The ETF Industry's 800-Pound Gorilla

In my previous ETF column, I profiled PowerShares, one of the newest and smallest exchange-traded fund shops. This time, I'll take a look at industry-behemoth Barclays Global Investors.

In a sense, San Francisco-based Barclays is the  McDonald's (MCD) of the ETF world. McDonald's didn't invent hamburgers and Barclays didn't create ETFs, but the companies each exploited and popularized their industry niches to a greater degree than anyone else. Barclays' family of 99 iShares is the undisputed 800-pound gorilla of the growing ETF market. IShares has grown from a few funds and $2 billion in assets in 2000 to a complex of 99 domestically available ETFs that cover virtually every major asset class and have about $115 billion in assets. It's now difficult to assemble an ETF portfolio without an iShare. The firm claimed more than 80% of all ETF flows in 2004.

That's not an accident. Barclays' strategy has been simple: Launch ETFs tied to as many of the most popular benchmarks available and market them relentlessly. It doesn't ask if seven broad-based large-blend funds or six technology offerings are too many for one category or sector, and it doesn't try to tell investors which of the indexes are the best. The firm just wants to make it impossible for investors who want a broad-based, style-specific, regional or sector ETF to ignore iShares.

Because of their low costs and trading flexibility it seems natural to pitch ETFs to do-it-yourself individual investors. Barclays takes its cues from financial planners, though. Demand from financial advisors, which Barclays considers iShares' primary market, determines what kind of ETFs the firm launches as much as anything else. Advisors also indirectly influence iShare expense ratios. Barclays factors in the costs of spreading the gospel of ETFs through seminars, white papers, and other services when pricing its funds. This is not a build-it-and-they-will-come business model. The firm is an aggressive evangelizer.

This is not to say iShares is all shake and no bake. The more than 30-year-old Barclays Global Investors is one of the largest institutional asset managers in the world with more than 2,000 employees and more than $1 trillion in assets under management in index funds. It obviously has some redoubtable resources and capabilities.

About a dozen portfolio managers work on iShares. Five split up the family's 57 domestic equity iShares, four run its 35 international ETFs, and three managers are dedicated to the fixed income ETFs. While not graybeards, most of the managers have at least five or more years of experience with Barclays as well as prior industry experience.

Like most index-fund managers, the iShares jockeys play close attention to tracking error, transaction costs, and taxes. Unlike some rivals, such as Vanguard's Gus Sauter, however, the iShares managers will not attempt to add value at the margins by opportunistically buying futures contracts or other tactics. Even though the risks of such stratagems are small, the iShares managers argue they would rather not chance increasing tracking error. Furthermore they contend many iShares clients use ETFs to hedge their portfolios and are more interested in replication than outperformance. The managers, however, are willing to diverge slightly from their benchmarks to harvest tax losses. When  Hewlett-Packard (HPQ) bought Compaq a couple years ago, for example, the iShares funds sold Compaq and bought Hewlett-Packard just before the deal consummated, which gave them almost the same returns as well as tax losses because Compaq performed poorly even after the merger was announced.

It's clear Barclays knows how to run an ETF. Most of its largest funds trail their benchmarks by no more than their expense ratios, which indicates they're doing a good job tracking their bogies. It also has been four years since any iShares ETF has distributed a capital gain (though  the funds have paid out dividend income), which shows the firm has delivered tax efficiency.

The low costs, tax efficiency, and competent management of iShares make many of them compelling choices, but competition is increasing. State Street Global Advisors is a distant second in terms of assets under management, but last year cut the expense ratio of its  S&P 500 SPDR (SPY) and some of its sector ETFs. Its  StreetTracks Gold (GLD) fund also was one of the most successful ETF launches ever. Vanguard now offers a family of ETFs with compelling costs and methodologies. And traditional fund families such as Fidelity Investments are making it harder to justify switching to ETF by cutting their traditional index fund expenses.

For now Barclays claims it feels no pressure to enter into a price war with Fidelity. Even with the cuts the  iShares S&P 500 Index (IVV) remains the cheapest index fund tracking that bogy. And even though Barclays doesn't price its fund at the level of their cost (as rival Vanguard does), iShares still are a pretty good deal with a weighted average expense ratio of about 0.30%.

To be sure, Barclays still sets the pace for the industry. Though growth in terms of new offerings will be slower in the future, the firm still plans to roll out more ETFs. It offers most flavors of equity funds several times over, but iShares hopes to expand its fixed-income lineup, which now consists of six funds. It also wants to extend ETFs to other asset classes such as real estate, energy, metals, and timber. Barclays is also interested in actively managed ETFs, which won't get regulatory approval as easily as equity funds. Each commodity, for example, has its own unique pricing and settlement issues to work out. If the approval process for iShares' recently launched gold fund is any indication, it could take years to secure the Securities and Exchange Commission's blessing. It's also not clear how an actively managed ETF would work or who would be interested in one.

In the end Barclays' may resemble McDonald's in another way. The restaurant's founder Ray Kroc once said, "I don't know what we'll be selling in the year 2000, I just know we want to be selling more of it than anyone else." There's a good chance that whatever ETFs are popular in the future, iShares will be selling a lot of them. That's a source of strength and concern. Many of Barclays' vast array of ETFs are good for the firm's business, but not necessarily good for the average investor's portfolio. An ill-considered bet on a single country or sector offering, for example, could do a lot of damage to one's wealth. The iShares family has a lot to offer, but investors don't have to buy everything Barclays is selling.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares.