How to profit from the booming ETF sector

Each week, a professional investor tells us where he'd put his money. This week: Oliver Smith of IG Smart Portfolios tips three firms benefiting from the growth in trackers.

A decade ago exchange-traded funds (ETFs) had not yet become mainstream. They were seen as niche retail products, as it was more cost effective for professional investors to buy index swaps or structured products from the banks than to spend 0.5% on an ETF with less-than-perfect replication of its underlying index. How times have changed better index-replication technology, a price war on management fees, and very tight bid-ask spreads (a result of keen pricing from market makers) has driven large-scale adoption by institutional investors.

ETFs are now the cash-management tool of choice; for example, trading a high-yield bond ETF has a much lower round-trip cost than buying and selling the underlying bonds. Indeed, the bond market, which is many times larger than the equity market yet underpenetrated by ETF providers, should be an area of huge growth. While giants BlackRock and Vanguard are working hard to attract the lion's share of inflows, an entire industry has sprung up to capitalise on the advance of these products. Market makers, trading platforms, custodians and distributors are among those who are profiting from this growing sector.

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Our clients in IG Smart Portfolios pay no dealing commissions the only cost of trading is the bid-ask spread of the ETF itself. That and a management-fee price war has meant that getting sufficient scale in the ETF business is key for providers, both in terms of assets under management and trading volumes.

A rapid-fire innovator

Consolidation is happening all the time, with several mergers and takeovers of the smaller ETF providers in the past two years. WisdomTree (Nasdaq: WETF), a provider of specialist ETFs that charge higher management fees than core FTSE 100 and S&P 500 products, has bought both Boost and ETF Securities, and now manages more than $65bn at an average fee of 0.5%. This business should continue to grow market share against traditional investment firms, given its ability to launch new ETFs quickly.

A growing network pays dividends

Closer to home (and held by the author), Tavistock Investments (Aim: TAVI), which listed in 2013 via a shell company, has built up a network of more than 200 advisers and is well placed to grow by offering a centralised investment proposition that uses asset allocation research from BlackRock and portfolios of iShares ETFs. With compliance and operational costs placing a larger burden on small, independent financial advisers, low-cost portfolios offer companies a clear head-start in winning new business. It has approaching £1bn in discretionary assets under management, and it was encouraging to see Tavistock gain approval this month to pay dividends.

A lucky escape

The London Stock Exchange (LSE: LSE) owns the fast-growing FTSE Russell group, which contributes more than 25% of its revenue and now has an excess of $15trn of assets benchmarked to its indices. Through a combination of increasing volumes in ETF trading and high-margin index provision, last year's merger collapse between the LSE and Deutsche Brse may turn out to be a fortunate escape for shareholders.