Morgan Housel had a post on the idea of conflicting skill sets. Morgan makes the following comment:

F. Scott Fitzgerald said intelligence is “the ability to hold two opposing ideas in your head at the same time and still retain the ability to function.”

It’s so hard to do. But there are all kinds of examples of when it’s necessary in investing.

Similarly, the ETF industry is made up of conflicting ideas. We’re a relatively new industry (first ETF established in 1993), but the majority of the rules governing the industry are based on the Investment Company Act of 1940. We tout new strategies like smart beta, yet we pitch them based off of 200-year-old backtests (Value and Momentum are two examples). We make ETF investment portfolio decisions at a definitive point in time as static ideas, but then have to implement those portfolios/strategies in a dynamic world.

Although the ETF industry is relatively young, we’re seeing it follow a similar path to other industries. The growth of the industry has attracted more competition–there are 92 firms today versus less than 50 firms five years ago– and the added competition is forcing previously comfortable firms to make difficult pricing decisions on their new and existing ETFs.

The generally accepted idea is that the low-cost firms are winning at the expense of everyone else.(1) But that is slightly misguided, as there is more than one way an operating company can compete in the ETF world.

The companies that are focusing on one (or two) core competencies are the companies that are growing and winning in the ETF industry.

While many in the financial media focus on one competitive advantage (cost), below we describe the three competitive advantages where firms can compete (hint: price is only one of them).

State Street and iShares duking it out!

The Three Pillars of Competitive Advantages to Win

In any industry, there are generally three ways you can win:

  • Be the low-cost leader
  • Provide great customer service
  • Provide great product (also known as providing value for your customer)
  • A firm that creates value for its clients is totally different than being the lowest cost firm, or being a firm that provides great customer service. Most successful firms are dominant in one area and have a strong competency in a second area. Even Walmart (lowest cost) wants to have its customers to have a decent experience, so they come back to the store again. But they can’t provide the same customer experience in their stores as Tiffany’s. Ritz Carlton and Mercedes Benz are examples of companies that combine numbers two and three. They provide great customer service, and they provide a great product…but they can’t also be the low-cost leader, nor do they want to compete in that area.

    As the ETF industry has matured through the years, the companies that are winning (and are likely to continue to win), are those who focus on succeeding in one (or two) of the three areas above.

    Competitive Advantage #1: Low-Cost Leadership

    Assets are flowing into the firms that are winning via low-cost leadership. And this makes sense. When you’re operating on razor thin margins, you need a lot of scale. When we think of low-cost firms in ETFs, we think of Vanguard and Schwab (and iShares, which we’ll get to further down in this post).

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