October 23, 2014 / 7:55 PM / 5 years ago

UPDATE 1-As ETF M&A heats up, industry wonders who is next

(Adds analyst comment about SEC notice in 11th paragraph.)

By Jessica Toonkel

NEW YORK, Oct 23 (Reuters) - When it comes to expanding in the $1.9 trillion U.S. exchange-traded fund market, which some forecasts say will pass the traditional mutual fund industry in size within 10 years, some companies have concluded it’s better to buy than to build.

ETFs are baskets of securities, like mutual funds, but trade on exchanges, like individual securities. They are cheaper than mutual funds and allow investors to trade throughout the day, with simultaneous pricing, unlike mutual funds, which price at the end of the day.

They are also profitable: In the third quarter, BlackRock Inc, the biggest provider of the funds, made $850 million in fees from its iShares ETFs, 30 percent of the $2.8 billion in revenue it reported.

Facing shrinking margins from their traditional businesses, asset managers are under pressure to offer ETFs. Last week, Janus Capital Group announced the acquisition of exchange-traded fund provider VelocityShares and Reuters exclusively reported last week that Goldman Sachs in talks to buy IndexIQ, another ETF firm [ID: nL2N0SB2NV]. Now, industry executives wonder who will be next.

“If you are chief executive of a traditional asset management firm, you are asking yourself, ‘What is my strategy for ETFs?’” said Michael Spellacy, a partner at New York-based Broadhaven Capital Partners.

Given how crowded the U.S. ETF market has become, it’s easier to spend a few hundred million dollars to buy an existing firm that already has a management team, relationships with advisers who will sell the funds and regulatory approvals for existing funds than to try to come up with a new and unique product in hopes of gaining assets, executives said.

The price Janus paid for VelocityShares hasn’t been disclosed. Matt Hougan and Dave Nadig of ETF.com made the estimate that ETFs would surpass the $11.6 trillion U.S. mutual fund industry within 10 years.

T. Rowe Price and Capital Research & Management are among a number of fund companies that do not yet have ETFs but have sought approval from regulators to launch so-called non-transparent actively-managed ETFs that don’t require daily disclosures of holdings.

On Tuesday, the Securities and Exchange Commission issued a notice stating that it intends to deny two applications for non-transparent active ETFs but similar proposals for active nontransparent ETFs may still get approval in the next several months, according to some industry observers.

That would put competitive pressure on fund companies like American Century Investments and Putnam Investments, which have not made any movement to get into the ETF space, to act quickly by acquiring small ETF funds that already have regulatory approvals to introduce active ETFs.

And if the SEC prohibits firms from launching nontransparent active ETFs, it means that asset managers will have one less opportunity to get into this space. “That in and of itself could lead to more firms buying ETF providers,” said Matt Hougan, president of ETF.com.

Just because firms like T. Rowe have applied for regulatory approval to launch active ETFs, doesn’t mean they might not ultimately acquire a smaller ETF firm to come out with something faster, according to Nadig at ETF.com. Janus filed to launch active ETFs a few years ago and is still awaiting approval, he said.

American Century and T. Rowe declined to comment. Putnam did not return calls. A Capital Research spokesman said the firm has no plans to acquire an ETF firm.

STRATEGIC TOOLKIT

One driver of future acquisitions is the growing popularity of actively managed ETFs, experts said.

While actively managed ETFs only make up 0.1 percent of the U.S. ETF market, some predict that they will gain traction as investors get used to the idea and certain products have success.

“The consensus wisdom today is that active ETFs are actually going to make money in the next three years and they are going to be a central part of the strategic toolkit for money managers,” said Donald Putnam, managing partner at Grail Partners LLC, a private equity firm that sold its own actively managed ETF business to Ameriprise Financial in 2011.

One target on many firms’ wish list is New York-based WisdomTree Investments, the fifth largest ETF provider. It has a market cap of $1.4 billion and already has regulatory approval to do active ETFs.

ProShares, the eighth largest ETF provider in the U.S. with $26 billion in assets under management, also could be an attractive acquisition because it not only offers active ETFs, but it has alternative investments ETFs, which have been popular with brokers and financial advisers as a way to protect clients from market volatility, experts said. Both VelocityShares and IndexIQ have alternative ETFs, noted Ben Johnson, an ETF analyst at Morningstar.

A WisdomTree spokesman declined to comment on speculation and said the firm remains focused on growing its business. ProShares declined to comment.

Experts and bankers expect smaller firms like Global X Funds and United States Commodity Funds to get bought in coming years as they have good niche products and both need distribution. New York-based Global X has 38 ETFs, including a number of portfolios that invest internationally. Its most successful product is its $1 billion Global X SuperDividend ETF. Oakland, California-based U.S. Commodity Funds has a series of ETFs that invest in different commodities, including oil and natural gas.

John Hyland, chief investment officer of U.S. Commodity Funds, said the firm was not for sale. Global X declined to comment.

OPPORTUNITIES AROUND THE INDUSTRY

The growth in the ETF industry also means that there are opportunities for acquisitions in businesses beyond pure ETF providers. For example, many private equity firms are looking to acquire companies that manage portfolios of ETFs.

Charles Schwab Corp put ETF model portfolios on the map for in 2010 when it acquired Windward Investment Management, now called Windhaven Investments.

Chicago-based Good Harbor Financial, a model ETF portfolio provider that private equity firm FTV Capital bought in 2013, would be an attractive acquisition, bankers said. FTV declined to comment.

Yet another acquisition strategy being considered as a way to benefit from the increasing amounts of money flowing into ETFs is buying the indexes themselves.

The London Stock Exchange in June announced a $2.7 billion takeover of U.S. index compiler and asset management firm Frank Russell. McGraw Hill Financial Inc’s S&P Dow Jones Indices and financial information services providers Markit Ltd are finalists in bidding to acquire Barclays Plc’s index business.

Niche index provider Alerian, which offers a number of indices including the Alerian Master Limited Partnership Index and has $21 billion tracking its indices, could be a potential target in coming months.

Alerian is not actively running a sales process but would be open to a sale at the right price and on the right terms, said Kenny Feng, the firm’s president and CEO.

Reporting By Jessica Toonkel. Editing by Linda Stern and John Pickering

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