Can Loyalty in Investor Relationships Calm the Competitive Disruption of ETFs?

Everyone’s talking about investing in ETFs, but the reality of ETF management reflects a web of investment managers vying to increase returns and retain clients. In the past few years, mutual fund managers started to also manage ETFs for their clients—a way to potentially alleviate competition, maintain client loyalty, and keep institutional money within a growing family of funds.

On the surface, the Exchange Traded Fund or ETF is a simple idea: a financial product that gives investors the opportunity to invest in a set of stocks tracked by a market index, without having to buy shares in each one. Yet this relatively straightforward concept has become a major disruptor in the sphere of money management.

“There has been a tectonic shift in the industry,” says Desautels Professor David Schumacher, whose recent paper, “Why Is There So Much Side-by-Side Management in the ETF Industry?” examines manager-client relationships and the competitive rise of ETFs.

There has been a tectonic shift in the industry.

Traded on stock markets, ETFs let investors buy a share of an ETF while the ETF holds the actual assets in the index and replicates the returns of the index as a whole—that’s what the investor gets too. The ETF gives small, retail investors the opportunity to have a diversified portfolio. On top of that, ETFs charge much lower fees than traditional investment vehicles, such as mutual funds, that give investors exposure to multiple securities through a single share.

“ETFs have grown tremendously and attracted a lot of investor money, often at the expense of traditional financial products like mutual funds—people have withdrawn money to invest it in these cheaper alternatives,” Schumacher explains. “We wanted to know how money management firms were responding to this competitive threat.”

The shift from mutual funds to ETF management

The very first ETF launched in 1990 on the Toronto Stock Exchange, but it was not until the past 15 years that this financial innovation really caught on. Recently, ETFs have attracted a lot of investor money. ETFs are a multi-trillion-dollar industry, but the space is dominated by just three firms: Blackrock, Vanguard, and State Street. In the United States, these companies manage about three-quarters of all assets held in ETFs.

As with any disruption, there are winners and losers.

However, they’re only the biggest players. These days, it seems that every financial services firm sells ETFs, from discount internet brokerages like Questrade to Wall Street aristocrats like Goldman Sachs. As with any disruption, there are winners and losers.

Over the past several years, many individual mutual fund managers have shifted to managing ETFs, but this switch is not an intuitive one. Mutual fund managers take an active role in selecting stocks and bonds to build a fund. Their promise to clients is that they have the expertise to choose the right ones—and they charge 1.5-2% in annual management fees for their services. In contrast, ETF managers typically aren’t selecting stocks at all. Because an ETF passively tracks an entire index, the hands-on selection of stocks and bonds is not necessary.

“From a day-to-day job point of view, these two jobs are not very comparable, even though they are both called fund managers,” says Schumacher. “These are ultimately very different products. In the past, a typical ETF manager would only manage ETFs. But that has changed. By 2018, a typical ETF manager was managing both ETFs and mutual funds.”

Averting risk through client relationships

Historically, mutual funds have mostly been purchased by retail investors, but some institutional investors hold them too. Money management firms often manage multiple mutual funds, and the group of funds they manage is called a family. In recent years, many of these firms have also launched ETFs. Schumacher found that some mutual fund managers have begun managing those ETFs.

He analyzed money flows at the time that the fund manager’s job switch was made. The data showed that when institutional investment money flowed out of mutual funds, there was often also a near-simultaneous inflow into a firm’s ETFs. And that’s not a coincidence: the fund managers making the switch are the same ones who were managing the institutional money held in mutual funds—they already had an existing relationship with the client.

“In the ETF industry, the biggest firms are the dominant providers and have very large market share. When clients withdraw money from mutual funds, a money management firm risks losing all of that money to these larger firms,” says Schumacher.

“It might be inevitable that some clients leave high-fee mutual funds, and rebalance their portfolios toward cheaper ETFs,” he points out. “But a fund family might be able to retain some of that money by channelling it to their own ETFs.”

That is where the mutual fund managers enter the picture. They already have relationships with their clients, and can use these relationships to try and retain clients who are withdrawing from their mutual funds.  By persuading these clients to invest in their firm’s ETFs, a fund manager might be able to avoid losing a client’s money entirely.

“The fund managers being reassigned to manage ETFs are those with important institutional clients,” says Schumacher. “In the face of a competitive disruption, mutual fund families are trying to use the client relationships of some fund managers to soften the impact on their overall portfolio.”

Client loyalty is obvious in many other industries but is underexplored in finance.

“This is ultimately about relationships in finance,” he stresses. “The notion of client loyalty is obvious in many other industries but is underexplored in finance. Loyalty has often been considered in the context of retail investors, like the relationship between client and financial advisor—do they buy the products their advisor tells them to? But it is less explored whether relationships or loyalty-based forces also apply to institutional investors that are thought of as more sophisticated.”

Bridging the investment gap to grow portfolios

Keeping institutional money under management could help fund families grow their ETF business and manage the transition from a portfolio of mutual funds to a portfolio of ETFs.

“This could allow more ETF providers to survive in the marketplace. It might be a very useful strategy to meet that competitive threat,” says Schumacher. But there is also the potential to carve out a market niche.

“Fund families also rely on product differentiation; they offer ETFs that are different from the ones offered by large providers,” he illustrates. “This helps create more product innovation in the market for ETFs, and it could be good for investors to have more product choice happening as newer firms try to compete with big incumbents.”

A new class of ETFs called “active ETFs” introduces some of the features of mutual funds. Schumacher notes a high level of product innovation coming from firms with a disproportionate amount of actively managed ETFs.

But whatever step they take next, money management firms will need to keep their fees low, or their profits very high. The demise of mutual funds is occurring because too few outperformed the market enough to justify their fees. “If the typical mutual fund cannot provide investors with returns significantly above the benchmark, then why pay those fees?” says Schumacher.