Thirty percent annual growth is expected in exchange-traded fund sales, and Vanguard Group, the mutual fund giant, expects to participate in that growth by competing on price despite the fact the market is dominated by three big banking companies.
Vanguard, which got into the business with its first exchange-traded portfolios in May 2000, had just 4.4% of the $294 billion under management at Dec. 31 by eight companies, according to data compiled by State Street Global Advisors. The Investment Company Institute has projected a 30% annual growth rate through 2010 for the product.
"Today, it is small, but in the next five years, exchange-traded funds will be a very meaningful part of our business at Vanguard, especially in terms of cash flow," said Gus Sauter, the Malvern, Pa., company's chief investment officer and a managing director.
Barclays Global Advisors managed 102 exchange-traded portfolios, with $170.6 billion of assets, or 56.5% of the total at Dec. 31, and State Street managed 32, with $85.1 billion, or 28.2% of the market. The third-largest seller, Bank of New York Co., manages six portfolios, with $30 billion of assets and a 9.9% market share, according to State Street. Their total share is 94.6%.
"You have to be part of a large company with a commitment to this [business] in order to succeed," said David Sandrew, State Street Global Advisors' director of exchange-traded fund sales. "This is not for the faint of heart, that is for sure."
Mr. Sandrew, who joined State Street four months ago after managing exchange-traded fund sales at Barclays for a year, said the two companies have a distinct advantage over those looking to enter the exchange-traded fund business.
"These firms have a 10-plus-year head start," he said. "This is a business that is a lot different than the mutual fund business."
But Vanguard's Mr. Sauter says his company has some competitive advantages. It has a strong brand and new sector products that other providers are not offering, he said, but ultimately will attract intermediaries because it offers ETFs at a lower cost than its competitors do.
Exchange-traded funds are "a low-cost, tax-efficient tool that intermediaries love to sell," he said. "This is a product that will have broad appeal with intermediaries, especially banks, brokerage firms, investment advisory firms, and independent advisers. This will be a nice way to target this segment of the market."
"Advisers are moving to wrap fees," he said, "and really they want to offer the lowest-costing product so that when they add their fee it isn't overwhelming to the end user. Our fees are lower than our competitors'."
"We have a healthy business there," he said, "but the penetration is still relatively low." Vanguard is not competing for shelf space in bank brokerage departments or other intermediaries; ETFs can be bought directly on an exchange.
The high sales-growth projection in itself promises an opportunity for a smaller player to grow. "We will end up ultimately with more than $30 billion in assets and less than $100 billion," Mr. Sauter said of Vanguard's ETF business.
TD Bank Financial Group's wealth management arm could not wait for the promise to be realized, however; it announced in December that it plans to liquidate its family of ETFs. A spokeswoman said TD Asset Management Inc., which is based in Toronto, decided to scrap the funds because of a lack of investor interest and low trading volumes since they were launched in 2002. The funds collectively managed $377.1 million of assets.
Others have entered the market, though. AST Trust Co., a division of New York-based American Stock Transfer and Trust Co., started 10 exchange-traded funds for retirement plan sponsors in November.
Vanguard introduced nine exchange-traded funds last year, Mr. Sauter said, and has registered four bond-index ETFs with the Securities and Exchange Commission that it expects to launch this year. In addition, he said, Vanguard has several ETF portfolios on the "drawing board" that it hopes to introduce in the next couple of years.
"State Street created the ETF back in 1991," Mr. Sandrew said. "Scale is very important." It is difficult, though not impossible, for companies other than State Street or Barclays to enter the business and grow by offering their own portfolios, he said.
"Smaller players have to have a niche and have to attack it," he said. "There is room for more players in this game because it is a growing space, but it is difficult."
Analysts said new product manufacturers are limited because the number of indexes is finite. State Street's exchange-traded funds are linked to the Standard & Poor's and Dow Jones indexes; Barclays', to the Russell indexes.
"The battle is really between State Street and Barclays in the exchange-traded fund space," said W. Christopher Maxwell, a managing partner at Conestoga Capital Advisors, a Rock Hall, Md., wealth management firm. "It is hard to generate share away from Barclays or State Street."
But large companies, like Vanguard Group, whose ETFs are linked to the Morgan Stanley Composite Index, have a chance to grow, he said. Vanguard also has the ability to offer strong funds in sectors where exchange-traded funds are generally unavailable, he said.
"Vanguard is playing from behind, but they are a large firm with the backing to offer exchange-traded funds as long as they'd like to," he said.
"We are getting strong endorsements from intermediaries such as investment advisers and bank trust departments," Mr. Sauter said. "We are really gaining traction in an area of the market that previously didn't utilize index products."
The fund company launched its first ETFs in May 2000. And since last March, when it introduced three international exchange-traded portfolios, it has added 50% to its ETF assets under management. Mr. Sauter said he expects to end up with 40 to 50 portfolios in the Viper share class, which now has 23.
In the past year, State Street expanded its exchange-traded fund assets by 11.9%, to $85.1 billion. Mr. Sandrew said the company continues to add assets because of the strong reputation it has developed. "A firm like ours can walk into a firm and launch a successful ETF product for them," he said. "Other firms don't have that kind of reputation. That is why we have seen some firms exit out of this business."
Vanguard offers 11 "broad" sector ETFs, but Mr. Sauter said it does not plan to offer ETF portfolios in its smaller sector funds. "We have a technology exchange-traded fund, but we wouldn't break it out further with an Internet exchange-traded fund or one that focuses on hardware or software," he said.
The company plans aggressive efforts to expand distribution through banks and other intermediaries, he said.
State Street also plans to increase distribution through bank trust departments, Mr. Sandrew said. Bank trust officers are attracted to exchange-traded funds because they are a cost-effective way to allocate assets, he said.
Mr. Sandrew said State Street began adding staff in the past four months in an effort to increase distribution through bank trust companies. It has added six people, he said, and will expand "substantially" from here in markets like Boston, San Francisco, Chicago, New York, and Florida.
"We want to mirror major markets where trust departments are concentrated," he said. "We are expanding rapidly as the product continues to expand rapidly."
