As if the strong flow of new money to ETFs was not enough for mutual fund companies to contend with, firms must now confront another challenge: the small but growing influence of ETF models under a managed account offering. At present, ETF managed portfolios with a wide global mandate total only $57 billion. However, these managed portfolios are beginning to generate increasing assets and attention among retail and intermediary investors.
For the past 15 years, managed account asset allocation products have been an important business to Fidelity, Russell Investments and others. These accounts allocate client money across various asset and sub-asset classes to create a diversified investment portfolio that captures market price appreciation, while managing portfolio risk in line with a retail investor's profile. While the underlying assets are not always restricted solely to mutual funds, the core of these products is proprietary and third-party funds.
The value proposition for the retail client is clearly the ongoing asset allocation service, since academic research by Gary Brinson and others indicates that asset allocation, rather than security selection, accounts for as much as 90% of a diversified portfolio's performance.
Managed ETF sizing and participant firms
ETF managed account services are generally a more recent market development than the mutual fund offerings noted above. While some trace their history to as early as 2000, most were launched in just the last five years. Looking at the market size, the Morningstar managed ETF database puts total market assets at just under $57 billion as of last September, representing 486 strategies from about 120 firms. The underlying ETFs in these portfolios are largely comprised of the larger more liquid index-based funds, such as those based on the Russell equity and MSCI indexes.
If we spotlight only those ETF managed accounts offerings with a wide global and asset class investment mandate, and which invest wholly or mostly in ETFs, the universe is comprised of 33 firms, offering 57 ETF portfolios with assets of $17 billion. This sub-segment of managed portfolios is noted given their true all-in-one investment strategies and their primary investment reliance on ETFs.
Most firms offering ETF managed portfolios do not come close to the market leader, Windhaven (a subsidiary of Schwab) in regards to assets under management. Even if we broaden our discussion of ETF managed portfolios to include Morningstar's larger universe, the next largest firm after Windhaven is F-Squared with $8.5 billion in assets. So it is difficult to see these managed ETF funds as a viable threat to the managed account services offered by mutual fund companies.
But that will change over time.
One reason for that change is the number of firms with considerable market influence that promote managed ETF portfolios. These brokers and asset management firms provide ETF managed account providers with distribution through their intermediary relationships or through their presence in the direct-to-retail market. Besides owning Windhaven, Schwab provides market access to 15 firms that offer a competitive product in the managed ETF market. Heavyweight BlackRock does not directly own any providers of managed ETF portfolios but sponsors more than 200 firms that sell managed account portfolio solutions that invest wholly in ETF assets. In addition, a number of market factors are also driving asset growth.
Momentum in market accelerating
While most of these managed portfolios have a relatively short history — and each of the firms started with a very small asset base a few years ago — growth has been phenomenal over the past few years. Looking at Morningstar's expansive universe of ETF managed products, managed portfolios have grown to $56.6 billion today from approximately $14 billion at the end of 2009, growth of more than 300%. Our refined universe of broad-based ETF managed portfolios has experienced equally robust growth over that same time period, climbing to $17.2 billion from just $4.3 billion in 2009.
What has contributed to this strong growth?
First, there is a resurgent interest among financial advisers for asset allocation products that provide portfolio diversification at a relatively low cost, as security selection has become less important in the current investment environment and asset selection has become increasingly complex. Despite the growth in Rep as Advisor programs, an equal number of advisers recognize the difficulty of tactically or strategically managing client assets, and have turned to outside investment managers for portfolio management. Also, as Morningstar pointed out in its publication, ETF Managed Portfolios Landscape, the fiduciary standard for managing client portfolios has continued to rise and the pressure to move toward a fee-based compensation structure has become more commonplace. Consequently, these lower-cost, fee-based portfolios are ideally suited to meet those demands.
Second, performance has also clearly contributed to the growth. Based on data from Morningstar, returns have been solid for a significant percentage of the managed portfolios in the Morningstar universe and for most of the largest ETF managed portfolios and volatility has decreased year-to-year.
Careful consideration by mutual fund firms
For mutual fund firms that offer managed asset allocation services comprised largely or entirely of mutual funds, kasina believes they will need to evaluate the value-add of using mostly actively managed mutual funds in their client portfolios. If the actively managed fund adds little value and primarily offers beta, fund firms should consider ETFs as a better portfolio alternative. However, investments in underlying ETF assets will undoubtedly have some impact on the overall profits of the business as firms transition from mutual funds, particularly in situations where proprietary mutual funds are used.
For mutual fund firms that don't presently offer managed model portfolios, kasina would recommend they consider one of two options: either offer services of their own, or position their funds to complement these portfolios.
Whether mutual fund companies fully adopt ETF managed services or look to capitalize on this growing market has yet to be determined. Nevertheless, one thing is clear — ETF managed portfolios will continue to generate assets and fund firms will need to carefully consider their participation in this market.
Steven Miyao is chief executive of kasina, a consulting firm to money managers.
