Like Internet stocks, exchange-traded funds were a creation of the 1990s bull market. With investors actively trading stocks, along came index-pegged mutual funds that traded on exchanges and could be bought and sold just like stocks.
Unlike many Internet stocks, exchange-traded funds, or ETFs, have survived the tumult of the past two years. Yes, many ETFs' returns have suffered with the market, but they remain popular with investors as a vehicle.
Barclays Global Investors, the leading provider of ETFs, now has $22 billion in 77 different funds, called iShares. And the firm just launched its first four bond index ETFs that trade on the American Stock Exchange.
What gives these tradable funds staying power? Lee Kranefuss, CEO of the individual-investor business at Barclays, explains.
1. What is an exchange-traded fund?
An exchange-traded fund is the marriage of a stock and a fund. You're getting the professional management and diversification you expect with a fund. But you're taking the shares and listing them on a stock exchange so you can buy and sell them just like any other stock in any brokerage account. You can use limit orders, market orders or stop orders.
That's the big picture of what you're getting.
One other way to think about them: With equities, it's sort of a super stock. It's like you're buying tens or hundreds or even thousands of stocks with one trade.
2. How many ETFs are out there now?
There are 104 in the U.S.
3. How popular are they?
Very. Out of 104, we run 77 -- by far the largest provider in terms of number of funds. We launched in May 2000. Last year, which was the first full year, we were No. 3 in net equity cash-flow gathering, according to Financial Research Corp. We pulled in $10 billion in a time when the market was pretty sore for equity.
If you look at it, we pulled in more net assets -- not percentage assets but net dollars -- than
T. Rowe Price
. That even accelerated this year. During the first six months of this year, we pulled in another $10 billion. So as much as we pulled in during 2001 came in during 2002.
And that's because people see the benefits of low cost, tax efficiency and the wide selection.
4. Are people buying them predominantly through advisers and brokers, or on their own?
Probably 90% are bought through advisers, which is consistent with the rest of the mutual fund industry.
5. Why bond ETFs?
You get the same benefits you do with equity: the ability to go and get them in any brokerage account and the ability to get a diversified portfolio. Bonds usually have $1,000 value. If you want to put $10,000 in, it's hard get a diversified portfolio across Treasuries and corporate bonds.
And nowadays people are more concerned about diversification than they used to be.
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There's another big plus. In equity we can all go online if we're buying stocks and find any individual stock, how recently it's traded, how much it's traded, what kind of volume is going on, what's happening to prices. If we get a broker to do a market order for us, we know whether it's a good price or not. It's pretty easy to research and check.
With bonds being a dealer market, individual investors really don't have a lot of insight into pricing. We, as an institution, do, because we can get multiple dealer quotes and we have institutional pricing services. But if you go to buy a bond right now, put in a market order and the broker says that's $92, how do you know it's a good price?
regulatory guidelines, they could mark it up as much as 5%. Given current interest rates, that's amazing. It could be a year or more of interest lost to you on a three-year bond.
One of the nice things with bond ETFs is that they will be listed on the equity exchange. Number one, you've got the arbitrage mechanism at work to keep prices in line with fair value.
Note: The arbitrage mechanism is the structure developed to keep the price of an ETF's shares in line with the actual value of the underlying portfolio. Number two, you can use any of the equity services to see what the last trade was. But number three, just as with equity ETFs, every 15 seconds we publish the fair value of the portfolio.
6. How many bond ETFs are you unveiling?
We have four to start, with three Treasury ETFs: the short-term Lehman 1-3 Treasury, the medium-term Lehman 7-10 and the long-term Lehman 20+. And the Goldman Sachs InvesTop index, which is liquid corporates.
7. How can investors use these ETFs in their portfolios?
In a couple of different ways. Two years ago, people weren't interested in bonds. People liked growth stocks and tech stocks.
A lot of people thought they'd get rich holding just four or five stocks. And we've seen on the equity side that diversification has broadened out from sectors to style, and now we see money flowing to the Russell 3000, the total market index.
People have now gone back and said: Hey, fixed income does have a place in my portfolio. People in their 60s and their 70s who had 100% of their money in equities are realizing they shouldn't have done that. It wasn't right.
Suddenly a bond -- this quaint old concept two years ago that pays you back your principal and makes guaranteed payments and has the backing of the government behind it -- seems like an interesting financial product in the last few months.
There's a real place for it in portfolios and always has been, a well-constructed, well-diversified portfolio. An asset allocation should have the right mix of stocks and bonds. It's the natural piece that's missing.
8. What are the remaining bonds ETFs that are on deck?
We have two others approved already. The Lehman All-Treasury. It's basically a slice of the Treasury market. With this one, you'd avoid having to buy all three of the ETFs that are coming out now.
But these being the first bond ETFs, we want to launch four first to make sure everything is OK operationally and make sure investors are understanding them.
We're going to get to the others when we see how demand is. Further down the road we hear a lot of demand for agencies, mortgages, high-yield and munis.
9. Why the wait?
There are a lot of challenges. There are regulatory issues to go through in terms of pricing. And you don't want to own 100% of the bonds.
Even the way bonds work, if an index has 200 bonds in it, because they fall into buckets and are highly correlated, you wouldn't want to hold 200. It wouldn't make sense.
You get into three sets of issues, one of which is pricing data. Two, how you construct a portfolio? Because you have to sample to a much greater degree to make it work properly without excessive costs. And number three, the liquidity and availability of bonds. All of those are solved with Treasuries and liquid corporates.
With those extra categories of bonds, these issues get much more complicated. But they will get solved in time.
10. So, you have stock and bond index ETFs. Are ETFs based on actively managed funds out there in the future?
It's always out in the future. The question is how far out. An ETF is really a delivery vehicle. In our research, two-thirds of advisers believe they will use one in the next year.
Regarding actively managed ETFs, it's a matter of when, not if. But they raise a whole new set of issues. The
went through that whole question of whether mutual funds should disclose their holdings more frequently because it would be good for shareholders. But the mutual fund industry came back and said, wait a minute. It's not necessarily good for shareholders.
Number one, if I disclose my portfolio frequently, other people can go and copy my ideas. And most ideas have a limited capacity. So if everyone starts copying me, my shareholders lose their return, and that's what they're buying with active management.
Number two, if I start telegraphing what I am doing, what changes I am making, people can start trading against me and ahead of me. To make a long story short, the SEC agreed and said there's a value to transparency, but there is a value to keeping it secret in between reasonably well-defined periods.
However, with an ETF, the way the whole arbitrage mechanism works, you have to publish the whole portfolio every day. So you're really caught in a bind there.
You either have to find someone who has a strategy and doesn't care
if you constantly reveal what's in the portfolio, or you have to find a way of doing it without violating both constraints. A lot of people are working on that. I would say I can't imagine seeing one before 18 months, but I think three years from now someone will have figured it out.