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ETFs Out of the Sandbox, Onto the Swing

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar reporting from the 2010 Morningstar ETF Invest Conference here in Chicago.

What is next in the evolution of ETFs?

I'm here today with Tom Lydon. He is the publisher of ETF Trends and the president of the Global Trends' Investments Advisory Service. He is here to tell us a little bit about what he's saying in the ETF industry and where we may be headed next.

Thanks for joining, Tom.

Tom Lydon: Thanks, Jason.

Stipp: First question for you, we are still seeing fund flows into ETFs. We are still seeing new ETFs launched even as some other asset management areas such as active mutual funds are seeing outflows. I guess, I want to ask you first, where are we with ETFs? Are we still ramping up, are we still in the early stages of a growth trend? Or are we starting to see an inflection point to a more mature industry in ETFs?

Lydon: We are mature, and I think we're getting out of the sandbox and maybe jumping onto the swing set. You are absolutely right. There are more flows coming into ETFs when we are seeing money come out of mutual funds. But many of ETF providers are maturing. There are three of four that command the majority of the assets within the business.

Entry to this market has gotten a lot more competitive. And with this land grab pretty much all fully developed, there aren't that many asset classes, sectors, global regions that are yet to grab. But there are new ones that are being created. The question will be, will they be popular?

Stipp: And from the perspective of who's investing in ETFs, I know that there was a panel where they talked about how there is strong adoption at the institutional level first, but then they had to move to advisors and now to individuals. What's the penetration looking like as far as who's actually going into the ETFs? Are individuals adopting them at a higher level now?

Lydon: Well, they have been, but the ETF providers have really been concentrated on the institutions and advisors. At ETF Trends, we have all high-level of self-directed investors that have moved from mutual funds over to ETFs. We are also finding they are pretty sophisticated. 42% have graduate degrees; they've got 10 times the average portfolio size of the average investor, and they are getting over 90% of their information off the Internet.

So they still tend to be more in the sophisticated side. I think we're seeing more and more average investors that will come into ETFs over time, so there is still room to grow.

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Stipp: So speaking of growth areas, one of the things you hear about in ETFs is that one of the next big things is active ETFs. When we look at the fund flow trends, we're seeing actually money leaving from active management into more passive strategies. Do investors want active ETFs?

Lydon: Well, those providers that have not yet been in the ETF space are thinking that that's their entry point. That's their ticket in. And as you know, there is a lot that have applied for exemptive relief. Once they finally launch, the question is, if you build it, will they come? Probably not.

Morningstar has done a great job of studying this over time with mutual funds. It's nice when you come up with a new idea, but it doesn't necessarily mean that they are going to garner a lot of assets on day one. They are going to have to develop some type of track record. Even if there is a big brand behind it, a brand manager and a discipline, they are going to have to create their own track record before they will garner assets.

Stipp: So I think, you know, potentially they are looking at this to differentiate themselves from other ETF providers and by having that distinct strategy. But that also raises a question of on the indexing side, on the passive side, you know, in a lot of respect the ETFs are commodity products if they are following the same index. Price has become a differentiator. What does this mean for the fund companies that now they are competing on price on these commodified products?

Lydon: Sure, absolutely. Well, everyone is taking the gloves off and you're starting to see this price battle you've seen in the emerging market side. You're seeing with Vanguard going up against SPY and with the State Street, what Charles Schwab has done regarding under cutting the major indexes.

The big boys can do this because they have deep pockets. So again barrier to entry is going to be that much greater for those that are coming in.

There are going to be other manufacturers that enter that have distribution. We talked a little bit about that on the panel today. So, a company like Bank of New York Mellon that's got huge distribution may come in with some passive indexes and find some success in those areas. It will be interesting to see. But in the end, the average investor benefits because pricing continues to drop.

Stipp: Sure. Last question for you. As an industry observer, do you have an example, in an industry that is still growing is still releasing products. Do you have example of ETF innovation at its best and ETF innovation that is perhaps more questionable?

Lydon: Right. Well, we just saw this week a couple of ETFs close, Texas and Oklahoma; again, kind of good ideas, but maybe too nitchy, maybe too ahead of its time. I've got to say that the ETF industry has done a good job of shuttering ETFs that having garnered assets or traction--they've been very responsible in that regard.

I think one of the things that I'm really seeing as we talk about pricing, and no transaction fees both on the Fidelity side and what Schwab is doing, I think many are wondering, will we eventually see no transaction fee ETF platforms at the major brokerage firms? I think that that's probably coming just with the popularity and people that we're talking about, and it will be welcomed by advisors and individual investors.

Stipp: Tom, thanks so much for your insights today and for joining us.

Lydon: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.