From perplexed, to pioneer

During the 1987 market crash, 26-year-old Lee Kranefuss had a good chunk of his savings in an S&P 500 fund. When he couldn't take the anxiety of the market plunge any longer, he raced across Boston to the nearest Fidelity Investments branch to sell his shares. But when a representative there told him that he wouldn't know the selling price until the end of the day, Mr. Kranefuss was perplexed. “I asked, "Can't I just sell my shares to someone else?' And she explained how net asset values work and that I would know at 4 p.m.,” Mr. Kranefuss said. “All I could think about was, "Could you imagine going to a car dealer and asking how much a car is, and having the dealer tell you they would price all the parts and tell you at the end of the day?' It seemed ridiculous.” A decade later, Mr. Kranefuss solved this problem. In 1997, he joined Barclays Global Investors and spearheaded the development and launch of iShares, the first retail exchange-traded funds in the United States. Like mutual funds, these investment vehicles are composed of a basket of securities, but unlike mutual funds, they trade on exchanges like stocks. BGI, which was bought last year by BlackRock Inc., has 463 ETFs and manages $580 billion in assets.

ABILITY TO FOCUS

Those who know Mr. Kranefuss, now 49, attribute a large part of iShares' success to his intellectual curiosity and ability to focus on specific topics. “He is a guy who likes the business for the intellectual challenge,” said Don Phillips, director of research at Morningstar Inc. “He saw this opportunity and he was part of this big conservative bank, and somehow he managed to get them to embrace this idea.” Mr. Kranefuss initially worked as a consultant with Boston Consulting Group, which was doing contract work for BGI. But he jumped to BGI when it recognized it needed someone full time to help it develop its presence beyond being an institutional equity index shop. “The gaping hole was retail, particularly in the United States,” said Mr. Kranefuss, who started at BGI as director of strategy and corporate development. Originally, Barclays considered buying a mutual fund company to get into the retail area. “But it was the late "90s, and premiums were outrageous,” Mr. Kranefuss said. Recalling his issue with mutual funds 10 years earlier, he saw an opportunity to go retail by expanding BGI's presence in the ETF space. At the time, the only ETFs available in the United States were institutional. BGI acted as an adviser to the World Equity Benchmark Shares, or WEBS, which were 17 institutional ETFs that tracked MSCI country indexes distributed by what is now Morgan Stanley Smith Barney LLC. “It looked like an untapped opportunity that would fill the gap in our corporate strategy,” Mr. Kranefuss said. “Even if a lot of money was spent on developing it, it was cheaper than acquiring a fund company.” That isn't to say that senior managers at Barclays didn't have concerns. Mr. Kranefuss said they wanted to know that if his idea was so good, “why hasn't anyone ever done it before? And that was a question I had to ask myself: What were the barriers of entry?” It became clear early on that education was going to be the primary challenge. In focus groups before the launch of iShares, Mr. Kranefuss recalls how brokers couldn't understand the concept because it just didn't exist. In 2000, iShares launched 38 iShares funds and converted the WEBS to iShares MSCI Funds, creating the first family of retail ETFs. Mr. Kranefuss, who was chief executive of iShares at the time of the launch, decided that the firm's educational focus had to be on the benefits of ETFs, not on iShares alone. “Our philosophy was to try to build the ETF industry because we would get our fair share of it,” he said. “We knew we would probably also sell some of our competitors' products, but that was OK as long as we got a reasonable slice of the business.” The first few years after iShares' launch, Mr. Kranefuss, who lived in San Francisco where BGI was based, was in New York every other week, speaking at industry conferences, talking to the exchanges and index providers, and meeting with broker-dealers. “They would go into broker-dealer offices and would be dismissed,” said one BGI official, who asked not to be identified. Mr. Kranefuss likens the initial reaction to ETFs to the way people responded to electric lights. At that time, gas lighting was the norm, but one that held its own dangers. “Many people came home and were killed because they left the light on and the room would fill with gas, and they would light a match, and blow up and die. When electricity was created, people thought, "Am I going to blow up when the light bulb blows out?” Mr. Kranefuss said. The mutual fund market-timing scandal of 2003 proved to be a boost for ETFs, and iShares in particular. Eliot Spitzer, New York state's attorney general at the time, and the Securities and Exchange Commission charged a number of fund companies with allowing favored clients to trade in and out of their funds at the expense of smaller, long-term investors. “For the past few years, I had been talking about how ETFs, unlike mutual funds, don't have this issue of trading within the fund, but people were having a hard time understanding what I was talking about,” Mr. Kranefuss said. “Then the market timing scandals happened and everyone said, "Oh, I get it.'” Total U.S. ETF assets jumped 68% to $220.7 billion from the end of 2003 to the end of 2004, according to BlackRock. As of Sept. 30, there was $797.2 billion in U.S. ETFs and 890 ETFs in existence, according to BlackRock. That is a few too many, Mr. Kranefuss said.

RIPE FOR CONSOLIDATION

“There is something like 30 ETF providers in the U.S., and many of them are very small and just trying to cover a niche for themselves,” he said. “The industry seems crowded and ripe for some consolidation.” As for the actively managed ETF strategies that have come to market over the past few years, Mr. Kranefuss has his doubts. “It seems like a lot of firms are launching these active strategies as ETFs because no one would buy them as mutual funds,” he said. “They want to grab the sizzle associated with ETFs.” Still, Mr. Kranefuss does think that active ETFs have a place in the market because they will make these kinds of strategies available to the masses. “You don't have to open an account with a firm to buy an active ETF like you do with a mutual fund,” he said. These days Mr. Kranefuss, who stepped down as president and CEO of iShares in April following its acquisition by BlackRock, is thinking a lot about how to tie together his two passions: sustainability and investing. “A lot of people view sustainability as a political issue, and that it's the right thing to do,” Mr. Kranefuss said. “I tend to look at it as the right way to make money.” Although Mr. Kranefuss is ex-ploring investing ventures in-volving sustainability, he is also working on a side project on how he can drill down and use the earth's warmth to heat his home in Mill Valley, Calif., where he lives with his wife and three kids. The concept is simple, he said, but getting all of the permits is an ordeal. “My life seems to revolve around things that make perfect sense, and should get done, but the world isn't aligned to get them done,” Mr. Kranefuss said. E-mail Jessica Toonkel at jtoonkel@investmentnews.com.