Brave New World for ETFs?

There's big news in the exchange-traded fund (ETF) industry. Whether it's good news or bad news, though, remains to be seen.

The boom in ETFs -- which are similar to index mutual funds but are bought and sold on an exchange like stocks -- seems to have peaked, according to a May 2002 study by Lipper, a mutual fund research firm. As the industry struggles to reinvent itself, though, the Securities and Exchange Commission is taking a closer look.

Since their introduction in 1993, ETFs have only held equities that track an index. Unlike traditional, open-end mutual funds, though, ETFs trade like stocks (or closed-end funds): They can be bought and sold throughout the trading day, sold short and bought on margin. Most charge lower annual expenses than even traditionally low-cost index funds (0.19% vs. 0.65%, according to Lipper), although there's a commission charge for each sale or purchase. (So if you invest regularly, the periodic trading fees can add up to far more than an index fund's expense ratio.) ETFs and index funds share the tax advantage of low-turnover investments.

Despite the initial popularity of SPDRs (pronounced "spiders"), which were introduced in 1993 to track the S&P 500, ETFs really took off after the stock market peaked. In the past two years (2000-2001), ETFs went from 30 in number to 120, worth $87 billion at the end of 2001, according to Lipper.

"There are ETFs for every major sector, tracking every major index," says Lipper research analyst Jim Shirley. "The sector market is saturated, and the introduction of too many more equity ETFs will begin to have a negative effect."

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Because ETFs track indexes but trade like stocks, they can (but don't often) trade at a discount or premium to their net asset values (NAVs). The more ETFs there are tracking the same index (or a segment of an index), the more thinly investor dollars will be spread. As ETFs increasingly represent specific parts of the market or begin to duplicate each other, the less liquid they'll become, and their share prices may skew higher than the value of their holdings -- not a good deal for investors.

So in an effort to break new ground, financial institutions are devising new types of ETFs, and the SEC is wondering just how to regulate them.

The SEC voted last Wednesday to allow Barclay's Global Investors to offer seven ETFs that are based on fixed-income indexes. These funds, scheduled to launch in July, are the first ETFs in the U.S. that track bond indexes. The new ETFs will be marketed under the brand name iShares, the same as its other ETFs. Two funds will track corporate bond indexes, four will follow U.S. Treasuries of varying durations, and one will track a benchmark that combines Treasuries and corporate debt. Barclay's originally filed with the SEC in January 2001.

But while these bond ETFs are novel, they operate essentially the same way as the existing equity ETFs: They are based on an index.

What the SEC is now investigating is how to regulate an entirely new product that financial services companies are clamoring to release -- an actively managed ETF.

Because of the way ETFs are structured, institutional investors generally arbitrage away any difference between the index ETF's share price and its NAV. Essentially, an institutional investor can note any price discrepancies and buy, say, the lower-priced ETF shares and exchange them for the higher-priced underlying shares. In purchasing the ETF shares, arbitrageurs create greater market demand for the shares, which would likely raise the market price to a level closer to the NAV. If the ETF's share price is trading at a premium to its underlying assets, arbitrageurs would perform the same exchange in reverse. (Given the mechanics of how ETFs are structured -- and the huge amounts of shares required to do so -- individuals are not able to benefit from this sort of arbitrage.)

In an actively managed ETF, though, the holdings would change far more frequently than in an index-based ETF, making it more difficult for arbitrageurs to capitalize on any discrepancy. That can be bad news for the individual investor, since it's the arbitrageurs who keep ETFs trading at approximately their NAVs. If ETFs were to start trading at significant premiums or discounts to their NAVs, shareholders would be less able to know not only what they're holding, but also what their holdings are worth.

In a speech to institutional investors on May 24, SEC Chairman Harvey Pitt warned of his concern about "whether arbitrage mechanisms for actively managed exchange-traded funds are effective in moderating any premium or discount to a fund's NAV."

In addition, the SEC will look at disclosure requirements for actively managed ETFs. For instance, the SEC's concept release on this subject raises the question of whether actively managed ETFs should be required to disclose the full contents of their portfolios, or samples, or just general characteristics.

It's not just institutions such as Barclay's or other purveyors of ETFs (such as Cubes, which track the Nasdaq 100, or Diamonds, which follow the Dow) that are eagerly awaiting the SEC's assessment. That $87 billion invested in ETFs is money that would have otherwise likely gone into traditional mutual funds -- and don't think the fund companies don't mind. Vanguard, for instance, is preparing to launch an actively traded ETF when the SEC gives the go-ahead.

"That $87 billion is obviously a negative for the mutual fund industry, but on the flip side, it could provide an opportunity," says Lipper's Shirley. "They see a great opportunity there, especially since some great funds have been closed to new investors. This could be a way to offer essentially the same investment to new investors."

Whether or not there would be conflicts inherent in the same fund manager managing both an open-end fund and an ETF is another issue the SEC will investigate.