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Challenges Seen in Exchange Fund Growth

NEW YORK - While exchange-traded funds are expected to grow rapidly in the near future, their growth will be hampered by numerous obstacles.

To be competitive and overcome a number of potential weaknesses, exchange-traded funds will have to be carefully designed, said engineers and pioneers of these products at conferences here last week.

One of the chief criticisms of exchange-traded funds has been the fact that their net asset values can waver from the prices of the funds' baskets as they trade on exchanges, said executives at a conference sponsored by the Institute for International Research of New York.

Exchange-traded funds' net asset values do trade at premiums or discounts but arbitrageurs who see these price discrepancies eliminate any differences by trading on them, executives said.

"Arbitrage transactions are meant to keep markets in line," said Daniel McCabe, head of program trading and index arbitrage for Bear Hunter Specialists of New York. "There are so many specialists looking for any price differentiation that the spreads on some of these products, especially the QQQs, are not only thin but are so infinitesimal that they're just not there anymore."

Premiums and discounts on exchange-traded funds have not been wide, said Kevin McNally, an analyst with Salomon Smith Barney of New York. They have averaged no more than ten to 20 basis points. The highest premium on an ask that Salomon Smith Barney has tracked has been 1.01 percent and the widest discount on the bid has been 1.17 percent, McNally said.

However, there is a problem with posting a net asset value for an exchange-traded fund if the last trade of the fund on any given day is made well before the end of trading, said Nate Most, chairman of the board and president of the iShares Trust of Barclays Global Investors of San Francisco. Under these circumstances, the value of the basket could be substantially different than the value at the end of the day. Most invented Spiders, the first form of exchange-traded funds, in 1993, while he was senior vice president for new products with the American Stock Exchange.

Most spoke at a seminar on exchange-traded funds sponsored by Barclays early last week.

While the net-asset value can vary from the price of the basket at any given moment, traders readily see those price discrepancies and are quick to trade on them, Most said.

Each of the exchange-traded funds currently on the market have between five and 20 broker/dealers who serve as market-makers for the funds, McCabe said. QQQ's, or Qubes, the most heavily-traded of the exchange-traded funds, has 20 market makers, McCabe said.

Discussion of the intense interest among arbitrageurs to take advantage of even the slightest price discrepancies on exchange-traded funds led to discussion of another issue of particular interest to regulators - that they are thinly traded. Regulators are concerned that thin trading in the funds could widen discounts and preminiums to net-asset value, speakers said.

There are several constituencies for exchange-traded funds, executives said. While some said that retail investors are the primary market for exchange-traded funds, others said it was institutional investors. Still others said it will be broker/dealers who will be the major consumers of exchange-traded funds, especially because they can be arbitraged and used to hedge.

If all these groups show strong interest in the product, it will most certainly sell strongly, executives said.

The American Stock Exchange and the Chicago Stock Exchange soon will not be the only exchanges trading these funds, said McNally of Salomon Smith Barney. By year-end, the funds will be traded on the Chicago Board Options Exchange and the New York Stock Exchange as well, he said.

Another criticism that has been made of exchange-traded funds is that in some countries, a customer gets capital gains distributions rather than in-kind stocks when he redeems, Most said. This is because some countries - including Taiwan, Malaysia and Brazil - prohibit in-kind redemptions, he said.

It is also difficult to avoid capital gains for investments in countries dominated by "a few stocks of large companies with large capital gains," he said.

"So, we have to do some trimming,"

he said.

Currently, there are 69 exchange-traded funds on the market and another 15 awaiting SEC approval, said Lee Kranefuss, chief executive officer for individual investor business at Barclays Global Investors.

Other types of exchange-traded funds - actively-managed, fixed-income, leveraged and specially-devised index exchange-traded funds - are also being designed, speakers said. (MFMN 8/14/00)

This will soon lead to an explosion of exchange-traded funds on the market, speakers said.

In offering 56 of the current 69 total exchange funds on the market, Barclays hopes it has developed products that cover all the market sectors, said Most.