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Exchange-Traded Funds Changes Needed

BOSTON - Exchange-traded funds are approaching their capacity, and the development of new types of exchange-traded products is going to be necessary to sustain growth, according to industry executives who spoke here earlier this month at the Performance Institute's 2001 Summit: Beyond Mutual Funds (assets have grown at an enormous rate over the past few years. Total ETF assets were less than $10 billion in 1997, but have passed the $80 billion mark this year).

Alternative products such as ETFs, separately managed accounts, and online customized baskets of securities, or folios,' have received a lot of attention recently as emerging threats to mutual fund assets. ETFs differ from the other two types of investments in that they are actually registered products, and therefore face legal restraints that the others do not, which in turn has yielded a similarity among ETF products, according to Gary Gastineau, a managing director at Nuveen Investments, who spoke at the conference.

In order to register an ETF, a firm must seek an exemptive order from the Securities and Exchange Commission because the funds rely on certain exemptions from provisions in the Investment Company Act of 1940. Consequently, the SEC reviews all applications for ETFs on an individual basis, making their registration more difficult than other types of products, according to Gastineau.

Thus most products available are all pretty similar, he said. "We're now reaching the point where, in order to innovate, we need to have some differences in the nature of the products in some significant ways."

One recent innovation is the concept of fixed-income ETFs. Thus far, ETFs have been based strictly on equity indices. However, both Nuveen and Barclays Global Investors have filed applications with the SEC for ETFs based on treasury indices.

Nuveen expects to launch its Fixed Income Trust Receipts, or FITRs, some time in the next couple of months, pending SEC approval. Barclays says it will launch sometime in the fourth quarter. Although SEC approval may take a little longer than with normal equity ETFs, Barclays does not expect to have any problems with its registration.

Also, developments with the indices themselves will lead to new ETFs, according to Gastineau. "I think we're also going to see a lot of new equity index ETFs," he said. "We're going to see a few indexes that are designed for ETFs specifically and they're going to be drastically different in a lot of ways, most of them pretty subtle."

Some of the differences of the new indices will be that they'll be structured in such a way that funds will be able to operate more efficiently, reducing transaction costs, and they will be compliant with Real Estate Investment Trusts and Undertakings for Collective Investment in Transferable Securities. That will allow those ETFs to avoid having portfolios that differ from the indices they track, according to Gastineau "The notion that you are using representative sampling to create a portfolio from an index that is not inherently REIT compliant simply doesn't work," he said. "You have tracking error, which is difficult to explain, it's unnecessary, and you'll find that, as a portfolio manager, you're going through a lot of steps which don't make any sense."

Domestic equity ETFs will probably not capture much more of the market than they already have. However, international ETFs have a lot of room to grow, Kevin McNally, a VP at Salomon Smith Barney, said another conference speaker. Offshore ETFs held more than $10 billion by the end of May, according to Strategic Insight of New York, and they continue to grow, said Geoffrey Bobroff, an investment consultant in East Greenwich, R.I.

"Until the SEC gets a little bit more comfortable with actively managed ETFs, and ETFs start to evolve from where they are today, you're not going to see that much in new assets flow into ETFs," McNally said.

With regard to actively managed ETFs, most industry executives agree that they are coming, but that it is difficult to know when. The SEC said that it is working on a concept release dealing with the issue. It was supposed to be released by the end of the summer, but will not be released now until a new chairman is officially appointed.

Another innovation that is on the horizon is leveraged ETFs, exchange-traded share classes in funds that issue both income and capital shares. ProFunds of Bethesda, Md. has an application filed with the SEC for eight such products, which are scheduled to be launched in the third quarter, pending SEC approval.

"I don't see any reason why the SEC would not approve an additional share class in a leveraged fund," said Gastineau. "They've probably thought it through pretty thoroughly at ProFunds and I think those funds will be available relatively soon. And I think they will be very attractive to some investors."

Beyond that, future innovation with ETFs is likely, although unclear, according to Gastineau. "I think there are a lot of additional things that people will come up with that none of us can even imagine at this stage," he said.