Should State Street Worry About ETF Outflows?

The U.S. equity market has been quite volatile in 2014, with the S&P 500 index sinking from around 1800 at the beginning of the year to below 1750 in early February, only to scale record highs late last week. While one would expect these changes in equity market sentiment to impact the demand for equity-based exchange traded funds (ETFs), the trend displayed by the country’s largest ETF – State Street’s (NYSE:STT) SPDR S&P 500 – tells a different story altogether.

The SPDR S&P 500 has seen outflows of almost $18 billion for the first ten weeks of 2014 – undoing the growth the popular ETF saw in 2013, with $16 billion in inflows. ^[1] A bulk of these outflows came in the first week of February, which saw investors redeem almost $11 billion. ^[2] This was a direct result of the Fed’s decision to taper its asset purchases for a second consecutive month in February. ^[3] Although investors dumped the SPDR S&P 500 when the market began its slide, the trend did not reverse once the market began its recovery a few weeks later.

While a decline in demand for equity ETFs has been seen across the industry and is beyond State Street’s control, we believe that there is one factor that is working against the SPDR S&P 500 – its expense ratio – and it might need to be addressed by the asset management giant.

We maintain a $78 price estimate for State Street’s stock, which is about 15% ahead of the current market price.

See our full analysis for State Street

Equity ETFs Have Fallen Out Of Favor

With a lukewarm start to the year, the asset management industry demonstrated a shift in preference among investors for debt products compared to equity products in early February. This is demonstrated by the fact that global equity-based funds reported outflows of more than $28 billion in the first week of February. ^[4] U.S.-based equity ETFs were responsible for a bulk of these outflows at just over $22 billion. ^[2]  At the same time, taxable bond funds reported record weekly inflows of just under $11 billion for the same period. The switch can be largely attributed to growing concerns among investors that the Fed’s tapering plan is likely to negatively impact global equity markets, while the resulting interest rate improvement will boost debt market yields.

State Street’s SPDR S&P 500 Also Has Cheaper Alternatives

The SPDR S&P 500 is the largest ETF in the country with about $160 billion in assets under management. While equity ETFs suffered large outflows in February, almost all of them also began to add new assets once the equity market began improving in mid-February. However, the SPDR S&P 500 has seen its asset base remain nearly constant since then, even though the S&P 500 climbed to record highs.

The biggest reason for this is likely the lower expense ratios offered by competitors BlackRock (NYSE:BLK) and Vanguard for their own ETFs that track the S&P 500. While all three ETFs offer near-identical returns, the SPDR S&P 500 has an expense ratio of 9 basis points (0.09%) compared to 7 basis points (0.07%) for BlackRock’s iShares Core S&P 500 and 5 basis points (0.05%) for Vanguard’s S&P 500 ETF. Therefore, we expect that investors who redeemed their SPDR S&P 500 ETF investments earlier in the year – and who decided to reinvest when market conditions improved – likely picked one of the more cost-effective alternatives.

This brings us to an important question – what does this mean for State Street’s share price? While a reduction in ETF assets for State Street undoubtedly points to a reduction in overall value for the bank, the impact is not particularly sizable. This is because State Street’s primary source of value is its custody banking business, which accounts for almost half of its share value as shown in the chart above. In fact, State Street’s entire asset management business contributes just over 10% of its total value.

You can understand this fact by making changes to the chart below, which captures the assets under management for State Street’s ETFs. Assuming that these assets remain at the current level for the rest of the future – a very pessimistic outlook – the reduction in share value is still less than 2%.

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1. Investors pull $18bn from biggest US ETF, Financial Times, Mar 10 2014 [↩]
2. US taxable bond funds see record net $10.7 bln inflows -Lipper, Reuters, Feb 6 2014 [↩] [↩]
3. Federal Reserve issues FOMC statement, Federal Reserve Press Releases, Jan 29 2014 [↩]
4. Stock funds worldwide post record $28.3 bln outflow – BofA, Reuters, Feb 7 2014 [↩]