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Liquidity and Transparency Drive ETF Administration

Liquidity and Transparency

Assets in exchange-traded funds have nearly tripled in the past five years, from $302 billion at the end of 2005 to $819 billion at the beginning of this month. Year-to-date 2010 through August, investors have pulled $29 billion from traditional US equity mutual funds, while ETFs have seen $40.8 billion in inflows. Since risk aversion is rampant at present, what is driving this tremendous and curious interest in ETFs? Can this momentum continue to catapult ETFs to a second big wave of growth?

* Benjamin Fulton, Managing Director, Head of Global ETF Business, Invesco PowerShares

* Joseph Keenan, Managing Director, Global Financial Institutions, BNY Mellon Asset Servicing

* Jeffrey McCarthy, Director, Global ETF Product Head, Citi

* Kathleen Moriarty, Partner, Katten Muchin Rosenman

BNY Mellon and Citi sponsored the Sept. 10 event, which was moderated by Lee Barney, Editor of Money Management Executive.

Lee Barney: The $821 billion ETF industry is one of the brightest areas of mutual fund industry these days, particularly in fixed income, commodities, emerging markets and leveraged ETFs. What are you finding to be the big sellers among your clients right now, and what do you expect will resonate in the future?

Ben Fulton: In the last year, we have seen most of our flows going to fixed income, which itself has gone through an interesting transformation. Five years ago, a fixed income investment would have been primarily tied around the Lehman egg, or maybe even a 10-year note. Now, index providers have started creating a lot of unique indices, anything from emerging markets, to sovereign debt, to municipals and Build America Bonds.

Joe Keenan: There are a number of commodity products in single asset classes, such as gold, silver and other precious metals, along with other very targeted investments—all of which have high volatility. And some of those products have different tax treatments as well.

Jeffrey McCarthy: Across Citi, clients continue to express interest in fixed income ETFs, with the expectation that interest rates will rise. The other big areas is global products, with a lot of enthusiasm for emerging market frontiers, such as Columbia, which are rebounding and showing strong year-to-date returns.

As some of these frontier and emerging markets change, their regulations will allow more foreign investment into the markets, and we will see more access to products.

Kathleen Moriarty: The filings for future products we see are overwhelmingly for emerging markets and global commodities, and within that, fixed income.

Keenan: In tandem with that, there is now greater awareness of the volatility of the dollar as well. So we are starting to see products like emerging market fixed income products, that are both dollar-based, and local-currency based. However, investors need to be aware of the impact of the volatility of the foreign exchange market in addition to the rest of the markets.

McCarthy: Investors should also take into consideration the interest of money moving back into U.S. domestic. In the last 18 months, the banking and financial sector took a beating. It’s precisely the investments that were hit with tremendous outflows that will deliver potentially bigger returns as we move forward, as fund managers and then investors look to take advantage of these beaten-down stock prices.

Keenan: Clearly, there is a desire for a clean product among buy-and-hold investors. But there is also keen interest in the type of exposure that would allow an investor to very quickly take advantage of volatility, which is why we are seeing the introduction of products tied to the VIX, the volatility index, itself.

Institutions and sophisticated investors are now using ETFs not just as long-term investments but as trading tools.

Barney: But is the level of sophistication among investors - institutional investors, not just retail investors - keeping up with these increasingly complex designs?

McCarthy: Actually, no. I think ETFs have actually outpaced the sophistication of the investor. Some cannot appreciate the structural differences between a traditional ETF and a commodity, non-registered investment vehicle, in terms of the grantor trusts, the investment strategies or the heavy use of derivatives. Investors need to have a better understanding of how an ETF achieves its exposure, and how that affects its ultimate return when you go to liquidate your position. These finer points are still not brought up to investors, who clearly could benefit from more clarity and education.

Keenan: I would have to agree that baseline retail investors may not understand the nuances and the importance of bid/ask spreads and liquidity. However, the level of sophistication among RIA fee-based planners has absolutely changed. We have seen it directly at BNY Mellon.