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What's on Tap for ETFs in 2011?

Jeremy Glaser

Jeremy Glaser: What's on tap for ETFs in 2011?

For Morningstar.com, I'm Jeremy Glaser. I'm joined today by Scott Burns, he is the director of ETF research at Morningstar, to shed some light on this subject.

Scott, thanks for joining me today.

Scott Burns: Jeremy, thanks for having me.

Glaser: So 2010 has been another good year for ETFs in terms of assets flowing into the space and for a lot of new products, but a question on people's minds is what's going to happen in the next year. What do you think are going to be some of the big trends in the exchange-traded space?

Burns: Well, I mean just in terms of assets and flows, because you brought that up, we do expect the secular push into ETFs to continue. And that's really coming from two fronts. Some of it is really the switch to passive investing, and we see that trend actually echoed in the larger mutual fund space as well.

But also seeing more and more people adopt a macro strategy, so basically swapping out of individual stocks, bonds, commodities, etc., and moving into more thematic, broad-based ETFs that provide the liquidity that you would get with a single security, but in addition [offering] diversification. So that's what we see on trends and flows.

Glaser: So when we're thinking about product innovation, something that the ETF industry has been well known for, what do you think investors could expect next year?

Burns: I think when we look at the passive ETF format, which is really still the preponderance of the products and really the lion's share of the assets, I still think fixed-income is a ripe area for ETF providers to mine. Really, even when you look at the credit area, ETF providers have done a great job breaking up the duration scale, that is one-year, two-year, three-year, etc.

But really in terms of breaking down credit quality, there has been very little movement. We're basically still in a world of a choice of investment grade or high yield, and there is a lot of different bandwidth in between there. So I do expect from a credit perspective to see more product from a sector perspective and country perspective, when we saw actually some of that start this year with launches like emerging-markets bond ETFs, etc.

Glaser: The active ETF space is an area that I think many people thought was going to grow faster than it has. Do you think there is going to be a further push into active management for ETFs?

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Burns: So last year at this time one of my big predictions was we would see more active ETF launches, and we actually did. We saw, I think, some surprising traction considering that actively managed funds usually need a three-year track record, but we have funds like iShares Alternative Product, ALT is a ticker, that has over $100 million in assets, and a lot of other really strong launches that are breaching the $50 million or so, which we kind of consider to be a break-even point for at least the fund from a gross profit perspective making money.

So one of the things that made that prediction not come as true as I would have liked was that the SEC actually decided to sit on lot of the exemptive relief plans. A lot of that revolved around derivatives in funds and what their plans were to try to manage that. So we're starting to see signs that the SEC is thawing an approving that, and a lot of the providers are responding by stripping out derivative usage from their exemptive relief proposals.

So we do expect to see new entrants in the active space from some of the traditional fund companies, and also more active just from the entrenched ETF providers as we see. So active is definitely going to be a place that's going to grow. And I think combining with active and maybe even bringing in some of the passive, the other area where we really expect growth in ETFs next year is going to be in alternatives.

Again, a lot of that started this year, but we're seeing alternative flows, whether in mutual funds or ETFs, really starting to accelerate, and we're talking more like the hedge-fund-like strategies, where you are ... looking at more absolute-return-type strategies and other portfolio, risk-management-type tools. So I think that we're going to see a convergence of actively managed hedge-fund-like strategies really moving more into the mutual fund space, but the more passive, beta-like, just passive return, like a merger-arbitrage return or a momentum return, showing up as ETF vehicles and passive vehicles in the ETF space.

Glaser: Scott, looks like we have a lot to look forward to next year.

Burns: I think we do. It's always exciting in ETF land. It would be interesting I think to see how the ETF industry continues to innovate to solve investors' needs.

There is some unresolved issues in the commodities market regarding contango and backwardation in the yield curve, and we've seen some interesting innovation there.

And again, I think active will lend a whole new atmosphere to what's happening in the ETF space.

Glaser: Thanks again, Scott.

Burns: Thanks Jeremy.

Glaser: For Morningstar.com, I'm Jeremy Glaser.