees—a marketing fee that investors pay annually—can go to compensating the platform on which they’re sold.
ETFs don’t have share classes or 12b-1 fees, but they compensate the platforms in other ways. Most online brokers—like Fidelity and
Charles Schwab
—have a list of funds that investors can trade for free. For ETFs, these arrangements are set up at the firm level, rather than diverting 12b-1 fees. It was six years ago, for instance, that Fidelity—late to the game with its own ETFs—partnered with BlackRock. Fidelity customers can now trade dozens of BlackRock’s iShares ETFs for free, but buying or selling a Vanguard ETF will cost them $4.95 each time.
“Investors looking at a set of commission-free ETFs on any platform need to know that issuers pay to be on there, so they may not necessarily be looking at the best or even the cheapest option,” says Daniil Shapiro, associate director at Cerulli, a research firm.
Big issuers have armies of salespeople to get an ETF, or a suite of ETFs, onto the right platform—a huge advantage in terms of gathering assets. It’s also the reason that many firms with their own method of distribution do so well with ETF launches: Charles Schwab’s OneSource platform helped the firm move from the bottom of the top 10 ETF issuers to the top half in about five years.
JPMorgan
’s
BetaBuilders country-specific ETFs, which were picked up by JPMorgan advisors shortly after their launch, probably took some iShares’ country-specific assets.
“Without distribution, you can’t sell your products,” says Jillian DelSignore, head of ETF distribution at JPMorgan’s asset-management business. When asked if an in-house shelf was a more effective way to support the success of an in-house developed fund, DelSignore said, “All distribution is important.”
The small and midsize issuers are at a disadvantage, because they often can’t pay to play, and they have to familiarize themselves with the myriad of gatekeepers’ due-diligence processes, which are hardly consistent. For instance, some factor ETFs are treated like active products, and handled by active-management due-diligence teams, which often have an approach to evaluating products that’s very different from teams assessing index products.
Ironically, the brokenness of the ETF industry has everything to do with access. Easy access and low fees catapulted ETFs to nearly the same ubiquity as mutual funds in a little more than a decade. But if the biggest ETF, the (ticker: SPY), is an indication of what’s to come—it has seen outflows of $40 billion over the past 12 months—these are desperate times for selling for issuers and investors. The asset management industry needs to figure out how to keep investors—not to mention turn a profit—while charging less and less for their products.
Broken things are vulnerable to disruption. High-cost active managers who consistently lag behind the market have learned this lesson the hard way in the past decade. In the next decade, the answer to all of these problems might be the very thing that enabled the creation of ETFs—technology. Technology allowed fund managers to create portfolios that were more efficient and easily traded. Now, technology could very well enable investors to cut out the fund companies themselves. Index providers and active managers could one day directly provide investors with their portfolios, and improvements in trading technology will allow them to trade those portfolios as a single unit if they want—their own ETF. Imagine a day when you can stream Jeffrey Gundlachs’ ideas straight into your portfolio, says Dave Nadig, a managing director at ETF.com. No wrapper fee. No platform fee. No gatekeepers. Just better technology.
Nadig and Hougan will talk about “The Dawn of Mass Customization” in their annual speech at next week’s InsideETFs conference. “Maintenance and market access are fundamentally software problems that can be solved with almost no money. We know this from the success of robos and fractional shares,” says Nadig. “All of this is just math.”
Wall Street has a math problem to solve. Maybe the answer comes from within the industry and not outside it, but if it doesn’t, the next disruption could mark the end of investing and investing culture of the past 90 years.
Write to Crystal Kim at crystal.kim@dowjones.com
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