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ETFs: A Broken Business Model

ETF closures a telltale sign the business model is broken

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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?

Article printed from InvestorPlace Media,

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