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Common touch

Retail investors represent the fastest-growing segment of the ETF market. That's good news for State Street -- and great news for its archrival, Barclays.

In the world of exchange-traded funds -- baskets of securities that trade as individual stocks -- those that track the Standard & Poor's 500 index and the Nasdaq 100 index have long been Nos. 1 and 2 in assets. That's not surprising: Both are popular with institutional investors, especially hedge funds that use ETFs as trading vehicles.

But in the second half of last year, the ETF that tracks the Nasdaq 100 fell from its second-place perch to third. It swapped places with the ETF that replicates the MSCI Europe, Australasia and Far East index.

What the ranking shuffle reflects is that retail investors have become the fastest-growing segment of the ETF market. ETFs that track international stock indexes hold special appeal for individual investors because they offer a simple, low-cost and tax-efficient way to buy often-hard-to-access overseas equities, which were among last year's best performers. Three of the six biggest ETFs now track international equity indexes.

To capture burgeoning retail demand, ETF purveyors -- overwhelmingly dominated by Barclays Global Investors and State Street Global Advisors -- have been expanding their sales forces, rolling out additional ETFs and forming strategic partnerships to make the funds a staple of portfolios designed by financial advisers, wire houses and insurance companies.

The stakes in this scramble for market share are especially high for State Street. After years of coasting on the success of its now-13-year-old ETF product, S&P SPDRs, nicknamed Spiders -- whose ubiquitous symbol is a daddy longlegs -- the firm finds itself struggling to catch up to Barclays.

"I wouldn't say [Barclays' success] has gone unnoticed," allows James Ross, who recently became co-head of State Street's adviser strategies unit, which handles relationships with financial advisers and markets ETFs, mutual funds and separately managed accounts. "State Street is placing "a significant focus on new product development," Ross says, noting that in addition to three ETFs in registration that follow S&P indexes tracking the bio-technology, semiconductor and homebuilding industries, the firm plans to roll out ETFs pegged to international equities, fixed income and commodities. They may also develop actively managed ETFs.

The success of Spiders enabled State Street to rank as the leading provider of ETFs through December 2001, when it had $35 billion in domestic ETF assets, about double Barclays' total. By the end of December 2005, the two firms had traded places: Barclays had about $171 billion in domestic ETF assets, compared with $85 billion for State Street, according to Boston-based consulting firm Financial Research Corp. "Barclays has just crushed State Street," says one analyst who declines to be identified.

Moreover, State Street faces an uphill struggle to reverse the trend. In 2005, Barclays' ETFs enjoyed net inflows of $44.6 billion, compared with State Street's $10.2 billion, according to the companies. By the end of 2005, State Street had 28 percent of domestically listed ETF assets; Barclays had a whopping 57 percent. Bank of New York's BNY Hamilton Funds had about a 10 percent share. The remaining 5 percent was split up among such firms as Fidelity Investments, PowerShares Capital Management and Vanguard Group.

It's no wonder the battle for ETF dollars among firms large and small has grown so intense. "ETFs are playing on the same field as mutual funds and in many places replacing them in core investment categories," points out David Haywood, Financial Research Corp.'s director of alternative-investment research. "That's where we're seeing the growth."

Analysts reckon that independent financial advisers bring in 30 percent of ETF inflows, at least double what they did three years ago. One factor driving the trend is an increase in the proportion of the average adviser's compensation now generated by fee-only products -- one third, compared with 20 percent in 2000. For advisers who don't take sales commissions, there's no disincentive to push no-load ETFs. Although fees on broad index funds and comparable ETFs are similar, expense ratios for ETFs that invest in sectors of the market remain far below those of open-ended sector mutual funds. According to a Lipper report issued in October, the average asset-weighted expense ratio of sector ETFs was 0.39 percent, compared with 1.09 percent for comparable mutual funds.

In 2001, St. Louis­based A.G. Edwards & Sons began selling ETFs, including actively managed ETF-only portfolios. "They're probably our most rapidly growing program," says Michael Scafati, a senior vice president in charge of marketing managed investment products. "Brokers like the fact that they're an easy way to get diversification."

Domestic ETF assets have mushroomed from $1 billion ten years ago to $301 billion at the end of 2005. Net inflows totaled $53.7 billion in 2005, compared with $56.3 billion in 2004, according to Financial Research Corp. The consulting firm projects that net sales of ETFs will grow at a compound annual rate of 32 percent between 2006 and 2010, boosting total assets under management to more than $1 trillion. The consulting firm expects annual growth of 6 percent for mutual funds and 17 percent for hedge funds. To be sure, mutual and hedge fund assets remain much larger, with 2005 totals estimated at $5.8 trillion and $1.2 trillion, respectively. FRC projects respective assets of $9.5 trillion and $2.7 trillion for 2010.

ETF providers like State Street and Barclays make money primarily through asset-management fees, which typically range from 9 basis points for an S&P 500­linked ETF to 75 basis points for one tracking an emerging-markets index. (Unlike most other investment products, ETFs charge institutions and individuals the same fees.) Because the vast majority of ETFs simply replicate passive investment strategies, economies of scale help big indexers earn operating margins of more than 50 percent, says Paul Mazzilli, executive director of ETF research at Morgan Stanley & Co.

Such lucrative spreads underlie the State Street­Barclays ETF rivalry. State Street, in a conspicuous changing of the guard in August, named Ross and Greg Ehret co-heads of the firm's adviser strategy unit. The pair replaced Agustin Fleites, an 18-year State Street veteran who is now CIO of Bethesda, Maryland­based ProFund Advisors, which plans to enter the ETF business. (Fleites declines to comment on why he left State Street.) Ross played a major role in the successful development of State Street's gold ETF, known as StreetTracks Gold Shares, the first commodity-based ETF in the U.S. The ETF, which launched in November 2004, reeled in $1.2 billion in assets in a week; at the end of 2005 it had assets of $4.3 billion.

To broaden its lineup and thereby appeal to both individual and institutional investors, State Street in November introduced nine new ETFs, bringing its global total to 56, including 24 listed overseas. One of these is aimed squarely at retail investors: It tracks the S&P High Yield Dividend Aristocrats index, launched in November, which captures the performance of the 50 highest-dividend-yielding stocks that have boosted their dividends annually for the past 25 years. The other eight new ETFs, which track subsectors of the U.S. equity market, are likely to attract interest primarily from institutions wishing to fine-tune or hedge their asset allocations.

"State Street had gotten lazy on product development, but the new team has put out some good products, notably the high-dividend ETF," says Morgan Stanley's Mazzilli.

Compared with Barclays, State Street has placed a greater emphasis on developing its global ETF business, particularly in Asia. In December 2004, State Street launched the first ETF in China; it tracks the Shanghai 50 index and is listed on the Hong Kong Stock Exchange. The firm also plans to launch ETFs in other overseas markets this year.

Worldwide, though, Barclays sponsors 145 ETFs, compared with State Street's 56 -- and it remains better positioned to capitalize on the growth of the funds among individual investors.

"When the firm introduced ETFs in 1996, we viewed them as just another institutional product," says James Parsons, who heads global ETF sales at Barclays. "But in 2000 we rebranded our ETFs as IShares and saw the real growth in the intermediated retail space." Assets of Barclays' ETFs remain equally split among individual and institutional investors, but about two thirds of new money now comes from individuals.

One of Barclays' advantages in the retail marketplace: a sales force that focuses exclusively on selling ETFs to financial intermediaries. "Barclays' sales force is selling only ETFs, but State Street is also selling actively managed products that are more lucrative," notes Mazzilli. State Street's Ross counters that, rather than diluting its effort, its "holistic approach is a competitive advantage," one that better serves the vast majority of financial advisers.

To strengthen the SPDR brand, State Street has acquired licensing rights from the American Stock Exchange for the use of certain trademarks of S&P and Dow Jones & Co. The exchange and PDR Services, a unit of Amex, had previously held these licensing rights for ETFs.

Says Morgan Stanley's Mazzilli, "State Street can maintain or increase its market share if it can figure out how to leverage its SPDR brand of S&P index­ related ETFs." But how far do the legs of a spider reach?