iShares’ Big Ambitions

At a press briefing held earlier this week in London by iShares and featuring the firm’s US and European business heads, Mark Wiedman and Joe Linhares, one subject of discussion was conspicuous by its absence—iShares’ competitors in the ETF market.

There wasn’t a single reference to alternative European ETF issuers, and only one, veiled mention of a large US rival (presumably Vanguard).

In Europe, where iShares has hoovered up the lion’s share of new ETF fund flows for nearly three years now, the firm’s assets are more than double those of Deutsche Bank and over three times more than Lyxor’s, the second- and third-largest issuers in the region, respectively.

The fierce debates from three years ago between iShares and its investment bank competitors about competing ways of replicating indices now seem a distant memory. On the evidence of recent cash flows, iShares was the overwhelming victor in the debate, with its competitors forced into a late change of business models.

In the US ETF market, where exchange-traded funds’ legal structures are more standardised than in Europe, iShares has a slightly less dominant position, but its $526 billion in assets are still more than $200 billion ahead of those of its nearest rival, State Street.

But it wasn’t about ETF market competitors, nor even the traditional mutual fund business, that Wiedman and Linhares wanted to talk to journalists.

“One of the greatest misconceptions about our ETF business is that we see active mutual funds as our primary source of competition,” Wiedman said.

ETFs have taken steady bites out of the mutual fund business for years, with investors switching from high-fee active funds to cheaper index trackers.

Instead, says Wiedman, ETFs have huge headroom for growth when compared to other “investment vehicles”, including individual securities and derivatives of all types.

As support for this claim, Wiedman cited evidence that bond fund managers are increasingly replacing cumbersome holdings of individual securities with ETFs, while in Mexico there’s recently been a large shift from investing in the local stock market via index futures to using iShares’ MSCI Mexico Capped ETF.

In a presentation circulated to accompany the briefing, iShares produced a chart showing that its ETFs control only 1.3 percent of total US assets if you throw other investment vehicles into the mix (according to the firm, active mutual funds have a 9.4 percent market share, credit derivatives 26.9 percent and individual debt and equity securities 49.8 percent).

Can ETFs really replace a large part of the derivatives market, whether futures contracts or over-the-counter swaps? This may be less far-fetched than it sounds, given the declining global appetite for leveraged trading and the obstacles being placed by regulators on OTC trades since the crisis (such as punitive requirements to post initial margin).

On the other hand ETFs have some flaws in market structure to overcome to pose real competition to derivatives. With a large part of trading in Europe taking place off-exchange, there’s still a credibility gap when it comes to ETFs’ secondary market liquidity, particularly when compared with exchange-based index futures. And “ETF” still covers a surprisingly wide variety of legal structures across jurisdictions and even within them (as in Europe), whereas futures contracts are pretty similar around the world.

Does it make sense to talk of ETFs substituting for the underlying bonds and shares from which they ultimately derive their value? As Wiedman pointed out, you can see the advantages to a bond fund manager of having a liquid ETF rather than difficult-to-trade-in individual bonds.

But we’ve also recently seen predictions—such as from the UK’s John Kay—that we may witness the opposite: disintermediation, or a return to greater ownership of individual securities, rather than holding bonds and shares via funds, given the layers of hidden costs that fund investing can incur.

Time will tell whether iShares is now aiming to bite off more than it can chew. One thing is clear, though: the firm has very big ambitions indeed.

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