Companies and Markets
By Elisabeth Kashner, CFA|February 2, 2023
“I am thinking of launching an ETF business. I'd like to believe that investors would benefit from more differentiated products. With the right marketing strategy, I could get $500 million-$1 billion AUM within three to five years. I’d love to pick your brain.” That’s how a would-be ETF issuer introduced himself to me recently on LinkedIn. “Think twice,” I advised. The rapid growth of the ETF industry tempts entrepreneurs who dream of grabbing a share of the ETF market. After all, 146 ETF issuers attracted a slice of 2022’s $604 billion of ETF inflows. How hard can it be? Plenty hard, because the ETF industry is extraordinarily competitive and saturated. Each new entrant increases the product count—and the din. A data-rich assessment of the opportunity, the obstacles, and the industry trends might help LinkedIn guy make an informed decision. The opportunity is easy to measure. ETFs have grown phenomenally in the U.S., with annual organic growth of 12.25% over the past five years. 2022 was the second biggest ETF flows year ever, despite sharp market declines. Source: FactSet The number of ETFs has grown steadily, too, at about 8% annually over the past five years. The ETF industry is a real bright spot, especially compared to mutual funds. LinkedIn guy saw the growth, for sure. He probably also understood that while the $6.5 trillion in U.S. ETFs (as of 12-31-22) is unevenly distributed, there is room for smaller firms to grow.
ETF Growth Explosion
The Tilted ETF Landscape
“I am thinking of launching an ETF business. I'd like to believe that investors would benefit from more differentiated products. With the right marketing strategy, I could get $500 million-$1 billion AUM within three to five years. I’d love to pick your brain.”
That’s how a would-be ETF issuer introduced himself to me recently on LinkedIn.
“Think twice,” I advised.
The rapid growth of the ETF industry tempts entrepreneurs who dream of grabbing a share of the ETF market. After all, 146 ETF issuers attracted a slice of 2022’s $604 billion of ETF inflows. How hard can it be?
Plenty hard, because the ETF industry is extraordinarily competitive and saturated. Each new entrant increases the product count—and the din. A data-rich assessment of the opportunity, the obstacles, and the industry trends might help LinkedIn guy make an informed decision.
The opportunity is easy to measure. ETFs have grown phenomenally in the U.S., with annual organic growth of 12.25% over the past five years. 2022 was the second biggest ETF flows year ever, despite sharp market declines.
The number of ETFs has grown steadily, too, at about 8% annually over the past five years. The ETF industry is a real bright spot, especially compared to mutual funds.
LinkedIn guy saw the growth, for sure. He probably also understood that while the $6.5 trillion in U.S. ETFs (as of 12-31-22) is unevenly distributed, there is room for smaller firms to grow.
The largest asset managers dominate. Blackrock, Vanguard, and State Street (the “big three”) control 77% of the marketplace. The next 10 control 17.5%, and 219 smaller firms compete for the remaining 5.5%.
Here is a picture of the U.S. ETF market share by issuer as of December 31, 2022.
But the ETF market is not static. In 2022, the big three captured 65% of the flows, while the 219 firms garnered 11%, not including mutual fund conversions. In other words, the small guys pulled in twice their share of flows compared to their starting market size.
The opportunity is real. But that doesn’t mean entering the ETF business is easy. Dozens of firms have decided to go where the money is, especially in the past few years. Competition is accelerating, as shown in the chart below.
The recent uptick in new ETF firms isn’t correlated with explosive ETF asset growth as much as it is driven by regulatory changes. The SEC opened the floodgates in late 2019, as the “ETF Rule” reduced the barriers to entry. Soon after, the approval of non-transparent actively managed ETFs gave asset managers confidence that they could protect their intellectual property, and asset managers began converting mutual funds to ETFs.
Hence the explosion of ETF firms. LinkedIn guy will face lots of competition.
Competition limits opportunity. As a result, new entrants often struggle. Perhaps this is why LinkedIn guy asked to pick my brain. He knows he will need an edge.
Some asset managers have one. Hence my first question to LinkedIn guy: “Do you happen to have a captive investor base?”
The best path to ETF success these days is not product differentiation—it’s avoiding competition. Wealth management affiliates can direct client investments to in-house products. These affiliated assets comprise a growing portion of ETF AUM, especially for firms that have entered the ETF business in the past decade.
The ownership map of the Schwab Fundamental U.S. Small Company Index ETF (FNDA-US) shows how an asset manager can circumvent market competition. Schwab Intelligent Portfolios, their robo advisor, has conveniently selected FNDA from the 72 ETFs that offer exposure to U.S. small caps. As a result, Charles Schwab Investment Management (CSIM) comprises 72.12% of FNDA’s shareholders.
As of September 30, affiliated assets made up 18% of Schwab’s ETF lineup’s AUM. Schwab is the largest ETF issuer to leverage its wealth business thusly, but it is hardly alone. Many asset managers support their ETFs in this fashion. The newer entrants are increasingly dependent on in-house assets, as illustrated in the chart below, which highlights both in-house capital and converted mutual fund assets.
The trend is clear. As competition increases, firms with pre-identified investor bases have a clear edge.
Note: AUM statistics in the remainder of this article excludes affiliated stakes and converted assets, except where noted. AUM is stated as of September 30, 2022, as this is the most recent date for the 13-F filings that reveal institutional ETF positions.
Most ETFs Fail or Languish
That edge really matters. Without it, firms face steep odds, steep enough to shock LinkedIn guy. The chart below, which shows the recent AUM of every U.S. ETF firm that has ever existed, paints a picture of struggle.
Eighty percent of all ETF issuers who ever launched in the U.S. are either defunct or languishing. Backing out affiliated assets makes the ETF failure story starker, as more ETF issuers fall below $1 billion and fewer make it above $5 billion. Only 20% of ETF issuers have crossed the $1 billion threshold, and only half have reached the $5 billion level.
Note: The unaffiliated firm closure rate is higher than the headline rate because of the exclusion of assets that were converted from mutual funds or SMAs that swapped into the ETF wrapper puts two issuer’s AUM at zero.
The distribution of ETF success is even more skewed than the manager success chart suggests because of first-mover advantage. The largest ETFs are managed by a handful of firms that mostly entered the ETF business before 2010. These first movers manage trillions, while newer entrants struggle to attract their first billion. If I had to pick just one chart to show LinkedIn guy, it would be the one below, which illustrates first mover advantage in the US ETF business.
The trendline shows the extent of the first-mover advantage as it approaches zero for firms that entered the ETF business after 2010. Since then, even the most successful new entrants have attracted $10 billion to $20 billion apiece (unaffiliated, excluding mutual fund conversions). Even modest success—amassing just a few billion of assets—has become more elusive.
To see the effect of the first mover advantage on recent ETF businesses, we need a chart that scales not in the trillions, as above, but in the low billions, like the one below. This next chart measures success in tiers: survival, $1 billion, and $5 billion. Even so, it paints a grim picture for new ETF entrants.
New is a relative term. The U.S. ETF market’s first decade was full of opportunity. Its second decade presented plenty of chances, but success was less certain. In the past ten years, competition has become overwhelming, making success the exception, not the rule.
The earliest entrants, especially the big three, launched products that would become core portfolio building blocks. They populated the ETF landscape with simple, easily explained, hard-to-beat products. These products’ utility led to their ubiquity, which generated reputations and ETF brand recognition that are nearly impossible to replicate today. In short, the early entrants picked the low-hanging fruit. Their followers would have to be creative.
But creativity, often described as “product differentiation,” is hardly a golden ticket to ETF success. Poor results, including closures and firm assets below $1 billion, have increased dramatically over the past two decades. LinkedIn guy’s faith in differentiated products is probably misplaced, potentially encouraged by the conversation around the handful of winners.
Beating the Odds
To be sure, a few new ETF entrants have been clear successes this past decade. Cathie Wood’s ARK Investments, with $13 billion in AUM as of 9-30-22, launched in 2014. Pacer Advisors, $15 billion, followed in 2015. American Century, $12 billion, joined the fray in 2018. Dimensional, $19 billion, converted some of its longstanding mutual funds to ETFs in 2020. (Remember, these are unaffiliated, non-converted assets)
A handful of firms have accrued between $5 billion and $10 billion. 2013 also saw the entry of KraneShares and Janus Henderson; 2014 brought Crestview (VictoryShares and USAA). Innovator started out in 2015.
What explains the competitive success of these few firms? When LinkedIn guy asked to pick my brain, he might have been asking exactly this question. I found a few answers: loyal clients, sales muscle, media attention, and luck.
Some of the biggest ETF winners of the past decade, including Dimensional, American Century, and Capital Group, have enticed their loyal mutual fund customers to follow them into the ETF landscape. Dimensional, famous for its fanboy advisor club and extensive investor education, lowered investor cost and increased access by converting successful mutual funds to ETFs. American Century and Cap Group hired experienced ETF hands Ed Rosenberg and Holly Framsted, respectively, to jettison them into the 21st century. (Ed left American Century in November 2022).
Pacer ETFs has invested heavily in their sales staff, understanding that differentiated ETFs are sold, not bought. Pacer has also grown by acquisition.
ARK Investments’ CEO Cathie Wood became a media darling, spurred by ARKK’s meteoric 2020 gains. Even when ARK’s funds plummet, the press can’t get enough of Cathie Wood. Cathie’s fans, like Dimensonal’s advisors, are fiercely loyal.
Toroso Investments, a $2.3 billion ETF white-label platform, has also played the media game with its ETF Think Tank.
Some ETF issuers have struck gold by offering an exposure that meets the moment. Innovator, with its options strategies, has tremendous appeal to nervous investors, who have been plentiful during the market downturn. U.S. Global Investors took off with an ETF offering exposure to the airline industry. Anyone who boarded a plane in 2022 can understand the recent appeal of this niche exposure.
Back Down to Earth
But the reality is that for every runaway success, there are multiple asset managers whose attempts fell flat. In 2014, 10 asset managers besides ARK and Crestview opened an ETF line. Today, four have left the business, three manage less than $1 billion, and three have AUM between $1 billion and $1.5 billion. 2014 launch RealityShares, with their $160 million AUM, is aptly named— the reality of ETF market competition has forced them to share the opportunity.
For those taking the plunge, Jillian DelSignore, Head of Strategic Growth and Solutions at FLX Networks, suggests that new entrants invest in all the approaches by doing their best to bring along loyal clients, developing a distribution strategy, focusing on digital engagement and brand, and building media prowess.
Without a deep, loyal investor base, capital to invest in experienced ETF distribution, or outsized media savvy, ETF entrepreneurs will have to be exceedingly lucky if they are to succeed in today’s ETF business.
LinkedIn guy defined success as reaching $500 million in AUM in a three-to-five-year span. 25% of the firms that entered the ETF market in 2017–2019 have accomplished this. The other 75% have not. The median AUM for those years’ new issuers is just $37 million, $159 million, and $50 million.
What Would You Tell LinkedIn Guy?
I hope the data I presented has injected some realism into the ETF entrepreneurship discussion, enough to help potential entrants make an informed decision.
Their time is valuable and, like all of ours, limited. I hope we all use our days on earth wisely.
So far, I haven’t seen LinkedIn guy’s firm register any ETFs with the SEC, but it’s only been a few months since we chatted. Do you think he will give it a try in 2023? Would you?
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