SEC Wonders If ETF Business is Too Concentrated In the Big 3

SEC

ETF business is booming, and is now a $4 trillion a year industry. 80% of ETF business is concentrated in just 3 firms, with more than a hundred other firms fighting for the scraps.

Exchange traded funds, known as ETFs for short, have made huge inroads into the realm of investing, and are even getting in a position to represent a serious challenge to their older and more established brother, mutual funds.

ETFs are actually just a streamlined version of mutual funds, with some key differences. Mutual funds have remained behind the times generally, being mostly offered through what we could consider comparable to back when full-service brick and mortar brokerages were the only game in town.

This might seem appropriate given that this old-style form of offering securities does cater to the needs of a lot of investors, or at least might seem to, but as it turns out, the advice of these dealers doesn’t really amount to much more than their just being sold funds within some broad parameters of matching up their needs to classes of funds and various allocations among asset classes.

As investors move more toward index funds, where one is like another other than small differences in management fees, many have come to question the old ways, especially those familiar with the online world, which is most people these days.

Mutual funds have adapted to these changing needs and preferences somewhat, but still mostly cater to those who make their investments through some sort of advisor. This form of marketing of course adds to the costs of the offerings, instead of leveraging the efficiencies that online marketing provides.

The second major difference between mutual funds and exchange traded funds is that mutual funds are only offered on the primary market, either through a dealer or from the fund issuer, where ETFs are traded on the secondary market.

While going through a dealer has obvious disadvantages due to the markup involved, expressed through management fees, we might think that buying our funds right from the fund itself should be preferable to anything. However, this point is all about liquidity, and ETFs, since are traded on exchanges, are a whole lot more liquid.

When we place an order to buy or sell a mutual fund, the orders need to get sent to the trading desk of the fund, who later execute the transactions required on the market the next trading day. This takes time, a lot more time than just clicking on a button on your computer and having your order sent immediately to the market to be filled.

Many investors find this very appealing, and as more and more investors get turned on to this new way to invest, the expectation is that more and more of them will choose ETFs as their mode of preference.

All of This Business is Highly Concentrated

During the rise of ETFs, most of the business has been taken by just three companies. BlackRock holds 39% of the market, with Vanguard sitting in second with 25%, and State Street coming in third with 16%.

If we add in Invesco’s 5% and Charles Schwab’s 4%, the top 5 command a full 89% of the total market with ETFs. This leaves the over one hundred other companies in the industry fighting over the remaining 11%, in a business where you have to have a certain minimal level of funds under management to keep your head above water.

It isn’t unexpected that the numerous companies who now share such a small percentage of the business among themselves aren’t too happy, and they would love to see us regulate the big guys down a notch or two if they could.

When the people who actually make these decisions start getting involved, this means more, and the SEC is now seriously looking into the composition of the ETF market and wondering if there is anything that they can do to spread things around a little more evenly at least.

Having three major players dominate an industry isn’t all that unusual, and in itself isn’t a bad thing, so long as collusion isn’t involved and they make no real attempt to exclude their competition beyond just being more efficient and offering more value, or at least are perceived to.

The playing field in business is never a level one, nor should it be, because if we sought this, this would mean placing restrictions upon success, which is both unfair and goes completely against market principles and capitalistic ones as well.

A Lot of New Funds Just Don’t End Up Cutting It

What concerns the SEC so much is the high failure rates of new funds, where about half of the new ones introduced to the market end up failing. New funds brought to market by these lesser players are indeed at a disadvantage though, as the more popular ETFs are already being offered by the big fund companies, and competitors are forced more to the periphery if they want to bring something new and better to people.

This is somewhat like comparing a small retail store to Walmart, and you won’t beat Walmart trying to be like them and beat them at their own game, but you can carve out a niche for yourself by offering things that Walmart does not.

The SEC and others are concerned that the current landscape limits innovation, but for something to be considered innovative, it does have to be unique enough to not really be competed for, and therefore its success does actually stand relatively unopposed.

If someone really did come up with a more general innovation, this in itself would attract success, as this would result in beating the big guys at their own game, Beyond this, attempts to gain a share of the overall ETF business by catering to niches are left to stand or fall on their own merits, as it would be desirable.

A finding that Black Rock, Vanguard, and State Street have been found guilty of interfering with the market to prevent innovation would therefore be a surprising one, and whatever sanctions that may result would end up making things less efficient.

The SEC can look to make the entries into the market more efficient though, by simplifying the process and reducing start-up costs. Securities do tend to be over-regulated a bit, and while we do need this, we don’t necessarily need overly burdensome processes that place unnecessary extra costs on fledgling funds that have such a high failure rate.

Smaller funds do not enjoy the same pricing structure as the big fund companies enjoy, and this is indeed a competitive disadvantage, but a natural one. There are always different levels of competitiveness among companies in an industry, and those who compete better reap the rewards.

We cannot forget that we also reap these rewards, and we certainly should not look to cap or limit these benefits we receive. While it may be at least somewhat beneficial that the SEC is looking to make the ETF industry broader, there’s not a lot broken here that needs to be fixed, and we should not be looking to break something on purpose just to give small guys a hand, at the expense of the rest of us.