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Ex-CEO: iShares Needs Competition
By Paul Amery | 14 January, 2013

Lee Kranefuss, ex-CEO and architect of the iShares exchange-traded fund business, tells editor Paul Amery why his former firm needs more competition. Kranefuss is now executive-in-residence at global private equity firm Warburg Pincus, where his role is to look for investment opportunities amidst consolidation in the ETF market. Lee, where is the ETF market heading?

Kranefuss: We’re now near $2 trillion in worldwide exchange-traded product assets, which shows the continuing strength in ETFs and their importance as a core investing and trading vehicle.

Worldwide flows to ETPs were nearly $300 billion in 2012, another record year.

We were very cautious early on. When I started iShares in 2000 and we got momentum going by 2001/2002, others would keep asking us, “Are we past the top?” But I think there’s still a lot more runway ahead, and customers will continue to use ETFs and other indexed investment products in increasing quantities. It’s exciting after twelve years to see that momentum continuing. The US ETF market is still driving cash inflows. How do you see the European market evolving? Europe was growing faster than the US until 2010 but has slowed since.

Kranefuss: There are two things to watch. People report ETF assets by fund domicile, but many European investors buy US ETFs, which the numbers don’t reflect. Second, Europe has got itself into an unfortunate situation regarding industry structure.

There’s one large player—iShares—offering primarily physically replicated funds, and the firm is three to four times bigger than its nearest competitors, Deutsche Bank and Lyxor.

In addition, Deutsche’s and Lyxor’s fund ranges are predominantly derivatives-based—synthetic—and recent fund flows have shown that customers are reluctant to deal with anything that has an opaque structure and which relies on bank credit in any way.

So European investors have been driven towards dealing with iShares in the absence of credible alternatives, even to the extent of buying US-listed, physically replicated ETFs and suffering tax disadvantages as a result.

What Europe needs are some more large-scale ETF providers, offering a long-term commitment to the business and with a range of physical and synthetic funds. If you had such issuers I think the flows into European ETFs would be higher than what we see now. Who might step into the gap?

Kranefuss: That’s what Warburg Pincus is currently evaluating. So Deutsche and Lyxor—who have recently announced they are moving into physical replication—can’t fill it?

Kranefuss: There’s a big difference between running a physically replicated ETF range and running an investment bank derivatives desk issuing index-tracking swaps.

Europe’s UCITS fund rules allow banks to issue synthetic ETFs very easily and very quickly by writing a swap. Money gets moved from the balance sheet of the bank as you set aside some assets as collateral. By contrast, running an index fund requires huge scale and tremendous attention to detail: coping with dividends, tax issues, corporate actions, proxy issues, for example.

To be truly credible in the ETF market you also need to be independent of market-making arms, which the investment bank-owned issuers are not. What about Vanguard and State Street?

Kranefuss: The US ETF market played out as it did largely by historical accident. I have a great deal of respect for Vanguard, but at heart they are a mutually owned, domestic US entity with a strong retail bias. State Street is a great custodial bank, which has built up a respectable ETF business on the basis of a few key products—such as SPY and GLD—which were built and structured by others. These firms are very strong in the US, and State Street also has a good presence in Asia, but they haven’t yet registered in the European rankings.

What I expect to happen is for a different group or groups to provide competition for iShares in Europe, and we—Warburg Pincus—intend to be the people providing at least one of the new competitors. Who might that be?

Kranefuss: Stay tuned. But there’s a strong appetite out there and people are coming to understand that ETFs are the direction to go in. So these are presumably entities that don’t currently have a presence in European ETFs?

Kranefuss: There are a number of ways to configure it. But you need the right management team, an appropriate level of capital behind the venture and you can solve most of the remaining problems by organic or inorganic means—in other words by some partnerships and acquisitions, but also by internal growth.

And if such an entity is independent of any bank, trading house or distributor, it will have the greatest chances of success—the history of the ETF market to date has shown that this is the approach that customers favour: all of the providers who have grown beyond $50 or $100 billion globally are not an integral part of an investment bank or trading house But consolidation in the European ETF market—even with the iShares purchase of the Credit Suisse ETF business—seems to be happening very slowly. Why is that?

Kranefuss: Owners of ETF businesses still want to hold on to them in a rapidly growing market, as they have an option-like value, and they think that if they hang on there may be great upside potential. If you want an analogy, go back to the early days of the personal computer market. I used to work in Silicon Valley, and I counted eight firms who each maintained they would eventually have a 25 percent market share.  It’s hard to say “I can do best by selling into the right deal, now,” even though if they wait too long they may end up as the marginal seller when no-one needs to buy.

In the US ETF market, which has developed further than the European market, a number of firms have now shut down. Not only did they find they couldn’t achieve scale, they even found it hard to find buyers for their businesses.  Some of them could have sold a few years ago, but held back thinking there was an upside option with no downside risk.  It wasn’t true. You’ve said that ETF issuers should be independent of market makers. But how much independent market-making capital is there out there to support all the listings? In Europe, there are over 2,000.

Kranefuss: Market makers are already cutting back and refusing to support the more marginal products. Any fund with a billion dollars in it will find market-making support and natural trading volume. But compared with the initial days of the ETF market, when trading firms would happily offer seed capital, today it’s very hard to get a new idea off the ground. And it’s much easier in Europe, particularly, to issue funds than to ensure the necessary trading back-up. How important is “smart beta” or strategy indexing in the next stage of the ETF market’s development?

Kranefuss: Very.  There have been some new ideas, but I think they are still incremental.  For example, fundamental indices were a somewhat novel idea.  But, at the same time it’s taking an old idea and rehashing it, rather than offering a truly innovative way of doing things.

New approaches and real innovation will be very important.  As one example, I believe factor indexing is a very interesting approach.

To date in indexing and in ETFs, in general, I feel that a lot of the truly creative thinking hasn’t yet come to market. I wouldn’t want to say that the current market leaders in ETFs are complacent, but it’s also true to say that industries tend to change as a result of disruption, rather than as a result of the existing leaders pushing out the next new idea. More competition, at scale, will lead to more transparency, better product choices and more innovation, resulting in better outcomes for investors.

I think this will all come together in 2013 and you’ll see the first signs of it in Europe.

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