After Mega-Merger, A Blurring Of The Lines?

Late Thursday night, BlackRock Inc. finalized an agreement to buy Barclays Global Investors for $13.5 billion. Assuming it passes regulatory scrutiny, the merger’s expected to close later this year.

In the meantime, you’ll hear a lot about what a behemoth with some $2.7 trillion in combined assets can do. Pundits will point to new pressure on exchange-traded funds rivals such as Vanguard and State Street Global Advisors in a way they’ve never seen before.

But don’t believe it hook, line and sinker. There are a lot more moving parts to this story than one mega-merger creating a new dawn in the land of ETFs.

Any fund manager, no matter how large, will have to navigate a rapidly changing and unique ETF industry. Its investors come from all sorts of backgrounds and interests. In fact, even trying to get a handle on who’s the primary audience is a slippery slope of conflicting and somewhat vague data.

Years ago, when ETFs were in their infancy, the then-Morgan Stanley analyst Deborah Fuhr rummaged through obscure financial company filings to get a handle on the makeup of the ETF marketplace. Along with her own independent research, she has perhaps come the closest to piecing together a complete picture of the composition of the industry’s base of customers.

In the U.S., Fuhr has seen individuals – or retail investors – grow in size and market activity in terms of ETF transactions. Still, she believes institutional investors continue to comprise the majority of ETF business. Now working for BGI, Fuhr estimates that about 60% of all ETF assets are tied to those types of accounts.

"It's hard to say, though. A lot of retail investors in the U.S. have taken their money out of the market [during the recession] and put it into bank accounts," she said during an interview earlier this year, unrelated to later news of a potential sale of BGI. "There actually might be a slight decline in terms of retail use of ETFs."

Individual investors are notorious for their poor timing in markets. Fund flow data is considered a contrarian indicator – when big moves take place, a lot of investors take that as a cue to move in the other direction. By contrast, many types of key institutions – pensions, endowments and large corporate trusts – are known for their abhorrence of taking on more risk.

Such a conservative nature was evident last year as stock markets tanked and more speculative bond ETFs went south. Tom Kelly, who heads up the iShares capital markets group that manages institutional services at BGI, says he started seeing a noticeable shift last summer in fixed-income fund flows.

“We started talking to a lot more equity-type of clients about fixed-income ETFs,” he said. In particular, Kelly pointed to the iShares iBoxx Investment Grade Corporate Bond Index (NYSE: LQD) and the iShares iBoxx High Yield Corporate Bond Index (NYSE: HYG).

By year's end, Kelly noted that BGI was watching huge inflows into its bond ETFs – something that was quite different from previous patterns. “Our flows in the past had been dominated by equities,” said Kelly.

As of the end of 2008, shareholders in the LQD fund were about 33-40% institutional, he added. In the past, that had been closer to 20%. “So of the billions of dollars that flowed into all our bond funds, more than half were from institutions,” Kelly said.

While performance pushed institutions to shift into bonds, Kelly says a corresponding collapse in credit markets provided even more impetus for institutions to use ETFs. “We saw ETFs become the price discovery vehicle in many instances last year after markets become illiquid,” he said.

Last fall and winter, credit markets weren’t just frozen. They were also extremely volatile. “Even index providers were at a loss to mark the bonds. So the ETFs served as real-world indicators of prices. As a result, the ETFs became the preferred investment vehicles for institutional investors,” said Kelly.

And that continued into early 2009 as billions flowed into BGI’s fixed-income ETFs. “Most of that inflow is probably institutional because the [first-quarter] patterns seemed to be following the same trends as the third and fourth quarters of last year. The same funds were getting a bulk of the new inflows,” Kelly said.

On the equities side, institutions typically represent anywhere from a quarter to a third of iShares’ ownership, according to estimates. In the past, mutual funds seem to be the predominant institutional player. That seems to be staying rather steady. But as with iShares, other fund families are seeing institutions using ETFs in more varied ways these days.

“I’m not sure we’re seeing wildly innovative ways of institutions using ETFs. But we’re seeing institutional investors more prominently using certain tactical strategies with ETFs,” said Melissa Nassar, who’s in charge of Vanguard’s adviser and institutional marketing operations.

One of those is so-called "pair trading." That’s where someone will buy or sell more than one ETF at a time to get extremely precise market exposure. For example, if investors feel strongly that stocks will continue to rally but financials are overbought, they might short the Vanguard Financials ETF (NYSE: VFH). At the same time, they could go long through the Vanguard Total Stock Market ETF (NYSE: VTI).

“It’s a strategy that’s harder to do with mutual funds. In some ways, it’s nearly impossible,” said Nessar. “With mutual funds, even if they pair traded all on the long side, there’s just a lot more redemption fees and policies that makes it far more burdensome for an institutional investor from an administrative and regulatory view.”

It’s important to note that Nassar, Fuhr and Kelly never broached the subject of mergers and acquisitions within the industry. These interviews, in fact, were part of ongoing discussions I’ve been having with different key executives in the industry over the past several months. My intention was to get a feel of what’s happening in terms of the general complexion of the ETF marketplace – not to address the more recent BGI mega-deal rumors.

But as I’ve grappled to comprehend what a horrific bear market and simultaneous credit meltdown might mean for the future of ETFs, the growing number of warnings about how a BGI merger could have monolithic implications to investors seemed to ring false.

Consolidation has been a foregone conclusion in the ETF industry for years. But the growing interplay between institutional and retail investors seems fundamental in shaping the course of how sponsors design and service their new product lines.

In many respects, it’s not where any new owner comes from – active, institutional or retail. More to the point is how quickly they come to realize the degree of convergence taking place in the ETF marketplace now.

“At this point, the lines between institutional and retail uses of ETFs are to a great extent rather artificial,” said Rob Arnott, founder and chairman of Research Affiliates.

He points to a rising number of independent advisers who invest in big blocks like institutions but serve high net worth individuals. That’s skewering traditional ways of analyzing fund flow data.

“For example, the biggest use of ETFs by far comes in taxable accounts. So if a dividing line of taxable vs. tax-exempt is used to define activity, it would seem to indicate that institutions are more involved in the ETF market,” said Arnott.

The tax efficiency of ETFs, though, opens new avenues for retail investors and their advisers. “Retail mutual fund investors typically shy away from taxable accounts,” said Arnott. “But with more advisers warming to the tax-efficient structure of ETFs, an argument can also be made that more of that increased taxable investing is coming from individuals – not just big endowments and other institutions.”

As the industry grows in popularity, he adds, “the lines are blurring between institutional and retail uses of ETFs and the companies that serve those investors.”