The rapid growth of the exchange-traded fund industry has been documented ad infinitum, but there has been much less commentary about what this growth means for the second-tier mutual fund companies.
The short answer: nothing good.
Much as the evolution of the Internet has taken a toll on companies in the print media sector over the last decade, so too could ETFs bring about the demise of some of the weaker players in the asset management industry. But which companies are most at risk?
First, here are some discouraging numbers: According to etftrends.com, exchange-traded products have garnered $93.9 billion in asset inflows during the past three years, at the same time as mutual funds suffered outflows of $347.2 billion. ETPs still have a long way to go to catch up, with a total of $1.28 trillion in assets compared to $12.33 billion for mutual funds. Clearly, however, ETPs are where the growth is: IndexUniverse reports that exchange-traded products hauled in $119 billion in new assets during 2011, dwarfing the $58.6 billion that went into mutual funds.
You don’t have to look far to find the reason. Over longer time periods, the major ETFs have generally outperformed their counterparts on the mutual fund side by a comfortable margin — a reflection of both their lower fees and the tendency for active management to underperform index-based investing over time. Indeed, the performance of mutual funds (in the aggregate) has been abysmal.
This table shows the performance of various Morningstar fund categories compared with the relevant index over various trailing time periods. And the results are ugly: Mutual funds have underperformed their respective benchmark in 80% of the 20 most important categories during the past year, 65% during the past five, and 70% in the past 10 years. Little by little, this persistent underperformance has given investors a reason to take advantage of the better mousetrap offered by ETPs.
Performance isn’t the only issue working in favor of ETPs and against mutual funds. According to this USA TODAY article from May, exchange-traded products are beginning to work their way into tax-deferred acounts such as 401(k)s and 529 plans. ETPs only have a small foothold in this area right now — less than 1% — but any inroads would further cut into an area long dominated exclusively by mutual funds.
What’s more, financial advisers — long the forward infantry for the fund industry — are increasingly turning to exchange-traded products for their clients’ portfolios.
Finally — and this might be the worst news of all for the fund industry — young people are favoring ETPs over mutual funds.
Who Wins, Who Loses?
These trends represent an ill wind for companies in the second tier of the asset management business.
Behemoths such as T. Rowe Price Group (NASDAQ:TROW) and Franklin Resources (NYSE:BEN) are unlikely to be unseated any time soon, nor are managers with a large stake in the ETF business, such as BlackRock (NYSE:BLK) or Invesco (NYSE:IVZ).
However, this does leave a large swath of second-tier players that could feel the pinch in the years ahead, such as SEI Investments (NASDAQ:SEIC), Legg Mason (NYSE:LM), Eaton Vance (NYSE:EV), Waddell & Reed Financial (NYSE:WDR), Federated Investors (NYSE:FII) and Janus Capital Group (NYSE:JNS). All of these firms are in jeopardy of steady market share losses in the years ahead.
This isn’t a short-term call. The asset managers have been performing very well so far this year following a tough 2011, and they likely will continue to do so as long as the broader market keeps moving higher. What’s more, the sector — while more expensive now than at the end of last year based on forward P/E’s — isn’t prohibitively so. Instead, the issue is the lack of a clear growth driver for fund companies without the brand cachet of T. Rowe Price or the low expenses of Vanguard.
The chart below provides an appropriate final thought. Even as the broader market has climbed higher in the past two years, the asset managers have struggled just to stay even. Given the exploding popularity of exchange-traded products, don’t expect this trend to change for the better in the years ahead.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.