The biggest bond ETF provider says business may double in next five years

ETFs are traded on exchanges, so they can be bought and sold like stocks through a brokerage.

Fifteen years ago, on July 26, 2002, Barclays began offering a new way to invest in bonds through a new division called iShares. It was called an exchange-traded fund, or ETF, and even though only four funds were launched that day, it changed the way bonds are traded.

Fifteen years later, there are nearly 1,000 bond ETFs worldwide, with assets over $700 billion, most of it ($500 billion) in the U.S.

That’s a success by any measure, but the head of the biggest ETF provider in the world says the business is going to get bigger. Much bigger.

“People have come to understand the merits of index investing: you keep more of what you earn,” Martin Small, head of iShares America, told me. IShares, which was bought by Blackrock in 2009, is the largest ETF provider, with $1.2 trillion in assets under management.

Small says that despite complaints that the ETF business has grown too fast, ETFs are a very small part of the U.S. equity and bond business: about 1 percent of the $49 trillion bond market, and about 8 percent of the $26 trillion stock market.

That will be changing. Small believes that the ETF business could eventually get to 50 percent of the U.S. stock market from 8 percent today, though that will take many years. As for bonds, he says that business could double or triple in the next five years, going to $1 trillion to $1.5 trillion in assets under management, which would still be less than 5 percent of the bond market.

Despite the attention ETFs have attracted from retail investors there’s an even larger audience that the biggest ETF providers — the Blackrocks, the Vanguards, the State Streets — have set their sights on: institutional investors like sovereign wealth funds, university endowments and professional asset managers.

“We’d like bond ETFs to be as ubiquitous as bonds and bond futures,” Small said.

He notes that 10-year Treasury futures — mostly used by professionals — trade about $146 billion a day. Bond ETFs trade about $6 billion a day, about 4 percent of the volume of those Treasury futures.

That’s a big opportunity for the ETF business. Small says that more professional investors will be putting money into bond ETFs in the future as the bond business moves toward electronic trading, a shift that happened more than a decade ago in the stock market.

“Bond investors still pay a lot of money for the market, many still pay a 1 percent fee,” he said. More electronic trading will make the market more efficient, less expensive and will open up even more opportunities for lower-cost ETF providers.

It’s not just because investors are shifting money into ETFs: change is being forced on the industry by regulation. New regulations coming into effect in April 2018 will require the disclosure of bond markups, a move which will make those markups more difficult to justify.

“People who are charging a 1 percent commission are going to have to explain why that is a better deal than owning a bond ETF,” he said.

There’s also plenty of room for volume to go up in the stock trading business. Right now, about $186 billion in S&P 500 E-mini futures contracts trade each day. All the stocks in the S&P 500 trade about $125 billion a day. The major S&P 500 ETFs trade less than $40 billion a day, about 20 percent of the E-mini dollar volume.

“When I see mutual funds managers trading IVV [the iShares S&P 500 ETF] instead of the S&P E-mini contract I know we will have arrived,” he said.

While there is a small but growing business in ETFs from “active” managers, most ETFs are still tied to indexes. Small dismisses concerns that these “passive” investors are becoming too important and displacing those who are “active” traders.

“We are 25 years away from the question, is passive big enough to displace price setters?” Small told me.

In his eyes, this is much more of a turf war: “They are the owners of Blockbuster, complaining about Netflix,” he quips.