Shawn McNinch is responsible for leading Brown Brothers Harriman's Exchange Traded Funds servicing business, which includes providing Pre-launch Consulting, Custody, Accounting, Fund Administration, and Transfer Agency Services for Asset Managers/ETF Sponsors. Prior to working at BBH, he worked at Barclays Global Investors (BGI) where he was a Senior Principal within the iShares Product Strategy Group. Shawn graduated from Syracuse University and holds an MBA from the Stern School of Business at New York University.
Shawn recently sat down with Seeking Alpha's Jonathan Liss to discuss his behind-the-scenes role providing a range of services to some of the top U.S. ETF issuers. He also weighed in on a number of contemporary ETF-related issues, from the proliferation of active exchange traded funds to the SEC's continued examination of derivatives-based funds.
Jonathan Liss [JL]: Shawn, you've worked on a lot of ETF launches in your day, including when you were at iShares. What's it like getting an ETF from the conception phase all the way to its launch?
Shawn McNinch [SM]: A lot of the initial launch phase involves just deciding if a new product make sense, what need it fills, how it can be marketed. There are also significant issues of structuring - what index will it track and what will the holdings be? Also, what will it look like from a taxation perspective? And will it be more geared towards institutional or retail investors?
Once you can reasonably answer all these questions, then the actual launch phase can begin. BBH has actually handled the launch itself for 3 or 4 smaller clients but we work with bigger clients too including three of the top five U.S. issuers according to assets. They generally handle the launches themselves.
JL: A colleague of mine at Rydex told me a few years back that ETFs are rarely profitable with less than $50 million in assets - sometimes this number is closer to $100M. This includes the majority of ETFs on the market today. In your view, how profitable is the ETF industry? How much room is there for new issuers with the current level of market saturation?
SM: 71% of total assets in the ETF industry today are with the top three fund sponsors (in order of size, that's iShares, State Street and Vanguard). Something like the top 100 funds account for 65% of all U.S. ETF assets. On the other end of the spectrum, I'd guess the bottom 400 funds or so of ETFs and ETNs have under $20 million in assets. It's very hard to imagine these funds are profitable. The ETF industry can be very profitable but with the current level of market saturation, if you aren't either offering a new and unique product, or you don't have the name recognition and a plan to attract assets for 'me-too' products, you're unlikely to succeed.
JL: You mean like what Schwab (SCHW) has done recently with its line of very basic ETFs? There's been nothing original there in terms of actual products.
SM: Exactly. They launched their first ETFs in November 2009 and they have already gathered over $1 billion in assets for what are essentially copycat products. By offering commission-free ETF trading on Schwab funds to their brokerage account holders, they found a model that was advantageous to retail investors and as a result, they have been successful from the get-go.
They also got the already established issuers to take notice, so that iShares did the same thing as Schwab was doing with its clients via Fidelity, offering commission-free trading for 25 of the top iShares ETFs. [Editor's note: On Tuesday, Vanguard became the third ETF issuer to offer its brokerage clients commission-free ETF trading for all Vanguard ETFs.]
JL: Speaking of iShares, despite their first mover status, Vanguard has managed to take away huge market share from them on a product like iShares MSCI Emerging Markets ETF (EEM) with an ETF (VWO) that tracks the same exact index (albeit with a different tracking methodology).
SM: Well Vanguard's ETF strategy has been centered on lower costs, similar to its mutual fund strategy. In the case of the Emerging Market funds you mention, they were charging so much less than iShares for the same index exposure (0.27% vs. 0.72%) that investors took note and as a result, Vanguard has accumulated significant assets into its ETF product line.
JL: It seems like many of the products being launched at this point are 'me-too' products. In your view, what are areas of the ETF market that are still wide open for new or existing issuers to come and fill with innovative products?
SM: Active ETFs are where we feel most of the new growth will take place. There are still very few of these funds and the ones that have come to market haven't had a chance to build up a track record yet. Within the active domain, I think we'll start seeing more 'fund of fund' ETFs. Of course, these add a second layer of costs so the managers will have to justify the additional costs with better performance.
JL: For me, there's an inherent contradiction in actively managed ETFs. ETFs are all about 'full transparency' for most investors whereas actively managed funds thrive on being able to be somewhat secretive about what they're doing, not having to show their cards at the end of every hand, so to speak. How can active ETFs overcome this?
SM: Well first of all, the transparency issue is definitely the primary obstacle we've encountered from managers. It's the issue that's been brought up the most in our many conversations with potential active ETF issuers. Managers don't want to have to reveal their secret sauce at the end of each trading day. Many have proprietary strategies and they'd like to keep them that way. There are also concerns about 'front-running'.
That being said, the transition into active ETFs has already been done successfully by companies like PIMCO, for example. They've come to terms with the fact they have to publicize their moves in the bond market on a daily basis. They seem to be ok with this.
There's no doubt though that the transparency issue is a big reason we won't see actively managed mutual funds going away anytime soon. There are many fund managers that ultimately won't agree to the transparency ETFs require. Investors that want to have access to these managers will continue to buy mutual funds.
JL: What advantages (if any) does an actively managed ETF have over an actively managed mutual fund?
SM: Well most of the advantages of active ETFs are the same as the advantages of standard indexed ETFs, things like lower taxes due to the in-kind transactions performed by ETFs. ETFs also have significantly lower record keeping costs in most cases since they're traded on secondary markets and so these costs are largely passed on to the broker-dealers. Mutual Funds' direct sales structure means they retain many costs ETFs can pass on to other parties. Also, most ETFs don't have 12b1 fees, as opposed to mutual funds which do.
Another advantage of actively managed ETFs is transparency. As an example, I bet a lot of mutual fund owners would have liked to know what sort of exposure their funds had to Lehman Brothers back in 2008 as events were unfolding. As ETF holders, they would have had full transparency.
JL: Let's change gears here a bit. The SEC continues to focus on derivatives-based ETF products, recently going as far as to indefinitely defer reviewing any new exemptive relief filings for products that fit this criteria. This especially concerns leveraged and inverse ETFs. How has this affected what you do?
SM: Well it's definitely affecting our clients. The problem with some of these leveraged and inverse ETFs is a lack of education on the part of retail investors. Many of these products were clearly intended for the trading community, people who are highly sophisticated investors, to use for hedging purposes. They were never intended for buy and hold investors with a longer investing time-frame.
At first, many retail investors were misusing these products, not understanding how they were meant to be used, or to not be used. For example, if they bought a triple leveraged ETF and the underlying index was up 10% over a year, they expected to see gains of 30%. They didn't take into account things like compounding, as these products are reset daily.
Since then, the issuers have focused a lot of their energy on educating retail investors, putting out much more serious warnings on these products, doing web-based seminars, even adding in words like 'Daily' to the names of these funds. It's become a whole education process.
JL: So why is the SEC still pursuing these issuers if they have spent so much time and energy educating retail investors. Do you think it's somewhat politically motivated?
SM: I think the SEC first approached this issue out of a genuine concern for protecting retail investors from complex products they didn't understand. I wouldn't say it's necessarily political, but rather the SEC’s continued motivation to make sure they are doing everything possible to protect investors. We have to take a wait and see approach and see where it all ends up. Right now, it's unclear what, if anything, the implications will be for these ETFs.
JL: What lessons can retail investors learn from the institutional ETF experience?
SM: I think the main lesson is that proper education is the key. Don't invest in something until you fully understand how it works. Retail investors often don't engage in proper due diligence before entering a position.
There is also a better need to understand asset allocation on the retail level, the need to understand how a particular ETF fits into an overall portfolio strategy, how it alters a portfolio's overall risk balance.
JL: Are there risks with ETFs that most people are unaware of? For example, Claymore shut down its Global Shipping Index ETF (SEA) after the close on April 27 with no prior warning for investors.
SM: No, not really. The SEA closure was a real outlier in my view. It resulted from a failure to reach a shareholder quorum for a proxy vote. This same event would have had implications with an individual stock so it's not necessarily specific to ETFs. ETFs are no riskier than mutual funds in this regard.
JL: Finally, Vanguard's John Bogle's main concern with ETFs is the temptation for retail investors to trade them far too frequently, undercutting profits. In light of the recent TrimTabs report showing ETF investors are extremely poor market timers, do you think ETFs have been positive for retail investors on the whole?
SM: I think the advantages ETFs offer versus mutual funds have been great on the whole for retail investors - the lower costs, better tax treatment, full transparency. So while the evidence does seem to show that ETF investors make poor market timers, you can't blame the product for that. There's nothing inherent about ETFs that forces investors to make bad trades. Ideally, you can use an ETF just like a mutual fund, hold it for long periods of time and pay lower expenses, while saving on your taxes.
JL: Thanks for taking the time to speak with me today Shawn. It's been extremely interesting and educational.
