index funds, passive ETFs and operating leverage

Russell leaves the ETF business

Early this month, the financial press carried stories that Russell Investments, the pension consultant turned money manager, has decided to close its ETF business less than two years after entering the field.

What’s going on?

(By the way, Russell’s is the typical pattern in many commodity-like industries, where latecomers are never able to achieve the scale needed to become profitable.  Presumably, Russell knew this before made its move into ETFs.  It concluded that the possible gains justified the initial outlays.  On the other hand, maybe it didn’t.)

the case for passive products

Arguably, given the repeated failure of active managers in the US equity market to outpace the S&P 500, or other standard benchmarks, passive products are better choices.

At the same time, with passive ETFs or index funds, the possibility–however remote–of market-beating performance is eliminated as a selling point.  Every fund targeting the same benchmark index will have (more or less–a comment on this in a minute or two) the same gross return.  As a result, the only real difference among funds is the size of the fees the fund operator charges.  Lowest fee wins.

basic assumptions

Let’s look at the situation as if we’re a newcomer to the passive fund industry.

We’ll have expenses:

–for a bank to keep custody of assets

–for mathematicians to oversee construction of the portfolio and to monitor the trades the fund makes to deal with purchases and redemptions

–for traders to buy and sell the securities in the fund, and to process customer orders

–for overhead, that is, office space, marketers, boards of directors, lawyers. top management…

To make the numbers easy, let’s say all that costs $1 million a fund a year.  (Unless a firm plans on having a ton of funds, $1 million is going to be much too low.)

Let’s also say that once we have all this infrastructure in place, the variable cost of running a given fund is the electricity needed to power the computers that keep the fund humming.  Call that zero.

charging for our services:  the view from below

Now we’re ready to offer our products to customers.  Customarily we charge a percentage of the assets as our fee.  How do we set that percentage?

well, our fund has to be at least reasonably competitive with other offerings in the market.  Let’s say the most prominent fund among our rivals charges a fee of $.20% of assets.  If we match that fee, then we’ll only achieve breakeven when our assets exceed $500 million.  Until we reach that level, we’ll have to subsidize our operating expenses.

Our other choice is to charge a higher fee, at least initially.  But since low price is the major selling point for the product, it’s not clear that this will be successful.

Worse than that, there’s a second issue with passive products–the question of how faithfully a given index fund or ETF mimics the benchmark it intends to duplicate.  This is called tracking error.  Passive portfolios don’t usually buy and sell tiny bits of all the stocks in their benchmark.  They transact in small, more liquid subsets of the index that their statistical analysis says will mirror the overall index closely.

Assurance that tracking error is low comes partly from the fund promoter’s promises, but mostly from seeing the fund deliver on those promises over long periods of time.  A startup fund only has the first.

It’s going to be hard to attract assets away from the market leader who has a low tracking error by charging more.

the view from the top

Look at the market leader.  He’s getting in new money on a regular basis from IRA or 401k clients.  If the relevant index is up, say, 20% over the past year (the S&P is a tiny bit better than that), his assets under management–and therefor his management fee–have gone up by that amount just by not losing net customers.  So the market leader is making at least 20% more money than he was in 2011.

What’s his best strategy?  Cut his management fee percentage, of course!

If the market leader decreases his management fee to .175% of assets, he’s still making more money than before.  His product looks even more attractive.  And he’s forcing the startup to cut management fees, too–raising the startup’s breakeven to $570 million, thus lowering the chances that the startup will ever reach profitability.

more wrinkles

There are a few.  But I’ve made my main point–that unless the market leader gets piggish and creates a pricing umbrella under which the competition can prosper–it’s tough for a latecomer to gain any market traction.  That’s natural market evolution.  And it’s what has happened to Russell.

That’s it for today.