ETF Roundtable transcript

The following is an edited transcript of the round-table discussion. It was moderated by InvestmentNews deputy editor Evan Cooper and reporter David Hoffman. InvestmentNews: What will be the big issues for the ETF business over the next year? Mr. Archard: I feel very strongly there's still going to be growth coming in the industry. I think year over year, we've seen continued adoption and new entrants into the market. We used to see a client using two or three key products, and now they're spreading out into more aspects of a portfolio. We're seeing ETFs being used in different types of wrappers as an underlying investment. All of that is going to accelerate next year. On the fringes of the ETF business, I think there's still some regulatory confusion that needs to be hammered out. Mr. Ross: I completely agree that the growth of the product line will continue. I think you'll see more people adopting and using ETFs in more ways than they have in the past. The competitive landscape will continue to change. We'll continue to see entrants into this marketplace and more competition for the share of wealth that's out there, which makes complete sense. From a product standpoint, one area would be fixed income. Then I think there'll be more use of ETFs as underlying products, and potentially suites of ETFs to get to different asset classes and different objectives for investors. You'll see continued scrutiny of ETFs across the board from a regulatory standpoint, and also from a media perspective. It all comes down to the industry having to continue to educate investors. Ms. Papariello: Retail ownership of ETFs in 2000 was under 30%; today it's well over 50%. That, in and of itself, will be a significant influence in 2010 for regulators and product providers. If you look at the entire ETF industry, 50% of the products today are what we would consider niche, subsector, leveraged or inverse. That, against the trend of growing retail ownership, will be cause for some concern and cause for some opportunity. At a minimum, there will be much more emphasis on education and making sure buyers understand what they're considering using. Mr. Resnick: I think for 2010, you'll continue to see product innovation. You'll continue to see a greater adoption of users and more disclosure. On the distributor side, I think you'll see more due diligence. And you will continue to see more packaged products.
Mr. McRedmond: If you really think about what is at the ETF's core, it's really just a delivery vehicle for some type of an investment. It certainly has greatly evolved, but I think it will continue to serve that role and in 2010 probably provide access to more unique areas. I don't necessarily see that it's a huge market for an individual investor. Those are tools to be used more by professional investors. We're hearing more, from a distributor's standpoint, that it's not OK to make a new ETF freely available to our advisers. There's scrutiny being put on distributors to make sure that they have taken a look at these before simply turning it loose to advisers to use. Mr. Magoon: I think 2010 has the potential to be a banner, signature year for ETFs. There are a variety of new entrants, be it a [Pacific Investment Management Co. LLC] or [The Charles Schwab Corp.], for which 2010 will be their first full year. We've also got some acquisitions that have happened in the ETF space, either with iShares or even our firm, Claymore. So that's going to really flesh itself out in 2010. I think there'll be more consolidations of sponsors and products. In a higher-volatility market with higher taxes and lower returns, the efficiency and the transparency and the flexibility of ETFs really stands out. So if you can be tax-efficient, if you can have lower fees than many other packaged products, if you can be transparent in terms of your holdings and if you have the flexibility of intraday liquidity, I think that sets ETFs up for a unique value proposition in 2010. InvestmentNews: What are your thoughts about some of the challenges that ETFs face? Mr. Archard: At the end of 2008, ETFs were tested, and they came through beautifully. We've seen these spikes in growth in the ETF markets after each one of these sorts of bumps, whether they were market-driven bumps or industry-driven bumps, and ETFs did what they were supposed to do — provide liquid, transparent access to the markets. Some of the products were misunderstood in the marketplace, and that caused a bit of this fallout. So the challenge is really going to be making sure the education is there and that the core product set continues to be robustly used. When you look at commodities, it's about 10% of the ETF market. When you look at sectors and subsectors, it's about 12% of the ETF market. These are not the core holdings of most ETF users, and that's what we really have to focus on — making people understand how core products work versus the niche products. Mr. Ross: Making sure people do understand the difference between a commodities ETF, based on futures, and a commodities ETF, based on physical underlying, versus leveraged and inverse, and when they are appropriate and when they may not be. It's a $700 billion industry. If you threw in all the commodities and all the leveraged and inverse products together, it's probably less than 10% in total. So the core products, which are well-understood and have the core benefits that ETFs have had for years, get lost because they're not as sexy anymore. InvestmentNews: What are your firms doing to educate advisers on ETF issues?
Ms. Papariello: We've seen real change in what advisers are looking for, certainly from Vanguard. Advisers who understand the product and consider it against competing choices now are looking for additional assistance on how to engage their clients in a more meaningful discussion that's not just about the performance of a product but more around planning and goals. At Vanguard, we realize we have to do things that are more unique for advisers. It's not just simply re-purposing messages that we've had for other markets. So like many other firms, we're devoting a lot of resources to making sure we reach out creatively, whether it's thought leadership or primary research done at Vanguard, or providing access to the experts at Vanguard, whether through webinars or live events. And we need to continue to get more creative in the deployment of them, because the clients have a lot of noise to contend with. How do they decide who they want to listen to? InvestmentNews: What can advisers expect from your firms in the way of education? Mr. Magoon: Well, we have a variety of white papers that try to delve deeper into certain topics, and one of the issues that many people seem to be very concerned about is the structure of the ETF. Is it a commodity pool, or is it a traditional [Investment Company Act of 1940] product, or is it a [Securities Act of 1933] product? What are the tax consequences of that structure? What about trading an ETF? What are the best practices? What do you need to look at before you purchase an ETF? There are a variety of specific topics that you can really get into. So we're going to continue to do things like webinars and white papers. We all have specialist teams either in the field or accessible via phone that actually can get into these subjects very, very deeply. Mr. McRedmond: I think the topic of education is a huge one. For the last few years, we've been doing our PowerShares University events around the country. I think we'll probably do 12 to 15 of them in 2010. It's amazing and frustrating when you go around to conferences that, 16 or so years in, there's still a lack of understanding and a lot of work to be done on that educational front, even on basic topics of ETF tax efficiency, and ETF trading and liquidity. What we try to hammer home is that you need to look under the hood, because not all the indexes and ETFs are created equal and the different biases that are built into the index construction methodologies can mean night-and-day differences in performance. If you look at a broad technology sector ETF or a broad utility sector ETF, of which there might be five or six, there might be a 1,000-basis-point difference in performance between the best and worst performers over the last 12 to 18 months. And it all goes back to the index-construction methodology — is it cap-weighted, equal-weighted, modified, more of a total market with some small- and mid-cap? Even some of the leveraged products are constructed differently — daily reset, monthly reset? People really need to understand these things. Mr. Resnick: We will continue to educate at the product level. There's been so much that the marketplace has had to digest and assimilate over the last several years. As an industry, we've got to continue to innovate products, but at the same time, to make sure that we don't get too far ahead of ourselves. Keep things simple. So you'll continue to see us educate more from a risk management/asset allocation perspective with white papers and educational brochures. Mr. Ross: We launched [SPDR University] midway through last year. It is a separate educational portal accessible only by advisers who register. The key that we focus on is portfolio construction. We want to help financial advisers with their practices and really build good will. Does the SPDR you have [have] the requisite product application? Does it have portfolio construction and thought leadership? But we've really built out a segment of it that is more toward helping financial advisers build their businesses. InvestmentNews: What are your thoughts on Schwab's getting into the market with commission-free ETFs? Ms. Papariello: One, it's not surprising at all that Schwab's made this move. I think it remains to be seen how successful they can be, given the indexes they have chosen. They have had traditional index mutual funds with some limited success in attracting assets to those products, because they're competing against the brand of the underlying index. So I think that's a head wind for them. From a commission standpoint, there's been commission compression going on in the industry for years. People have been predicting zero commissions' coming soon. When that happens, I don't know. I wouldn't have said that 2009 would be the year, given all the other factors. But will it come eventually? It's quite possible. So it's a bold move on their part, and it's going to attract some attention. The bigger thing will be the attractiveness of the underlying indexes and their ability to attract assets to those. I think also the fee structure ought to be given some attention. How have they been able to come out with the very competitive fees that they have? How sustainable are they? The other thing worth noting is, there are 12(b)-1s not activated, but possible, on these products. That's an interesting question overall for the ETF industry, because those are not the only products that have 12(b)-1s as a possibility, yet not activated at the moment. Mr. Magoon: I think it's a fantastic event for the ETF business, because it potentially could compress the trading fees on all of our exchange-traded funds and in the whole industry, and I think that's fantastic. However, not paying $9 for a trade doesn't really take into account the full picture of what it costs when you buy an ETF, when you might have one index that outperforms another index in the same sector by, say, 1,000 basis points. So it's a great way to generate publicity, and it should benefit all of the firms if many of the broker-dealers reconsider how they're going to price some of their ETF trading. But I think in the long term, it's going to boil down to the indexes, the fees, the spreads and other factors to calculate the total cost of ownership of ETFs. Mr. Archard: It comes down to the whole experience, and I think advisers are pretty savvy at scoping out what they're getting out of the various relationships. We have a whole series that looks at practice management, iShares on Campus, where we invite them to listen to some of the best professors at Harvard, Stanford and University of Chicago talk about people issues and how to position your firm strategically. We have a team that looks at how to position ETFs within the portfolios. We do one-on-one match-ups with an adviser for their firm. We have another team that talks about something as fundamental as trading ETFs. Ms. Papariello: Do you believe that a major target audience for this move is retail direct shareholders? Mr. Magoon: It's a slippery slope because maybe retail investors aren't as sophisticated and might assume that, “Oh boy, I don't have to pay $9,” but don't understand all the other trades. So there's a lot of information and dynamics in the marketplace, but not a lot of wisdom. The industry has to be careful to not go down that certain slippery slope. Mr. McRedmond: Ultimately, it comes down to the total return you're taking out after everything else is taken into account. The spread, the commission, the return of the underlying product all have to be taken into account. The first place I worked at was Schwab, and I would not underestimate them for a minute. I believe they will be a tough competitor. They're a pretty savvy organization. But I think their focus would seem to be more toward the self-directed, the registered investment adviser. Obviously, they're a huge custodian of RIAs. So they certainly have a lot of data they can mine. Mr. Archard: We know there's no free lunch. So if you're giving up commissions here and you have a low-margin product there, are you going to fund the support that you need to really educate a direct retail push? I think that's what remains to be seen. Mr. McRedmond: It's very smart on their part; got a lot of press. But if you really think through it, the reality is, they're still making money on those trades, because in all likelihood, I would assume, they are somehow being paid for directed order flow. That's certainly something that goes on in that world. So even though they're not charging any commission, they may well be getting something somewhere. So they're still making money on it, in all likelihood. InvestmentNews: Might this accelerate the trend of commission compression? Ms. Papariello: Commission compression has been happening. That's a fact. And there's been talk in the brokerage industry for years that we're ultimately going to get to zero. Now Schwab is going to zero on a small set of products. Let's keep perspective on this move. It's how many ETFs? Mr. Archard: Four. Ms. Papariello: So it's four products. So the whole world hasn't gone to zero commissions. I don't want that to be the headline. But I just think it will give people in the brokerage industry pause, because to have someone take that step isn't necessarily a comfortable thing, even if it is just a very small step with just four products. InvestmentNews: Do you think that the questions surrounding the leveraged and commodities ETFs are going to be resolved? Mr. Resnick: Sure. I think what you're seeing to help resolve a lot of these questions is enhanced disclosure within the prospectus and the marketing materials, as well as enhanced education material. You have also seen more scrutiny and due diligence at distributors. So I think that it has actually been a benefit to the overall ETF industry. As an industry, we are concerned that there's going to be some sort of product development that just tags the industry as a whole. And so what it has created is more disclosure, more education. There's still speculation as to what's going to happen relative to the commodity perspective. But it's continued disclosure, continued education. I give Schwab credit for what they're trying to do, but when all of a sudden, you talk about no commissions, is that what we want to be promoting within the industry? We've talked about risk management, portfolio construction, asset allocation. That's where you're going to see a greater need and use of exchange-traded products. Mr. McRedmond: Something I thought that was very interesting and insightful was a piece from Scott Burns, Morningstar [Inc.'s] director of ETF research. He talked about the idea, as it relates to the leveraged and inverse products, of more education, training and licensing for advisers who use those products, something along the lines of what currently exists for options. Mr. Archard: Or margin accounts. Mr. McRedmond: Yes, all those types of things. So at least it's been brought to the client's attention, and hopefully, they've read it and understood it. I think that makes a lot of sense. There should be more checks and balances, and these people who are using the products have at least acknowledged that they understand or think they understand what it's about. InvestmentNews: That speaks to the leveraged and inverse, but what about the commodities? Mr. Archard: The demand for commodity products is undeniable. We get that from advisers. We get that from institutions. They want diversification, and they want the inflation protection. You have to split that between the future-based versus the in-kind product set. With the future-based, the regulatory bodies are just questioning the effect of the investment on that underlying commodity, particularly in those that you can burn or eat. The logical thing is to do what the regulatory bodies are doing. Step back. Review it. And part of that education process has got to be us, as sponsors, helping to educate the regulators. InvestmentNews: How do you think education is going? We are seeing ETF sponsors halt trading to some of these commodities ETFs. Is that a trend that's going to continue? Mr. Archard: It depends on what the regulators do. They're taking a logical approach in shutting down access if there are questions about market stability. They're not going to be quick to open up new avenues of investment until they understand what the underlying problems are. InvestmentNews: It seems that ETFs have been terrific as trading vehicles, if they're understood, and terrific as accumulation vehicles because of the cost and the tax benefits. But as the baby boomers get older, what about decumulation, if the mechanism of redeeming the shares is expensive, and you have to sell the ETFs on a regular basis? Mr. Magoon: I think there are going to be more products developed in that outcome-oriented, income investment objective. I think you're correct that most of the development has happened in the accumulation space. We're moving more toward one-stop asset allocation, outcome-oriented ETFs. Or you may see some type of a managed distribution or an income stream that flows through, so the investor does not have to sell units of the ETF, but inside the ETF, there's actually some type of transaction going on to create that income stream. Maybe it's an actively managed ETF that's liquidating positions, on a tax-managed basis, to kick out an income stream to investors. That's going to be a huge growth area for the industry as a whole, not just ETFs. Mr. Ross: Understand that fixed-income ETFs pay out in monthly or quarterly dividends. Equity ETFs either pay out quarterly or annually. So you're getting that traditional stream. Granted, that does not address the need to continue to sell the fund, but I think you will see products coming out that will try and address that. Mr. Archard: Part of the value that ETFs add to the whole equation is managing both the accumulation and then the distribution phase, and the subset of products that's going to do it. So I completely agree about the types of products that are on the design board. But I also think that it is a question of how you are using ETFs within your portfolio, along with the subset of other products that complement them. InvestmentNews: Would there be something particularly appealing about having income distribution from an ETF portfolio that people haven't seen yet? Mr. McRedmond: Well, you've seen closed-end funds with managed distribution that say, “OK, we're going to target to give you 6% a year, and each year, we're going to break that down to say, this came from income, short-term, long-term gains, return on capital.” But you're just wanting the cash flow off of it.
Mr. Magoon: I think ETFs have a very interesting safety net when it comes to risk control. A lot of times, you need to have discipline set up ahead of time to make sure you do what you intend to do when the heat of the moment comes. And ETFs, through setting up either “buy” or “sell” limit orders, give the investor a chance to create a floor on their portfolio. How many people were getting set to retire over the last 12 or 18 months and wished that at a certain point after they were down 5% or 10% that there was an automatic sell discipline for them to go to cash instead of staying in the market and continuing to fall? One of the unique characteristics of ETFs that has not been utilized as much is these buy/sell limit orders. Some of the best fund managers in the world can articulate their buy and sell discipline, and follow it, even in the heat of the moment. Well, this is a mechanism that ETFs have that many other packaged products don't have that I think is going to be used more, especially as people near their retirement years, when they can't afford a 40% decline. Mr. Resnick: When you are talking with an adviser and they're looking at a client's overall portfolio and goals, it's imperative that we have the discussion about what product structure makes sense for what they're trying to accomplish. But at the same time, we can have the conversation about your asset allocation strategy. If I can show you that, through the use of ETFs, you can save 100 basis points in fees, that goes a long way to the other part of the conversation about retirement income. So I think it's important that we look at it from the standpoint of what they're trying to accomplish with their investments, their asset allocation strategies, their goals and what structure makes sense. Mr. McRedmond: I think it gets back to what we talked about on education. It's up to us to educate the advisers on where an ETF is appropriate, where it's not, and how you can use it in conjunction with other things to the benefit of the client's portfolio and reaching their goals. InvestmentNews: Do you find that wirehouse advisers are less concerned with the overall cost to the customer? Ms. Papariello: I don't find that to be so. I find two things with the wirehouses. One, home offices are really exerting a lot of influence. The people that are making those investment decisions are very expert. Many of them are [chartered financial analysts]. They are true investment professionals applying a very heavy due-diligence process and have a lot of confidence in what they're doing and the way they're making their decisions, and I think people should feel good about that. I also see a big shift at the adviser level at wirehouses as more and more of the [financial advisers] in those firms are truly embracing fee-based business and all that goes with that. So I've seen a very big shift in the years that Vanguard has been focused on financial advisers, so I'm optimistic about that. Mr. Ross: I would say wirehouse broker-dealers and wirehouse financial advisers are competing with independents, and they compete with them every day, all day long. So their costs have to be in line. They're absolutely concerned about the level of expense of their overall program because they have to compete for those dollars. They're competing for the share of wealth. The same way we're competing by trying to get dollars into our ETFs, they're competing for the client. And that competition is very strong and robust. And it's not just strong among the wirehouses; it's very strong when people are selecting an adviser, whether they go with the wirehouse or an independent. The lines have blurred a lot over the recent years, and you have wirehouses that really look and act like an independent financial adviser. They're a wealth management team that has been built up and has a certain strategy and focus. Granted, the home offices are getting a lot more focus, especially on what types of products they'll approve, but the wealth managers at those offices really do still have the flexibility to build programs and compete with the independents. Mr. Resnick: We work more closely with the research analysts. So from a cost perspective, they've built models that now are inclusive of ETFs, because they realized this is a better way to garner exposure to a particular asset class, whether it be from a cost perspective, a flexibility perspective, or a tax-efficiency perspective. In the full-service firms, you've seen ETFs become much more a part of the models that they offer through their advisers. InvestmentNews: How much more are the wirehouses squeezing you for fee consideration than they have in the past? Mr. McRedmond: Not at all.
Mr. Archard: I haven't seen that. Generally, getting on platforms just involves a list of due-diligence questions. “What type of benchmark is this covering? What's the underlying structure? Is it "40 Act? "33 Act? What are the fees? What's the trading volume?” A year back, it was just, “What's the expense ratio? What's the benchmark?” And then it evolved to, “What's the trading spread? How long has it been in the market? What's the daily average trading volume?” What they are asking for is deeper information. InvestmentNews: Would any of you pull back from distributing through Schwab, because it moved to offer commission-free ETFs? Mr. McRedmond: It's interesting you say that, because we've certainly had that discussion. Obviously, they're a huge client, and now they're a competitor. So it's a balancing act as you work and interact with them. Mr. Ross: We do distribute through Schwab, but there are other parts of State Street that compete with Schwab. We have a trading platform, but we also have a service swap on the mutual fund side. So those types of things happen all the time. Are they a competitor in the ETF space? Yes. I'm happy to have them here. It continues to show that ETFs have gone from what was a little bit of a niche product based on just index sponsors to a broad mainstream product that Main Street wants to hear more about and that has been supported by the largest financial services firms in the world. So we're going to continue to work with Schwab. We're going to continue to work with financial advisers who clear through Schwab. Ms. Papariello: Vanguard has long had its products available through Schwab, however, not through OneSource. So investors have had to pay a transaction fee to buy Vanguard if they want to buy it on Schwab's platform. So we've had that kind of relationship with Schwab for a long time now. In the end, the investors figure out what information is important to them in making their buying decision. Mr. Magoon: It's a bigger tent. I think we're probably all excited about it. InvestmentNews: Will you have to change your advertising budgets, since Schwab is going to go directly to the adviser's client to market these commission-free ETFs? Ms. Papariello: No. I think if anything, you would make sure you educate your front-line crew to make sure they know about the latest competitive development and how they ought to respond to potential client questions. But it wouldn't change an advertising strategy. I wouldn't expect that. Mr. McRedmond: They will be a formidable competitor to pay attention to. At the same time, they've recently, in the second half of this year, surpassed Merrill Lynch [& Co. Inc.] as PowerShares' largest client holder of our products. And I'm guessing it probably might be similar at a few other places. Mr. Archard: You've got to be aware of what the competition is doing. But if you start letting that drive the way you interact with your clients, that's a pretty big mistake. We have a really diverse client pool, and how can we understand and respond to the needs of all of them? We do a lot of work and research to get there. So changing that midstream because of a new entrant, that's a pretty bad track to run down. InvestmentNews: Which channel is most important to you in terms of volume? Has it shifted more to the RIAs? Ms. Papariello: We all have our hands on the industry data. When you look at adviser-sold business in the mutual fund space, not just ETFs, RIAs are really only a very small slice of that. It is the broker-dealers, the broadest definition of that — the wirehouses, the independents and the regionals — that are the biggest cohort. So we see utilization across all channels. We don't see RIAs' increasing, and broker-dealers' lightening, the utilization of ETFs. Vanguard is very heavily involved in the retirement space, retail direct and adviser-sold. We believe diversification is good in a portfolio, and so is diversification of your client type. We value business from the banks, insurance companies, true RIAs and all the broker-dealers. So I don't think you isolate one channel over another. Mr. Ross: I don't think you isolate different channels. You try and support all the channels, but you support some differently. We have different support mechanisms for what I'll call the institutional-hedge- fund trading channel than we do for the financial adviser. Hedge funds don't want you coming and saying, “What do you think of my views on your portfolio allocation?” They'll throw you out in about three seconds. They want information. They want the ticker, they want some Bloomberg symbols, and they want you to go away. And they want a phone number so if they have a question, they can call, and somebody on the other side of that line has knowledge. We have similar things for financial advisers, but there are different levels of information you're trying to get to them, because they're trying to solve a different equation. We have hedge funds, professional money managers, potentially mutual fund managers, insurance companies — and today, banks — all using ETFs somewhere along the line. And how you communicate with them and work with them is very important. But you do have to tailor that somewhat, depending on what their needs are. InvestmentNews: How about ETFs in the retail area, rather than their institutional use? Mr. Archard: We've hit this balance of almost 50/50 retail versus institution. But in retail, you have to peel down RIA versus broker. You're going to have different conversations around the solution-oriented set. We have a lot more dialogue coming from the RIA channel around constructing portfolios that might deal with distributions or targeted allocations pooled together. The brokers in some cases are still looking for very discrete beta cuts to go into their separate account platforms so that they've got plug-and-plays for dollar levels below separate-account minimums that they want to park until it gets big enough to roll into an active manager. So the conversations are different, but the load balance is almost equal, because of that utility across the spectrum. Mr. McRedmond: You always hear people ask about the breakdown between institutional and retail, and the answer is, it's going to vary for each of us. When PowerShares was launched, the focus was going to the advisers, particularly the wirehouse advisers, because that's where you could go and hit a large universe. But it's definitely evolved now to separate channels. You call on the RIAs, because as you said, it's a different sale, and it's tougher to serve the RIA channel than the broker-dealer, where you've got these big pockets. It's the same thing on the institutional side. We started a dedicated institutional desk, so they know that they can pick up and call and get exactly the information they need. InvestmentNews: With so many channels now using ETFs, do you see them as a threat to mutual funds? Ms. Papariello: We've seen both our traditional index mutual funds continue to grow and the ETF category grow very rapidly. But bear in mind that a lot of our ETF growth has come through growth in our business with financial advisers, which is a category that a decade ago, we weren't calling on, because frankly, at the time, most advisers were not even called “advisers.” So for us, this has been largely added, and we haven't experienced the cannibalization that everyone has fretted about. But for certain investors, the traditional index mutual fund may be the better choice, and for other investors, the ETF is the better choice. And frankly, we just want to help them get to the conclusion that makes sense for them. I do think, though, growth in ETFs has come at the expense of individual securities and [separately managed accounts], if you believe data from firms like the [Financial Research Corp.] and Cerulli [Associates Inc.] and the like. It really has not yet come from traditional index mutual funds. But also, advisers as a category, with the exception of true RIAs, didn't use index products. That wasn't in their mindset. I don't know if others see it differently, but I do not fear the demise of the traditional mutual fund at the hands of ETFs. Mr. Magoon: We don't believe that ETFs are the be-all and end-all investment. We allow people to understand where an ETF may fit in context, but we don't believe that the ETF is always the right answer. We see advisers mixing ETFs with SMAs, with mutual funds, with closed-end funds, with individual securities. We see mutual funds owning ETFs. We see SMAs of ETFs. We see annuities with ETFs underlying. So I think it's just another tool in the box for advisers to use. And has some of the market share been taken away from other tools? Yes. But I don't think we're seeing necessarily the demise of the mutual fund business per se. When you look at where the majority of mutual fund assets are, they really are in actively managed strategies, and ETFs really haven't cracked that nut in a meaningful way. I think that's why people in the past have said, “Boy, wait until true active ETFs come out.” There are some that are out there certainly, but I don't think they have made a significant dent. I think that's more due to how people select actively managed mutual funds. A lot of that's based off of longer-term track records, star ratings, etc., and the active ETFs do not meet some of those standards, because they're so new. Mr. Archard: Maybe something innovative will come down the pike later that will be even more efficient, but when it comes to liquidity, access, cost, the trend is in the favor of the ETF.
Mr. Ross: I look at ETFs as being one more tool in the toolbox of the adviser or the investor, whether it's a professional investor, financial adviser or an individual, where they can weigh the benefits themselves. Do I want to buy a passive S&P 500 index fund or do I feel that this active mutual fund is a better choice for me? It gets into the whole active/passive debate, which is a debate that's been raging forever and will continue to rage. Sometimes passive will win, sometimes active will win. Nobody's ever going to win outright. When you think about the ETF in its base form, it's an implementation tool to get you access to something. There's 700 or 800 of them now. So you have more options than you probably have in the traditional index mutual fund world. You can get access to virtually any asset class that you want in the world these days, but it's just one piece of the investor strategy. What's my strategy? Do I want to just buy large-cap-core and large-cap-international, and that's it? Let's call that the couch potato portfolio. You can do that probably today in two ETFs. The adviser and the investor have to make the decision on whether they want to try and outperform, and how they want to do that. Do they want to do that by doing a sector rotation strategy holding all ETFs? You can do that. Many do. Do you want to do that by trying to buy just active portfolio managers? There are cost benefits to all of those. Sometimes you'll see people get more focused, probably when the market's going up, on active because maybe then they can outperform, and they really want to do that. And then you see markets shift like last year, and some people just completely get out. And some people shift back to core indexing in some cases. Mr. McRedmond: I think the industry is always evolving, and we probably all agree that the evolution toward fee-based has been a huge driver in the ETF space, probably even more so than just the product innovation. If you look back at mutual funds, they've experienced a similar thing, where it was always the load, the A shares. But as the industry moved toward fee-based, they came out with no-load, fee-waived, particular shares for wrap programs, and they've garnered huge assets in that. And I think you're beginning to see ETFs move into that, where now people are coming out with ETF wrap programs. But if you look at the dollars that are still in mutual fund wrap programs, compared to ETF wrap programs, it's a drop in the bucket. So I think there's huge opportunity for ETFs to gather some of those assets. The mutual fund wrap programs used “set it and forget it” asset allocation, in which you couldn't be too active because of the issues around trading and moving the funds in and out, and redemption fees. And all of a sudden, ETFs came along and dealt with those issues. You could have a more dynamic or tactical asset allocation, and make changes in the portfolio and use ETFs to implement it, and you didn't run the risk of questions about whether you were timing the mutual fund and moving money in and out too quickly. So I think it's just an evolution. Mr. Ross: Seventeen years ago, a very large broker-dealer put a notice out to all their brokers saying, “Do not trade [Standard & Poor's depositary receipts]; it's not good for you.” Basically, “We don't know enough about the product, and it's not good.” Those same wirehouses today have multiple ETF wrap programs. So it just shows time changes things. Mr. Resnick: The benefits that equate in the current ETF structure do not necessarily equate to an actively managed ETF at the moment. Once that changes, then it's a whole new ballgame. Ms. Papariello: That could be a long time. For those who are applying a true institutional due-diligence process, they're looking for a three-year track record. I do think this track record issue is one that doesn't get talked about very much. But all of us have been in this industry long enough to know that there are a significant number of investors where track records matter. So we'll be patient and let that track record build. That's what active managers had to do, historically, in traditional funds, right? So maybe it's not that big an issue, but it will be a dampener on early days of success. We'll have to be patient and maybe give it three, four or five years to see what the real end story is with true active ETFs. Mr. Ross: And there are still structural challenges. You have to be fully transparent. You can't have an active mutual fund that's research-driven and fundamental, and tell that portfolio manager you're going to disclose his holdings on a daily basis for everyone to see. It's just not going to be well-received. Mr. Archard: I think as an industry, we've approached this incorrectly. My view is, we're trying to create active ETFs to look just like index ETFs, and I don't think that should be the point. If there are tax inefficiencies in an active mutual fund, if there are cost inefficiencies to portfolio construction, what are the head winds that batter a good manager, and how do you remove those? That's how I think we should approach the active-ETF market, rather than trying to say, “We want something that looks just like an index ETF.” Mr. McRedmond: I truly believe that the actives will be a major player. I disagree a little bit on that transparency. I think it's somewhat of a cop-out because the reality is, if you're a separate-account manager, you're disclosing your holdings on a daily basis. You're just disclosing it at each firm level. Mr. Ross: Not every fundamental portfolio manager is in the separate-account business. Mr. McRedmond: Exactly. Getting back to the idea that the ETF is a delivery vehicle, every year, Lipper does a study of cost and taxes in the mutual fund industry. One of their slides asked whether active managers are bad stock pickers. And their conclusion was no. The performance of their stock picks was actually pretty good, but the net that the investor received after capital gains taxes and the cost of trading was not good. If you can capture back a big part of what's lost through the mutual fund delivery vehicle, then that in and of itself should be a huge value for delivering active management through the ETF structure. The whole active/passive debate will never be solved in our lifetime, but I do believe that the ETF as a delivery vehicle for active management will eventually be a player and a competitor, because it does have some potential advantages. InvestmentNews: How long before actively managed is a major player? Mr. McRedmond: I still think it's definitely a way off, whether that's three years, five years, 10 years. It's true the existing actives are quantitative, but is it that big a stretch from what's already being done with traditional active managers, where the majority of them have some kind of quantitative process to pick funds that the manager chooses from? But it is a challenge. Managers are concerned and hesitant about that idea about disclosure. Ms. Papariello: As a practical matter, much of the early products, while labeled “index,” were active strategies packaged in a manner that allowed them to be approved. Mr. McRedmond: Active in the index structure. Ms. Papariello: Right. That's where the industry was in terms of its willingness to approve certain product types. And if we could re-label them all today, I think a fair number of products that are categorized as true index would shift over to be at least quasi-active. Mr. Ross: I asked a client advisory council we had whether they were looking forward to active ETFs. And the answer was no. The answer was, “We'd much rather you work on XYZ.” They really didn't seem to have a lot of interest. Now I think if you get it done and you get it right, that would be very interesting for them. But are they looking for their current ETF sponsors to launch active ETFs on their behalf? Remember, most of these financial advisers see that as part of their job. They want to try and add value by packaging the active mutual funds along with ETFs in their portfolio construction. It was an interesting dynamic, because it's a question that's asked a lot in the media and among us at conferences, but when you talk to financial advisers, they're not banging on the table. They're banging on the table about a lot of other things they would like to see. InvestmentNews: How much seed capital do you need to start an ETF and where's it coming from? Ms. Papariello: Four years ago, you could come to market with a new product idea and get $20 million or $40 million in seed capital. Today it's $2 million, maybe $4 million if it's a really great idea. Mr. Archard: You have to do your homework. You can't go to the lead market maker with a pie-in-the-sky idea. You need to be very specific about who it has been built for, who you think the early adopters are going to be, what that usage is going to be, and then work with them post-launch to make sure that things are going the way that you want. We have a whole unit that focuses just on that capital market interaction. InvestmentNews: It sounds like the changes make it much more difficult for new entrants to put together a successful launch. Ms. Papariello: There has certainly been a slowdown in new-product launches. That's undeniable, and that's not solely due to changes in available capital. Mr. McRedmond: I think it's much tougher for a new PowerShares or a Claymore type of a situation to develop in the current marketplace. You've still got the Schwabs and [Pacific Investment Management Co. LLCs] that have that brand, but for a new startup player to try to break into the market, it's got to be extremely challenging. One, that seed money, and two, establishing a foothold and a brand. There might be niche opportunities here and there, but it's harder and harder to tap into. Mr. Magoon: In the past, we probably viewed exemptive relief as maybe the biggest, widest moat. Now I think that's not necessarily the widest moat. But I think the process to get in the business to do a generic exchange-traded fund has shortened quite a bit. It's now the seed capital. There have been other large firms that have come into the business and haven't been successful. I think there is a unique set of market conditions, knowledge and skills that are needed to effectively launch and run an ETF product line. It's not a very transferable set of skills from a firm that just focuses on mutual funds or SMAs.
Mr. Resnick: Beyond just launching pure products, you have to have a well-thought-out distribution marketing plan and penetration strategy in place. If not, you're not going to be successful. We've seen that happen. Mr. Archard: The most abused word in every ETF conversation is “innovation.” Innovation has to be good ideas with good execution, not just the good ideas. The firms that have been in it the longest know about execution. The new entrants don't know what they don't know, and that's where some of the pain points come up. Mr. McRedmond: We all have bright product development people, but the reality is, most of the time, their best ideas are coming from the clients. When people talk about there being too many ETFs, the thing they are missing is that more ETFs are being developed as a specific tool. From our conversations with clients, we know that there's an interest. There's some pocket of demand before that product gets launched. It might not be a product that has widespread retail use, but you've got a client saying, “I can put $100 million in that.” InvestmentNews: It doesn't sound like you would expect to see all the ETFs that are currently in registration make it to market. Ms. Papariello: We've seen many of these products shut down. Some are bad ideas and should be closed. But in other cases, maybe the idea's a decent one, but it still doesn't attract assets. There's not an infinite amount of money to invest in these products, so we will hit that wall, as an industry, where demand suddenly starts to dry up vis-à-vis the supply that we're putting on the table. I think we're still in the phase where firms are going to be doing everything they can to be part of this market. Even though there's been a slowdown — for a variety of reasons we discussed — in new product launches, I don't think we're coming to the end of that line. There's still a lot of new product to come. But in terms of the long-term sustainability of those individual products, I think we'll see a lot shut down. Mr. McRedmond: But it's not necessarily a bad thing. It's really just a normal evolution of any product cycle. Products come out, for whatever reason, they don't gain traction, and they'll close down, and new ones will come. But you still want to have that innovation where people are bringing out that new product. Even if other people are saying there are too many, you don't want to dampen that too much.