ETFs: A Broken Business Model

ETF closures a telltale sign the business model is broken

By Will Ashworth, InvestorPlace Contributor

What do BlackRock (NYSE:BLK), State Street (NYSE:STT) and Vanguard all have in common?

Well, besides controlling 83% of the American ETF market, all three combined manage several hundred billion dollars in mutual fund assets.

The two are not coincidental.

Recently, I discussed why the ETF market needs more players and how the ongoing industry consolidation is bad for consumers. In less than a month, more ETFs have closed, including Russell’s entire ETF business save the actively managed Russell Equity ETF (NYSE:ONEF) — which is an excellent fund, by the way.

Proponents of ETFs will suggest this is the natural evolution of an industry still in its infancy. I, on the other hand, believe this is proof that the ETF business model is terribly flawed and needs fixing.

At the core, this continues to be a discussion about what’s wrong with investment management in general, and not so much the pros or cons of a world with more choice. If ETFs are to flourish, the infrastructure needs to change.

When you talk about first-mover advantage, nowhere is it more prevalent than in the ETF industry. The largest ETF by assets is the SPDR S&P 500 ETF (NYSE:SPY) with $110.6 billion. It was the first ETF introduced in the United States, getting its start in January 1993. In fact, if you look at the top 10 ETFs by assets, the average age is 11 years, which doesn’t give much hope for new funds. Furthermore, only the PowerShares QQQ (NASDAQ:QQQ) comes from a firm outside the big three.

How many asset management firms are there in the United States?

I would guess hundreds, if not thousands, of businesses. Yet 83% of the ETF industry is controlled by just three companies. This can’t be healthy for consumers, and it’s probably not good for the practice of money management, either. Many businesses that currently manage assets for high-net-worth individuals, institutions, corporate pensions, etc., will never get the opportunity to do the same for smaller investors because the doors to the ETF industry are closed.

When a company like Russell — a world leader in indices — can’t operate profitably, one wonders why.

Towers Watson‘s (NYSE:TW) investment services division puts out a short document for institutional and retail investors explaining ETFs and exploring possible future opportunities. What stands out for me is the section stating an effective ETF needs a four-way partnership that includes the sponsor (BlackRock, etc.), brokers, stock exchanges and index providers. On the same page, it explains how the primary and secondary ETF markets work together to provide investors with liquidity in specific baskets of stocks.

What’s wrong with this picture?

The industry has created a model that relies on the creation/redemption mechanism to function. Without the ETF sponsor and authorized participant (market maker, institution, etc.), there is no ETF. The behind-the-scenes machinations of the primary ETF market keeps the share price in line with the value of the underlying securities. Because the authorized participant assumes all of the trading costs and fees, the management expense is kept low, unlike mutual funds, where trading costs are assumed by the fund itself.

In theory, it’s a wonderful concept.

However, it’s a model that keeps the power squarely in the hands of market makers and institutional investors because to play the game, you’ve got to own the underlying securities of a particular fund in large enough quantity to exchange for creation units, typically 50,000 share chunks, which then are resold to the public at a profit.

Market makers and institutions aren’t doing this out of the goodness of their own hearts, but rather for cold, hard cash. We are the pawns in their game.

There are five major players in the U.S. index business: Standard & Poor’s, Russell, MSCI, Dow Jones and Morningstar. From these five companies, hundreds of ETFs have been created based on various indices. Why can’t you take $1,000 down to your local Schwab office and have them invest it in the stocks that make up the S&P 500 with the same exact weightings as the index?

In a world where I can watch TV on my phone, how is it that individual investors are unable to buy fractional shares of company stock?

Washington-based FolioInvesting allows you to buy fractional shares, but it doesn’t give you the option to own the entire S&P 500. Instead, it has the Folio 50, which is the 50 largest stocks by market cap in the S&P 500. It’s close, but no cigar. However, the simple fact that it can do this suggests that the technology exists to make it happen.

And that’s the crux of the matter. Individual investors have little say in how they purchase their investments. Years ago, when online trading brought the cost of investing down, everyone thought individuals gained the upper hand. Not so much. We still have to go through a middleman to own the index.

I used to think many of the indices being created in recent years were simply a marketing tool for the inevitable ETF. But now that I see all sorts of funds closing, I realize that there’s nothing intrinsically wrong with the creation of indices like the Solactive Global Fishing Index, which until recently was the tracking index for the Global X Fishing Industry ETF. Although the ETF was shut in February, the index itself lives on. I should be able to buy the stocks in that index at my desired level of investment using current weightings, avoiding the ETF machine all together.

Alas, I can’t.

The democratization of investing, as witnessed through the ETF oligopoly, is a long way off. Only when we can do what I’ve described above will we be truly free.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

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