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The Future Of ETFs: Discount Brokers And Convertibles Only

|Includes: BlackRock, Inc. (BLK), CNS, CS, SCHW, TROW, UBS

"Older men declare war. But it is the youth that must fight and die." -Herbert Hoover

The exchange-traded fund, or ETF, got its real start in 1993 when the SPDR S&P 500 Index ETF (NYSEARCA:SPY) was launched. The industry grew slowly, on an aggregate fund basis, through the 1990s and early 2000s. In 2000, iShares was launched as Barclays bank invested heavily into the future on ETFs. Vanguard joined suit in 2001 and through the next few years the playing field remained in their hands.

The ETF Evolution

Back in the early 2000s, all of the U.S. ETF listings fit nicely into less than a quarter page section of The Wall Street Journal. I remember reading the prices and noticed when new funds were launched.

I knew each ETF as if they were all part of my fantasy stock league, acknowledging returns, management fee differentials and top holdings. It was exciting for me as a fresh face eager to soak up as much information as possible. Since I wasn't born when John Bogle took mutual funds to the next level with the passive indexing strategy, it was very cool to be on the forefront of the what could be the next big thing to shake the fund universe.

As it turns out, ETFs did rock the fund landscape in the U.S. According to CNBC, there were 1,439 ETFs listed domestically as of May 2013 with a value of $1.47 trillion.

Survival Of The Fittest

With a list that large, it becomes impossible to acknowledge all of the funds. The larger funds are still increasing in size while the smaller funds either grow large or as in many cases, they exit the market completely.

The Competition And Economies of Scale

As with any business, there are fixed costs associated with operating an ETF. As assets under management remain small, so does the management fee. If an ETF has a larger base it is able to charge less and also become much more profitable than smaller competitors.

For example, an ETF with only $10 million in assets that charges 1% annually will bring in $100,000 in profits. 100k is hardly enough to even cover the lead manager, let alone other business expenses. A fund with $500 million that charges .5%, however, is able to produce $2.5 million in revenue for the ETF operator. Both funds may have similar fixed costs, however the larger fund may employ more personnel, hence a rise in only variable expenses and the achievement of economies of scale. With scale comes lower prices and a dominating opponent.

Competing With The Giants

For smaller funds to compete with index or commodity-based investments, they must change direction or they will be lost in the sea of sunken investment vehicles. With generally higher fees, very low liquidity and an uncertain outlook, investors are cautious and thus the fund is engaged a battle that can hardly be won.

The Discount Brokers Are Now Entering The ETF Party

Most index and commodity ETFs are very similar, however they either track different indexes of a near-identical nature (index ETFs) or they hold the same commodity but in a different facility (commodity ETFs). The only way these funds can compete is with bargain-basement management fees, large assets under management and incentives such as free-trading for particular brokerage firms.

This is a new trend that discount brokers such as Charles Schwab (NYSE:SCHW) and Fidelity have adapted, who have recently been able to launch their own index ETFs that compete with the big three ETF families, as they are built with low management fees and come with a no trading fees for clients benefit.

In this regard, these new index ETFs for these firms are better suited for both current and new mutual fund holders, as well as holders of competing index funds, as they retain a no-fee clause on trading, lower fees and can be exited at a moment's notice.

For example, the Vanguard Mid-Cap ETF (NYSEARCA:VO) charges 0.10% in annual management fees, yet will cost a fee to trade. The newer Schwab U.S. Mid-Cap ETF (NYSEARCA:SCHM) has showcased a similar performance through a similar yet different index of stocks. Schwab clients may prefer to enter SCHM versus VO however as there are no trading fees and the expense ratio, at 0.07% per year, is lower.

Managed ETFs Gaining Traction

Newer index classes, specifically non-index or managed ETFs, are also gaining traction. In this regard, performance must be measured to encourage investors who are overwhelmed with options. Just as Peter Lynch of Fidelity grew an incredible amount of assets under his flagship fund for some time, there is always the possibility a new managed-ETF could do the same.

There are major problems with this theory, however, as low assets under management with an unproven management style or directive will create an unprofitable fund off the bat. To couple this problem, new investors should be hesitant to invest in such a vehicle as low liquidity gives way to outside arbitrage or unfavorable premiums in the purchase price, not to mention potentially unfavorable discounts at the exit window.

The Only Way To Compete Moving Forward

Moving forward, if a smaller company has a great idea for a new ETF it will likely fail due to the competition in terms of liquidity and competition of funds with a similar concept. If it does well, a copy-cat fund would likely emerge quickly.

So how is an ETF with less than $100 million in first year assets, that is not a discount-broker sponsored fund, able compete with the big boys? The answer may be the introduction of a new convertible investment vehicle that takes advantage of both the mutual fund and ETF structures.

The New Investment Vehicle: Convertible ETFs

For the time being, a convertible ETF is non-existent. This concept will be explored and if it does receive notice and applause, perhaps it would be implemented. As an outsider and an investment expert, however, I do feel this option is best suited to give newer funds the chance of success. Also, this would only be applicable to index, commodity and managed ETF structures, not day-trading vehicles such as inverse or leveraged return ETFs.

A New Hybrid ETF: ETF Conversion Vehicles

While it may be nice to drive down the California coast with the top down, when it rains the option to put the top up is imperative. With young ETFs as well, there is no reason to run with the top down 24/7 as the rain could be detrimental to the vehicle's survival.

In this analogy, the problems with the young ETF survival rate involve low assets under management, small trading volumes, competition and lack of long-term investor confidence. There is, however, a way to eliminate at least some of these concerns.

Introducing The Modifiable Exchange-Traded Fund

The easy solution to alleviate low assets under management and lack of trading volume would be to start the ETF as a mutual fund, with a clause that once assets hit $100 million then it would be converted into an ETF.

With such a convertible fund in play, a retail investor could purchase the fund as a no-load fund and reduce his trading cost. Also, the retail investor would be adding to the assets under management with the trade, rather than purchase an already-existing class of shares.

Moving forward, when enough assets are under management for a specified moving average, the fund would automatically transition into an ETF such that the benefits of immediate market-timing and liquidity could be achieved. With historical returns that outperform peers, new ETF investors would be more apt to purchase shares as the fund would be of a larger size, be equipped with liquidity and be able to compete with management fees. Investor confidence would be restored and a new ETF, once converted from a mutual fund share class, would have a much larger probability of success.


New ETFs are unable to compete unless they are brokered via a discount broker with no-trading clauses. There is a way, however, that new ETFs could become competitive and that is through a convertible ETF structure.

As this is a new idea, or so I think it is, please comment on the pros and cons of convertible ETF shares. I would be interested to hear professional opinions, as well as those of the retail investor. As always, thank you for reading.