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Exchange-Traded Funds Threat Downplayed

Greg Ehret is principal with the exchange-traded funds division of State Street Global Advisors of Boston. Ehret recently discussed the growing popularity of exchange-traded funds, some of their advantages and drawbacks, and their future in the industry with Mutual Fund Market News reporter, Andrew Brent. An edited account of their conversation follows.

MFMN: What sparked the relatively sudden growth of exchange-traded funds? They have been available since 1993, so what has changed?

Ehret: There are a number of factors. First, the performance of benchmark indices has been very good. And by virtue of getting that better performance, people have gotten more excited about index funds in general, seeing as how a lot of index funds have taken in decent amounts. As people are switching to indexing in their portfolios, ETFs seem to be a natural progression. I think secondly, the QQQ, [the Nasdaq-100 Index Trading Stock offered by Barclays Global Investors of London], helped add to the excitement behind the whole concept because it did such incredible trading volumes, because again, as a benchmark index, it returned something like over 100 percent in one year. So that kind of return said, Oh, wait a second. You can actually make money with index funds.' Thirdly, the proliferation of a number of different new entrants and new indexes in the past year and a half has raised education on the product, and by virtue of that, the product as a whole has reaped the rewards of that broader education base.

MFMN: Are exchange-traded funds competing with mutual funds for assets, especially, as you indicated, index funds, or are those assets coming from another investment segment?

Ehret: They are a separate asset class in that they do provide a trading vehicle and proxy for people using futures contracts. In other words, they provide another way of gaining exposure to market segments similar to the way futures contracts do. So [to] that extent, they compete with the futures market.

But secondly, I think they do compete with index mutual funds as another alternative to gaining index exposure. I don't see them competing with traditional mutual funds on the active side because today there aren't any active ETFs.

MFMN: How well are exchange-traded funds tracking their respective indices? Is there any difference in tracking error between exchange-traded and index funds?

Ehret: The tracking error is comparable, the big difference between ETFs and a typical index fund is the cap gains piece....[Investors are] charged to come into the [ETFs] so the other holders of the fund won't be basically paying to transact for that inflow. With a traditional index mutual fund, the holders are always paying for the investments of others, so the long-term buy and hold investor is paying for cash inflows into the fund. With an ETF, that does not happen because all subscriptions and redemptions are done in-kind and most retail buyers are buying them on the secondary market on the exchange. So transaction costs are really born by the subscriber, and that's a big plus. You really get true index exposure from an ETF. The second piece is that because all the transaction activity of an ETF is on a secondary market, none of those transactions actually affect the trust... therefore we don't have the same buying and selling to meet redemption requests, which would cause a capital gain. So, I think, especially in a down market when people are redeeming, they don't like to see a capital gain distribution in a year when they actually lose money.

MFMN: What are the obstacles to bringing out exchange-traded funds in Europe? Have they had success?

Ehret: There's a bunch of stuff out there currently, and they've had some success. [The importance of] education there is obviously huge because they haven't had a product around since 1993, first of all, so they can't really go back on track record with education.

Secondly, one of the problems with Europe is that to settle a basket appropriately is very challenging because you have many different settlement systems since you're dealing on a cross-border basis. We're launching 15 funds in Europe. We're really paying heed to the fact that operationally, it has to work as smoothly and efficiently as possible, and we're spending some extra time trying to work through that specific issue.

MFMN: Will actively-managed exchange-traded funds realistically be offered anytime soon in the U.S. as some suggest? What are the obstacles there?

Ehret: I don't think they'll be offered soon. There are a number of hurdles, both regulatory and from the structural perspective, that need to be addressed before you can actually offer an ETF that's actively managed... Things need to be sorted out in the way the SEC views exchange-traded funds, particularly an active exchange-traded fund. From an ETF provider perspective, the asset manager has to get comfortable with the transparency issues with an exchange-traded fund in particular. And, you really have to find a strategy that befits an exchange-traded-fund, in other words having liquid securities, low turnover, and things of that nature.

MFMN: If the development of actively-managed exchange-traded funds is not the next direction exchange-traded funds will take, what is? Do you think they will maintain their current popularity?

Ehret: I think they'll stay popular and will get increasingly popular. I think they are the best way for individual investors to gain access to the tools that only institutional investors had up until this point. In other words, the whole concept of doing core-satellite portfolios, which institutions have been employing for years, is really much easier to implement now with the advent of the ETF.