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 The backlog of filings for new exchange-traded funds is growing at a pace that rivals the number already on the market. With such a booming product pipeline, demand for increasingly exotic indexes is following suit. Does that translate into boom times for indexers? Maybe, maybe not.
Several unique challenges face smaller index providers. For one, the path to profitability for a new index provider is a long one: First, you have to develop the index, which can take years; then you have to license it to a product issuer, fighting with other index providers for limited slots; then the product must actually launch and attract assets, which is a big hurdle (currently, more than 100 U.S.-listed ETFs have less than $10 million in assets).
As more active ETFs come onto the scene, indexers face new challenges, as the need for indexes may be outstripped by the high-profile nature of popular managers.
Still, against these odds, some upstart index providers have done their homework and say they like what they've found. One is Jim Huguet, chief executive at Great Companies, a Tampa, Fla.-based investment management and research shop. At first, he and his colleagues set out to create a mutual fund around his firm's expertise. But they decided to enter the ETF fray instead. "It came down to more than just that ETFs were a faster-growth area," Huguet said. "The ETF market also offers much lower entry costs for new providers."
With a mutual fund, he says, start-up expenses for his firm would come to anywhere from $150,000 to $200,000. And that doesn't count costs of marketing the new product. "It can take a huge amount of money to get a mutual fund to a profitable level of assets. Our estimate was that, just to break even on a mutual fund, we'd need around $200 million," Huguet said.
That figure was based on a very limited marketing campaign. Huguet says ETF providers should be prepared to spend much more when trying to introduce new indexed products into the ETF field.
Since mutual funds are dominated by active managers, Huguet says most advisors won't recommend new funds to their clients without at least three years' worth of performance data. "The ETF marketplace is largely indexed, which makes it more straightforward in presenting information indicating how a new index performs in different markets," he said. "Advisors will accept backtested data with ETFs. But they generally ignore backtested data with mutual funds."
In a more structured environment, Huguet found that testing model indexes was more a matter of selecting appropriate software and finding the right people to do the research. Since Great Companies already had many of those capabilities in-house, he estimates the firm spent around $25,000 to equip itself to do historical tests on its indexes.
Index developers in conjunction with their sponsors also need to pay someone like The American Stock Exchange or Standard & Poor's to maintain and calculate the index on a regular basis. Huguet says that probably costs his firm in the neighborhood of $25,000 per year.
On the plus side, the close relationship between index developer and ETF provider firms translated into a lot of resource sharing, he says. That can be especially helpful in further reducing marketing and other non-research expenses.
Nearly a year ago, a product based on Huguet's index launched: the Claymore/Great Companies Large-Cap ETF (AMEX:XGC). As of March 2008, however, the fund had little in the way of assets. Still, Huguet says that going the ETF route makes sense. "One of the big problems with starting a new mutual fund is that you face a lot more barriers to entry than with ETFs," he said.
Searching For New Angles
Kevin Carter, chief executive of AlphaShares, also sees ETFs as the best platform to apply the firm's research and investing expertise. But he warns that rising competition leaves few truly unique openings for new indexes. That's driving rivals to move into more niche markets, Carter says, where it could prove difficult to attract enough assets over longer periods.
"Finding a new way to index the market is tough enough," he said. "But you've also got to make sure there's enough demand to attract assets over the long-term." He and his partner Burton Malkiel saw limited opportunities for U.S. investors to target small-cap and real estate stocks in China.
"The only indexes with accompanying ETFs were for megacap stocks in China," Carter said.
Malkiel, of course, has an extensive history with index mutual funds. He was a long-time Vanguard Group board member and also chaired the new products committee at the American Stock Exchange when the first ETF was launched in 1993. "Our primary business isn't indexing," Carter said. "But we were looking around to find the best way to pursue our research and investment strategies."
The result was the creation of benchmarks for the Claymore/AlphaShares China Real Estate ETF (NYSE Arca: TAO) and the Claymore/AlphaShares China Small-Cap ETF (AMEX: HAO). AlphaShares has also created separate all-cap indexes for value-oriented and growth-focused stocks in China. While it might be easier to get started, however, Carter emphasized that making sustainable and lucrative profits in ETFs isn't a walk in the park.
Indexing as a business requires scale to make real money, Carter said. As a result, he says, unless you're an established name in the industry such as Standard & Poor's or Dow Jones, it can be tough to focus solely on providing indexes.
"The problem is that to get scale, you've got to find an index with real demand," Carter said. "If you're providing an index to a $50 million [in assets] ETF, then you'd better find a night job."
How Big, How Fast?
How big is the ETF market opportunity? Currently, some 450 different prospectuses for ETFs and exchange-traded notes are in some form of review by the SEC. Those funds would join 648 ETFs that were already trading on the market through last year, representing over $600 billion in assets.
As Figure 1 shows, the growth of the industry has been astounding … both in the number of ETFs and the assets linked to them.
The new crop of funds is much different, however. Traditional market-cap sized benchmarks are giving way to more fundamentally based and quantitative methodologies. A very significant number of the new ETFs are alpha-seeking mechanisms.
"They're quasi-active or active management using some sort of judgment for putting securities in portfolios," said Jeffrey Ptak, a Morningstar analyst.
As next-generation types of indexes come out, "they represent a stark break from more traditional market-cap-based methodologies," he added.
Niche products are also growing in numbers, as are bond ETFs. "Index providers keep an ear to the ground for interesting twists in the market. They're not going to mint and license new indexes if they don't think they're going to draw interest from investors," Ptak said. "But sponsors are very cognizant that there are certain names in the market such as S&P, MSCI, Russell, Dow Jones and FTSE [with established brands]."
As a result, he says, there's probably always going to be a natural tendency by ETF sponsors to look first "to align themselves with the more marquee players in the indexing business."
A Focus On Quality
With close to 80 percent of the industry's assets held by the top four ETF providers, Thomas Mench says he wonders how worthwhile it is for investors and advisors to keep up with all of the smaller benchmarking firms.
"The rest are just trying to survive," said the Cincinnati-based pioneer in using ETFs within strategically managed accounts for institutional investors. "The smaller players tend to come out with more of the indexes we think are less reliable and court tracking error problems. We also don't want to consider investing our clients' assets in something that might face liquidation down the line."
He pointed out that Claymore had to shutter 11 ETFs recently. "With the number of ETFs coming on the market, we're going to see more consolidation in this industry," Mench said. "And larger ETF providers are going to start gobbling up smaller ones to a greater extent than we've seen in the past."
As competition grows in the market, ETF providers tapping into outside indexing researchers and index providers are going to need to make sure they've got tight rules and procedures in place to maintain product quality, says Christian Magoon, the new president and chief executive officer at Claymore Investments.
Although his firm became the first major U.S. provider to close a number of ETFs recently, Magoon says Claymore took such action as a precaution ahead of a looming glut of funds. He believes the shuttering was the responsible action to take for investors rather than waiting until later.
"All firms have to assess if it's the best thing for shareholders to keep so many products out there," said Magoon, who before his recent promotion headed up Claymore's ETF business in the U.S. "We're constantly reviewing each fund's performance as well as changing asset levels relative to their peers."
Picking index providers involves a combination of factors, Magoon says. Selecting an area of the market that shows increasing demand is only one part of the equation, he adds. "As more ETFs come out, it's becoming even more important to select index providers with strong backgrounds. You've got to look at expertise and make sure to do your due diligence," Magoon said.
Claymore's 29 ETFs track indices from more than a dozen different index providers. That's similar to the number that PowerShares Capital Management uses to support more than 120 ETFs.
"We've got two camps of indexers. One is the more globally well-known providers who aren’t very open to changes to their indexes,” said Ben Fulton, executive vice president of product development at PowerShares. “Those can be well-established providers like the FTSE, S&P and Dow Jones, which have set models and demonstrated research.”
On the flip side are smaller index shops such as WilderShares, Dorsey Wright, Lux Research and Mergent. In many cases, PowerShares finds that with less widely known indexers, “we can work with them to turn their theoretical research models into working indexes,” Fulton said. For example, Dorsey Wright has been providing technical analysis for decades to Wall Street. “I knew them well and knew they had created rankings for each company in terms of relative strength in the market,” Fulton said.
Once someone has some sort of ranking system, then it can be fairly straightforward to create an index, he added.
“But we also like to see providers with brand-name awareness. If they don’t have that or some sort of ranking system, we might as well go to an established benchmark like S&P or FTSE,” Fulton said. “Without some sort of value-add, turning research into an index doesn’t make much sense.”
The indexes used by PowerShares are almost exclusively designed for ETFs. “Most other ETF providers start the other way. They’ll put out a request for proposal of all the indexes you have at a specific time,” Fulton said. “What you end up getting is all the indexes that haven’t been licensed yet to your competitors. We really try to sit in an advisor’s seat and consider what they really need.”
The key is to make sure an idea is investible. An example the firm cites is its recently launched PowerShares India Portfolio (NYSE: PIN). “We looked at the existing indexes, which included the SENSEX, the S&P Nifty Fifty and the MSCI India. But those were all developed for people inside India to track,” Fulton said.
Once you move outside of the country, he added, there are all sorts of regulatory issues regarding foreign ownership restrictions. “So we were concerned about the tracking error. We want to make sure we can manage a fund in a realistic manner. It’s more a matter of common sense than anything,” Fulton said.
With his 20-plus years of industry contacts, he started talking to smaller research groups focused on India. One that stood out was Indus. “Their specific focus is around India-based indexes for the U.S. marketplace,” Fulton said. “And they were willing to devote the time to create a customized index just for an ETF. And then we hooked them up with Standard & Poor’s to maintain and calculate the index's performance on a daily basis."
But the India ETF's launch was one of the rare times when an idea moves to full fruition. Only about 4 percent of the ideas originally pursued wind up as an index that PowerShares picks for an ETF, he added. His team maintains that many concepts for new products are on the drawing board despite years of research.
"The bottom line is that we need to have confidence in an index and index provider," Fulton said. "They've got to go through a gauntlet of criteria we impose. We do heavy due diligence for everything before even considering actually putting it out on the market."
He added: "We've had hundreds of research groups and existing index providers come to us and talk about creating ETFs. But we only work with a very select few. The lion's share don't make the cut."
In fact, Fulton says, many of PowerShares' competitors' new products came to him first. "I'm sure at least one prospective index provider a day contacts us," he added. "And we get them from all over the world."
He says that the index monitoring isn't a one-time gig, either. "We continue to monitor the portfolios and index constituents. We also think it's important to keep track of what the index providers are doing with their businesses."
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