Chuck Jaffe: iShares deal signals big changes ahead for ETFs

The recent news that Barclays is trying to sell its exchange-traded funds business was virtually ignored by fund investors, but the changes that any deal for the iShares business will spur won't be ignored for long, as they are likely to coincide with major changes in the ETF business.

How quickly the ETF landscape is altered may depend, in part, on who winds up buying iShares, but the final outcome could help to move the general public much further along the trail of moving from traditional funds to ETFs, which is why it's worth considering how this scenario will play out.

Barclays (BCS), the troubled British bank, has been a pioneer in the ETF business, with Barclays Global Investors and its iShares by far being the dominant provider of exchange-traded funds with more than 360 funds, hooding some $300 billion in assets, or about 45 percent of the total market. The company confirmed March 16 that it is looking to sell iShares, creating an opportunity for another management company to instantly have a dominant position in the industry.

Exchange-traded funds are built like traditional mutual funds but trade like a stock, listed on a stock exchange and available to buy or sell minute-by-minute on the open market. Typically, investors are attracted to ETFs because they get diversification and trading flexibility at a low cost.

The iShares brand is built around indexing a wide range of benchmarks, with seemingly every conceivable market measure having its own flavor of fund to go with it, from such mainstream markers as the Dow Jones U.S. Index or the Russell 3000 Growth Index to social-index funds, to single-country measures for seemingly every country on the map.

Potential buyers

Among the logical potential buyers for the iShares business are such big brokerage firms as J.P. Morgan Chase and Goldman Sachs, traditional mutual-fund giants like Fidelity Investments, and private-equity firms and smaller money-management companies looking to make a splash in the business.

Big banks, such as Citigroup or Bank of America, might have been a potential buyer during better economic times but are so troubled now that they can't be expected to pony up the $3 billion to $5 billion to make a deal happen.

No matter who ends up with the iShares business — and Barclays is in such deep trouble that it needs a quick resolution if it indeed goes through with a sale — the landscape for ETFs changes.

The next big deal in the development of ETFs will be a surge of actively managed funds, many built around current mutual funds, so that the XYZ Managed Growth fund would have an ETF counterpart. Esoteric ETF rules have made this virtually impossible to date, but trading developments appear likely to change that in the next 12 to 18 months.

That's why you could see a PIMCO or Schwab — both of which are set to enter the ETF business — making a big splash but why, ultimately, you could also see something like the iShares Fidelity or iShares Eaton Vance funds.

Comfort level

Factor in the time that it will take to get a deal done and you are looking at a scenario that suggests that when investors are feeling more comfortable about the market and looking to take trillions of dollars off the sidelines and put them back into the game, they could be doing it with actively managed ETFs, essentially buying an improved version of their traditional funds.

"Active is going to happen at iShares, it's a seed that has been planted, so you could see a fund firm basically buy the current franchise and expand it," said Jim Wiandt, director of operations at IndexUniverse.com, which tracks the ETF business.

"Even if they do not buy the iShares business — and I don't think it will be a big fund company that does — you will have a new player coming in, anxious to make a statement right at the time when you are seeing all of the developments that make active ETFs more possible and likely."

Added Gary Gastineau of Managed ETFs, an industry consulting firm: "To the extent it means anything, iShares means benchmark index ETFs. I'm not sure the brand has an enormous amount of traction with Joe Sixpack, who may know of ETFs but doesn't recognize iShares as the predominant way to buy them. ... I think iShares remains the dominant provider of benchmark ETFs, whoever owns the business."

What's clear is the industry's next public battle could be over the active ETF business, with that hybrid of traditional and new structure being the "fresh idea" sold to investors who have soured on their mutual funds through the downturn, but who might be enticed back into the market with a bit of a rebound and a new product.

Copyright 2009, MarketWatch

Chuck Jaffe is a senior columnist at MarketWatch. He can be reached at cjaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.