In the world of capital markets, the exchange traded fund is a textbook case of a “disruptive technology,” says ConvergEx Group chief market strategist Nicholas Colas.
The first ETF in the U.S., SPDR S&P 500 (NYSEArca: SPY), was launched 19 years ago and the business has mushroomed to over $ 1 trillion in total assets.
Citing Clayton Christensen’s book The Investor’s Dilemma, Colas explains that disruptive technology happens when new competitors with a cost advantage, but not much else, target the cheapest offerings in a given industry.
Indeed, ETFs started out as low-cost funds that tracked broad-market indices for stocks and bonds. Essentially, they were index funds that offered better tax efficiency and the ability to trade during the day.
“The established players … aren’t especially concerned with holding market share at the low end – they have more profitable fish to fry. So they let the new players take over the cheap stuff,” Colas wrote in a note Wednesday.
“Over time, the new entrants begin to expand their product offering up the price scale. Again, the existing players cede the battlefield. Their margins, after all, are still rising as they exit lower profit segments,” he added. “Before the entrenched players fully realize it, they have lost their entire market. What’s even worse than that, however, it that they intentionally did so. And for ostensibly ‘good’ reasons. After all, they held onto the high margin high-end as long as they could.”
Although most of the assets in the ETF business are held in passively managed index portfolios, active ETFs are a big potential growth area.
For example, PIMCO Total Return ETF (NYSEArca: BOND) has already gathered $1 billion in less than three months of trading. It’s the ETF version of PIMCO’s behemoth Total Return Fund, and both are managed by bond guru Bill Gross. [PIMCO Total Return ETF]
More mainline fund companies could follow PIMCO’s example and introduce ETF offshoots of their most popular active funds.
SPY, the first ETF, was quickly adopted by hedge funds that found the product “provided an efficient hedge to their single-stock portfolio of favorite names, rather than using the more complex futures market,” said Colas, the ConvergEx strategist. “And in a stock market that seemed to set new records every week (remember, this product was launched near the start of the 1990s bull market), individual investors and professionals alike appreciated the intraday liquidity and transparency of a low-fee product that traded like water.”
He argues that the mutual fund industry missed the boat by not jumping on the ETF trend just as it began.
“U.S. equity mutual funds are down over $500 billion in assets under management since January 2007 and haven’t had a month where flows were positive in a year. The success of ETF asset gathering over the same period is well documented,” Colas wrote. “The variety of products available in the ‘ETF Ecosystem’ holds tremendous appeal for a wide array of investors. And while it is easy to fault the mutual fund industry for not adapting more quickly, Christensen’s paradigm very neatly describes what happened. Passive index products such as the SPY are lower margin than actively managed funds. Who would have thought, almost 20 years ago, that ETFs would progress as far as they have?”
Full disclosure: Tom Lydon’s clients own SPY.