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Exchange-Traded Funds Face Challenge

Some mutual fund companies may be about to take an "If you can't beat em, join em" approach to exchange-traded funds.

A handful of retail-oriented mutual fund companies are examining whether to begin offering exchange-traded funds, according to fund and securities industry executives and fund company consultants. The Vanguard Group of Malvern, Pa. is considering the possibility, John Demming, a company spokesperson, said last week.

At least two fund companies have made draft filings with the SEC on possible exchange-traded funds that would be similar to their open-end index funds, according to one securities industry executive. Kenneth Berman, associate director of the SEC, declined to comment.

All of this comes as exchange-traded funds are completing another year of robust growth. Exchange-traded funds are funds which track various market indexes and include such products as S&P Depositary receipts, known as spiders. They have increased in assets under management from $15.6 billion as of Dec. 31, 1998 to an estimated $27 billion now, according to Strategic Insight of New York, a mutual fund consulting firm, in a report this month. Exchange-traded funds had approximately $500 million in assets under management as of Dec. 31, 1993, according to Strategic Insight. Exchange-traded funds will generate roughly $7 billion in net sales this year, Strategic Insight estimated. That may only be the beginning.

"I think you're going to see the market (for exchange-traded funds) really take off in the next two to three years," said Gus Fleites, a principal at State Street Global Advisors of Boston who manages SSgA's exchange-traded funds. SSgA manages approximately $16.7 billion in assets in 11 domestic exchange-traded funds.

Fleites, securities industry executives and fund consultants see retail fund companies that offer open-end index funds as potential managers of exchange-traded funds. That is due in large part to concerns among retail investors about large unrealized capital gains in open-end index funds, executives said.

The exchange-traded funds, which redeem their shares using securities rather than cash, do not build up the unrealized capital gains of open-end funds, according to money management executives and consultants. Indeed, fund companies that offer open-end index funds seemingly have been slow to react to a potential competitive threat, some observers said.

"The [fund] industry has sold exchange-traded funds short," said Geoffrey Bobroff, president of Bobroff Consulting, a mutual fund consulting firm of East Greenwich, RI.

But, that may stop. Gary Gastineau, senior vice president for new product development for the American Stock Exchange, confirmed that several retail fund companies have approached the American Stock Exchange to consider development of exchange-traded funds in addition to their open-end index funds. He declined to identify the companies but said that they could file registration statements for the new products with the SEC by June 30.

Those efforts are in addition to steps that Barclays Global Investors of San Francisco has taken to offer at least 51 exchange-traded funds beginning next year, according to fund and securities executives.

Vanguard has not decided whether it will offer exchange-traded funds, Demming said.

The American Stock Exchange is investigating how companies may be able to offer actively-managed, exchange-traded funds, Gastineau said. Several hurdles must be overcome before such products can be offered, he said. He declined to identify the obstacles to offering exchange-traded, actively-managed funds. The funds will not be available before 2001, Gastineau said.