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Exchange-traded fund strategists make hay on industry boom

Traders work on the floor of the New York Stock Exchange December 3, 2013. REUTERS/Brendan McDermid
Traders work on the floor of the New York Stock Exchange December 3, 2013. REUTERS/Brendan McDermid

By Ashley Lau

NEW YORK (Reuters) - As the $2.2 trillion exchange-traded fund industry grows at a rapid clip, a group of investment consultants who specialize in creating portfolios of the funds - so-called ETF strategists - are reaping high returns.

The group that began as a handful of managers taking interest in the funds during the early 1990s has now grown into an established market, attracting the attention of ETF providers who view the strategists as a key to promoting their ETFs.

"It's a segment that's exploding," said Steve Cucchiaro, chief investment officer of Boston-based Windhaven Investment Management Inc, which ranks among the largest ETF strategists. At more than $18 billion, assets at Windhaven, owned by Charles Schwab Corp , are up roughly 32 percent this year.

The strategists, who research, design and manage ETF portfolios, see demand for their specialized expertise among investment advisers, individual investors and, increasingly, institutional clients like state pension funds and large insurance companies.

Chicago-based research firm Morningstar Inc counts 645 strategies from 145 firms with total assets of $80 billion as of June - an 18 percent jump since January and up 46 percent in just a year.

ETF strategists like Cucchiaro say they expect an increase in the use of their portfolios by institutional clients and foreign investors to drive growth over the next few years as the market expands.

Until recently, ETF strategists were mostly used by financial advisers for their clients, said Sue Thompson, managing director at iShares, the largest U.S. ETF provider owned by BlackRock Inc . But in 2013 "we've really started to see the ... institutional buyers start to come in." That has resulted in greater use of ETFs in client portfolios.

IShares started tracking ETF strategists in 2008, when it saw about $5.8 billion in assets managed by some 25 strategists. Now it tracks more than 200 strategies from more than 100 managers with more than $64 billion in assets. Thompson said she expects that number to double again in the next two years, to $120 billion in assets.

"You'd be hard pressed in this industry to find anything that grew from $5.8 billion to ten times that in five years," Thompson said. "I anticipate that we've got quite a bit of runway before you begin to see that growth rate taper off."

RISE OF THE STRATEGISTS

Much like stock pickers, ETF strategists select funds that fit a specific investment concept - be it a tactical response to market conditions or a more strategic asset allocation approach. Their portfolios can focus on the U.S. market or be international in scope, and quantitative or fundamental in the way they analyze investments. But rather than choose individual securities, they create portfolios of ETFs.

Windhaven, for example, offers model portfolios composed of ETFs across a variety of asset classes that clients use for a set annual management fee - ranging from 0.7 percent to 0.95 percent, based on the amount of assets they are investing.

ETFs, which trade in real time on exchanges like stocks, typically track an index of such securities. They tend to be transparent, so researchers can know exactly which stock shares or particular bonds are in a particular ETF.

"Our ability to add value is just as great as the value that can be added through average stock pickers," said Scott Kubie, chief investment strategist at Omaha-based CLS Investments, LLC, which designs ETF portfolios.

PROMOTIONAL OPPORTUNITY

With roughly 5,000 exchange traded products listed globally, including 1,500 listed in the United States, ETF providers know that having their funds included by a successful ETF strategist could open the door to a flood of end-client investors.

"It could mean a lot of money" for funds that are used in strategies, said Brendan Ahern, a former iShares director who now works at New York-based KraneShares, a start-up ETF provider whose funds are focused on investing in China.

The largest ETF providers do tend to appear most in the strategists' portfolios, but the strategists do offer entree to ETF firms with fewer offerings.

Providers like Ahern talk up their products at large industry conferences, like Morningstar's annual ETF Invest conference in October, where an entire section, called the "Managed Portfolios Gallery," was dedicated to booths of ETF strategist firms.

"You want to be that tool of choice, and that's the same as it is for KraneShares as it is for iShares," he said.

Many ETF providers have also built out sections on their websites dedicated to ETF strategists and asset allocation models. KraneShares, for example, has an Asset Allocation Benchmark Series, which includes a section on ETF managed portfolios that assesses different strategies.

INSTITUTIONAL, INTERNATIONAL GROWTH

The next leg of asset growth for ETF strategists and portfolio managers could be coming from institutional clients and non-U.S. investors who are increasingly using strategists.

BlackRock, which has published a guide to ETF strategists in the U.S. for five years, recently expanded the program to Europe.

Jeff Montgomery, chief executive officer of Texas-based AFAM Capital, an asset manager that specializes in managing ETF portfolios through its Innealta Capital division, said much of that increased interest from institutional clients has come over the last 24 months.

"Institutions and endowments, pension plans, 401(k) plans and retirement plans have begun to take a very, very close look at our space, and they're beginning to place assets with us," Montgomery said. His firm ranks fourth among largest ETF managers according to Morningstar.

Still, the vast majority of the firm's current business - roughly 85 percent - is with financial advisers, as has historically been the case with most ETF strategists.

"The financial planner looks like the general practitioner doctor that can do a lot of things, and they go find a specialist when they need brain surgery," said Montgomery. "Well, we're the brain surgery piece."

(Reporting by Ashley Lau; editing by Linda Stern and Andrew Hay)

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