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Active ETFs on the Launch Pad

Scott Burns

Scott Burns: The state of the ETF market. Hi there. I'm Scott Burns, director of ETF research with Morningstar. Joining me today is founder of Portfolio Solutions, Rick Ferri. Rick is also the author of the ETF Book and he has a column that he writes for Forbes Online. Rick, thanks for joining me.

Rick Ferri: Thank you, Scott.

Burns: Well, when we talk about the state of ETF's in 2010, I know there's a couple of themes for you. One was in a column that you recently wrote on Forbes, and you talked about these structured portfolio index notes.

Ferri: Oh, Spindexes.

Burns: Spindexes. [laughs] I got a little chuckle out of that. I won't say I totally bought in with everything. But what were you kind of talking about there with this Spindex comment?

Ferri: Well, we all have what we know and love as an index, which prior to a lot of this product being launched in the last few years, indexes were measurements of benchmarks of the market. It might be the stock market. It might be the bond market. I mean, they were benchmarks to measure how the market is doing and also how your performance is doing in relation to the market.

Burns: They weren't even meant to be invested.

Ferri: Not originally. They were not. No, that's a good point. They were just meant to be benchmarks. Now what has happened over the last few years is that product providers who want to launch more of an actively managed fund, but want to do it under an ETF structure, have to take that active management strategy and turn it into an index first.

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So they take their structured portfolio and they turn it into an index, which I like to call a "Spindex," because they are really not indexes. I mean, they're not the measurement of anything. They're not measuring market performance. They're nothing that you would measure your portfolio against. They're a product. They're a product that was an active management product, for the most part, that is only being called an index for the purpose of launching a product.

Burns: Well, you know, and I look at these, and I'm actually kind of a quant guy. I look at that and I said, well, this makes sense. This strategy is sound. I can see some of these things.

Yeah, I think characterizing them as beta is definitely incorrect. But, you know, I do think there are investors out there, and if you like the strategy, if you want to go for the alpha, there is a risk return trade-off there that these are fine products, in a lot of ways, to go for that.

Ferri: Oh, I completely agree with you. In fact, I will go a step further and say that if you want that kind of active management, it is actually less expensive to do it in an ETF than it is in an open-end fund.

Where I think there might be an issue is in how these things are marketed to the less-educated public who thinks they are actually buying your old mom 'n' pop index, but they're going to buy this index because it is a better index.

And I think that is a little bit overdone, and the investor could be getting into something that they really don't want to be in. And that's the issue.

Burns: Right, or even understand, I think. And that's always the risk, is that education in the first place. So moving beyond that, when you look at the year of 2010 and ETFs, how do you think this year is going to be remembered?

Ferri: [laughs] Well, last year I thought it was the year of ETF closures, and we had a lot of ETF closures in 2009.

Burns: At the very beginning, yeah!

Ferri: Yeah. There were quite a few. Quite a few went under. I think the year of 2010 is going to be the year of active ETF launches.

Burns: Got you.

Ferri: The industry has been trying for years to expand the actively managed ETF. When you don't have an index, it is just like a regular open-end mutual fund.

Burns: We like to call that traditional active management--the idea of a manager and a team picking securities...

Ferri: Exactly. I think this is the year where we are going to see a lot of traditional active managed ETF launches.

Burns: Now, do you think that that is going to come from new startups, some of the existing ETF players, or do you think we are going to see a real wholesale shift from the established traditional fund management world into the ETFs?

Ferri: Yes. Both.

Burns: Both.

[laughter]

Ferri: We're going to see it come from everywhere. You know, we have had PIMCO come in. T. Rowe Price is coming in. I think that they are looking at this as a viable distribution method, whereas, a few years ago, they were still watching the industry. But it is now becoming a viable distribution method.

And once ETFs become more accepted in 401(k) plans, it is even going to get larger by more traditional mutual fund providers.

Burns: Even though the year 2010--and I know you are very careful to say the year of the ETF launch--I think this is the year they are incubated. And I think it is going to be really until 2013 when we start to see these three-year track records, when these funds start to have their star ratings and things like that, to where we really start to see asset gathering. Because that is one thing in the media. People are like, "Oh, these have failed. They haven't even taken off yet."

Some of that is just a matter of time. That would be true if they just launched open-end funds this year.

Ferri: I agree. And they are really tiptoeing in. We haven't seen any big name managers, Bill Gross or somebody, being given an ETF exclusively to manage just as an ETF. And I think that when these traditional open-end fund companies want to really step into the ETF marketplace, they are going to put a big name manager on top of an ETF and say, "The reason you want to get into this ETF is because of this particular, you know, Morningstar Manager of the Year or something, and he has only managing this fund.

That we haven't seen yet, but we could. But to your point, yes. If you don't have that, then you have to wait three years to get a track record. And so, this is the year of actively managed ETF launches. Maybe three years from now is actively managed ETF growth.

Burns: We'll see!

[laughter]

Burns: Well, that's all great points. Rick, as always, it's a pleasure having you here. One thing, I'm going to give a quick plug for your book here. Whenever I have new analysts join my team, the first thing I always have them do is read The ETF Book. It is a great book. You did a great job with it. And I think anybody out there watching who is looking to really learn more about ETFs couldn't find a better place to start besides Morningstar and The ETF Book.

Ferri: Right. Thank you, Scott.

Burns: I'm Scott Burns, director of ETF Research. For this and other ETF commentary, please check out the ETF Center on Morningstar.com and Morningstar's ETFInvestor Newsletter.