Pressure Mounts on ETFs at State Street, Vanguard

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It's gut-check time at State Street Corp. and Vanguard Group.

Though the two asset managers enjoy solidly profitable businesses in exchange-traded funds, their ETF operations are in for a shock if Barclays PLC's asset management arm is sold, as rumored, to either Bank of New York Mellon Corp. or BlackRock Inc.

Barclays has by far the largest ETF business, so "it could be really challenging for State Street and Vanguard to keep up," said Geoffrey Bobroff, president of Bobroff Consulting in East Greenwich, R.I. "They may be forced to change how they do business."

State Street and Vanguard already trail far behind Barclays Global Investors' iShares unit, which had $290.7 billion of ETF assets at May 31 — or 49.5% of the market, State Street Global Advisors said. State Street had $143.7 billion, or 24.5%, and Vanguard had $59.5 billion, or 10.1%.

Bank of New York Mellon and BlackRock have negligible or no presence in the ETF niche, but a purchase of iShares by one of them does more than simply change the nameplate over the funds' door. Analysts say Bank of New York Mellon and BlackRock could enhance iShares' ETF lineup by adding actively managed products to index funds for individual investors. Neither Vanguard nor State Street offers actively managed products, and they lack the capability to introduce them.

Bobroff said that, if BlackRock wins a bidding war for iShares, the New York money manager could introduce an array of actively managed ETFs focused on fixed-income portfolios. "BGI hasn't been a significant fixed-income ETF provider," he said. "There is an opportunity to package a whole bunch of new products here."

Cindy Zarker, a director at Boston's Cerulli & Associates, said she expects either BlackRock or Bank of New York Mellon to introduce actively managed ETFs after the deal's dust settles — and Vanguard and State Street must follow suit. "Whoever buys Barclays is getting instant credibility and can play big on the ETF market," she said. The buyer will gain volume and "all of the core ETF products that are impossible to build at this point."

Most new entrants already are introducing actively managed products rather than index products, Zarker said. Indeed, an executive at State Street said Wednesday that the company plans to get into actively managed ETFs. But an executive at Vanguard challenged the conventional wisdom, saying her company plans to compete on price to maintain its share.

Martha Papariello, a principal at Vanguard who runs its ETF distribution, said she does not expect the company to introduce actively managed products. "I don't believe an acquisition [by either Bank of New York Mellon or BlackRock] would force us to revamp our strategy," she said.

Vanguard plans to continue competing by offering the least expensive ETFs, she said. Vanguard's ETFs cost an average of 30 basis points less than competitors, she said. "Honestly," she said, "who we compete with is out of our control. Our strategy is clear. We want to bring the highest-quality, lowest-cost ETFs to the market."

"Our point of differentiation is our pricing," she said.

Bobroff said it would be difficult for Vanguard to introduce actively managed ETFs "because they really don't have those capabilities."

State Street filed an application with the Securities and Exchange Commission 15 months ago to introduce a series of actively managed ETFs. "We plan to introduce actively managed ETFs as soon as we get exemptive relief from the SEC," said James Ross, a senior managing director at State Street.

State Street, which introduced the industry's first ETF in 1993, has started five of the industry's 19 new ETFs this year, and Ross said he expects to continue introducing products as soon as this year. Most of the new products will be indexed, fixed-income ETFs.

"I don't think we have to make changes in order to adapt to the competition," he said. "Growth is coming from different directions, and we know that we are going to have to be innovative."

State Street "has significant active capabilities," he said. "We manage active equity and fixed-income products. Active management is core to what we do."

W. Christopher Maxwell, a managing partner at the Rock Hall, Md., wealth management firm Conestoga Capital Advisors LLC, said that the jury remains out on actively managed ETFs. Vanguard and State Street will probably look to keep pace, he said, by introducing index and sector ETFs. "State Street and Vanguard have always found ways to slice and dice their indices and to offer more ETFs," he added. "I think we could see more fixed-income ETFs from both companies."

Analysts said that, if the largest ETF providers begin offering actively managed products, it could hamper smaller providers that have focused on active management. William M. Thomas, the chief executive officer of Grail Advisors LLC, a San Francisco company that offers actively managed ETFs, said the largest ETF providers had been so focused on index funds that there were opportunities for smaller providers to add assets. Grail introduced its first ETF last month and plans to launch four more by Sept. 1.

The company, which had $300 million of assets at May 31, expects to have $1 billion within 12 months, Thomas said.

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