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What the hell is water?
BY JOHN DYALL | THURSDAY, 19 MAR 2020   3:13PM

There's a joke that has one fish swimming past another fish and asking: How's the water? The other fish replies: What the hell is water?

That's a question many of us would answer if it was asked about something as seemingly mundane as what we spend most of our working hours working on, or in.

Case in point: Recently while researching the Australian exchange traded product market I was fishing around for something meaningful to say. It's easy to be lured by whatever is bright and shiny, like the exponential growth in the market or the number of new products.

But I was asking myself different questions, like how has the structure of the market changed in the past few years and are these changes positive or negative for the end consumers of these markets: the investors, the financial planners, the creators of model portfolios.

We know that competition is a "good" thing, but how do we know if a market is concentrated and uncompetitive or open and competitive? More importantly, what direction is the market moving in? These are questions both for consumers in the market and for suppliers wondering whether they should enter or exit that market.

It was then I recalled something from more than 20 years ago: There was an index that could tell you how concentrated or competitive a market was. That index was the Herfindahl-Hirschman Index. The index shows where markets lie on a continuum ranging from: highly concentrated (a small number of firms dominating the market); moderately concentrated; unconcentrated; and highly competitive (a large number of firms with no dominant players).

First we looked at the obvious, concentration of managers by funds under management (FUM).

Since 2012 manager concentration by FUM has gone from highly concentrated to moderately concentrated. Instead of 80% of the market being controlled by three managers it is now controlled by just four.

That doesn't seem like a whole lot of difference until you look at what's going on beneath the surface. The market share of those initial three managers has more than halved. Two of the current top four managers were not in the top four seven years ago.

Seven years ago, ETPs were pretty much all market cap weighted index products and actively managed and smart beta products were hardly a thought. The main difference is that active and smart beta products charge more - a lot more in the case of active products - and that changes the arithmetic when you use revenue as a basis for measuring concentration.

And using revenue shows another, better, story. The market went from being highly concentrated in 2013 to being moderately concentrated in 2015 and finally to being unconcentrated in 2019.

One story that isn't quite so rosy is the concentration of index providers. It's a little-known fact (among consumers anyway) that products tracking a specific index pay the index provider to use that index. Usually this is in the form of a percentage fee of assets under management.

The thinking goes that investors care who the index provider is and are willing to pay up for the privilege of being associated with a quality brand name. At the end of 2012 one index provider controlled 80% of the index market. That was at the extreme end of concentration, which meant the index provider had nearly a monopoly on the market. That meant ETP managers didn't have much market power to negotiate lower fees and that meant investors paid more than they would have if the index market was more competitive.

Since then a new type of index provider has come into play. They charge an annual flat fee per product, which means the percentage cost reduces as the product becomes larger. This type of competition has seen the concentration of index providers come down. It's still highly concentrated, but the trend shows that by the end of 2020 it will be classified as merely moderately concentrated.

So the next time someone swims by and asks: How's the water? You can tell them: If you're talking about the ETP market, it's getting more competitive every year and that's a good thing.

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