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Key Themes for the 2013 Morningstar ETF Invest Conference

Jeremy Glaser
Ben Johnson, CFA

Jeremy Glaser: For Morningstar, I am Jeremy Glazer. I am here with Ben Johnson. He is the director of passive fund research. We're going to look at some hot topics from this year's ETF Invest Conference.

Ben, thanks for joining me.

Ben Johnson: Thanks for having me, Jeremy.

Glaser: Let's start with income. Obviously, that's not a problem specific to exchange-traded funds, but it's one that investors have been struggling with for some time in this interest-rate environment. What are you seeing in the ETF space in terms of products trying to address the income problem? What's the best way to use ETFs in this space?

Johnson: You're absolutely right. I think income is front and center in the minds of many, and I think it will be for some time as more and more people move from sort of the accumulation stage of their investment lifecycle to the sort of capital preservation and maintenance and decumulation stage.

Income is paramount, but income is scarce right now because interest rates are so extremely, historically low. In the ETF space what you've seen is product proliferation. People are searching high, low and everywhere in between for income. We've seen products, some of the most successful of which combined an income angle along with the potential to protect against interest rates in the bank-loan space.

We've seen a pair of very successful bank-loan ETFs. PowerShares Senior Loan Portfolio, ticker BKLN, which is PowerShares product that tracks an index of bank loans. More recently, we've seen SPDR Blackstone/GSO Senior Loan ETF, ticker SRLN, which is an actively managed bank loan product that's sponsored by State Street. So those have proved to be exceedingly popular because they combine income, which has been a hot topic, with also protection against the potential for rising rates, which is another very hot topic.

Elsewhere, you've seen continued proliferation in the master limited partnership space. The MLP space, when it comes to the intersection of MLPs and exchange-traded products, has become just a veritable alphabet soup and it's become increasingly complex, increasingly tricky to discern what's what in what might be the best vehicle for investors looking to gain access income streams offered by MLPs via an ETP.

If you're not confused yet, I don't know what else I could do to potentially confuse that scenario. But it's thorny, and it's something that we've been doing a lot of work to help investors untangle not only what are the sources of this income, what types of income are being spun off by some of these funds, and how is it being taxed, but also, what are the risks? And this is the biggest issue, I think, right now is, investors are kind of in some corners holding their noses as they're reaching for yield. And that historically has proved to be a very dangerous way to go about investing and to go about generating income.

If you look into, in particular, corners of the high-yield bond market, it would appear to me that investors are sort of again holding their noses as they go further and further out in their search for yield. There are plenty of products and a lot of complexities, but I think, first and foremost, what we need to revisit is the risk that's being assumed as people go out hunting for income streams.

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Glaser: A lot of these new products are somewhat novel, but are any of them a really good idea or have a risk/reward profile right now that makes sense? Bank loans, you mentioned, have been very popular. Is that an area that investors should be allocating more to now?

Johnson: I think it's an area that investors definitely have been allocating more to if you look at both the ETF and the mutual fund wrapper. What we've seen is a very small category has gotten very large in very short order over the course of the past 12 to 18 months because, again, you have these twin benefits of higher income, because bank loans offer junk bond-type yields, as well as floating-rate. They're linked to LIBOR; that rate will reset on a regular basis. So it will rise as benchmark interest rates rise.

Do I think everyone should be rushing to invest in bank loans? I don't think anyone should be rushing to invest in anything before assessing the goodness of fit within their portfolio and the risks that are associated with this particular asset class. I think bank loans are a very suitable asset class for many, but they're not necessarily broadly suitable. And first things first, investors should really be doing their homework when it comes to investing in these new, esoteric, more complex categories.

Glaser: The hot topic is emerging markets. There has been a lot of discussion around that, particularly given the underperformance of emerging markets versus the U.S. so far this year. Do you think that there is value in emerging markets right now, and if there are any new products that might help investors kind of tap into that?

Johnson: I think over the very long term, an allocation into emerging market equities still is pivotal in the context of a broad equity allocation. We've seen a lot of volatility in emerging markets this year. A lot of that has been driven by currency volatility. I mean it's important that investors keep in mind that these are not U.S.-dollar-denominated assets and the volatility in these emerging market currencies, the Indian rupee being a notable example this year, has been driving a lot of volatility in those equity investments.

I think they still play an essential role. I think there are pockets of value. I think some of the more interesting ways to add to emerging markets, via ETFs, is to look at some of those funds that specifically tap into what will be the future sources of growth in these markets. So, we've heard a lot about growing middle classes in these regions, young populations, urbanization, increased consumerism.

You want to move down the market-cap spectrum and look at an ETF, such as EGShares Emerging Markets Consumer, ECON; Emerging Global Shares has an ETF that specifically targets these emerging-markets-domiciled consumer-oriented firms. Another good tack to take is to look at those firms that, going back to the income theme, have and will continue to pay steady and ideally growing dividends over time.

One of our longtime favorites in the emerging-markets equity space is WisdomTree Emerging Markets Equity Income, DEM, that specifically singles out emerging-markets stocks that have paid and look as though they will continue to pay either stable or growing dividends with time.

Glaser: A lot investors like to have an active manager on emerging markets who can maybe kick the tires a little bit. What do you think the case is for active management in emerging markets versus going for an index approach or going for an exchange-traded fund approach?

Johnson: I don't think the active/passive debate or the result of that is really any different in emerging-markets context than it is in a developed equity market context. I think it's proved exceedingly difficult for many active managers to add value in emerging-markets stocks. There are some fantastic active managers out there that have done it and done it consistently and are definitely worth considering. You look at this suite of Matthews Funds in particular, they've done a tremendous job over a long period of time of adding value in emerging stock markets.

Now, the active/passive debate, and that's out similarly now, I would think that over time as more and more capital makes its way into these emerging stock markets, as they converge toward developed-markets status, they will become increasingly difficult as these markets, at least theoretically become more efficient for active managers to really consistently deliver outperformance.

Glaser: Speaking a bit more on this active/passive debate, over the past couple of conferences there's been a lot talk about these actively managed ETFs, but it's not an area that's really exploded yet or that has really gained a lot of popularity, with a few notable exceptions. Do you think this is the year that we're going to really see active ETFs take off, or is there something else that's holding them back?

Johnson: I don't think this is the year. If anything I would've thought, last year when we saw the launch of the PIMCO Total Return ETF, BOND, that that might have sort of conjured up the animal spirits that would finally get active ETFs really off the ground. I think the primary impediment right now to a bigger ramp in the launch and the uptake of active ETFs, lies at the SEC.

Given that, I think, the SEC is now sort of temporarily shut down, I don't think this is something that will resolve itself anytime soon. But it pertains to the approval of nontransparent active ETFs. These are ETFs that are actively managed that do not have to show their hand, do not have to show their portfolio on a daily basis. I think the asset management industry at large is really pinning a lot of its hopes on the approval of one of what are multiple different approaches to doing this that are under SEC review right now.

They really want to have that opacity, and it won't be opacity relative to what they're currently doing in mutual funds. There will still be regular portfolio disclosure, but it won't be the daily full disclosure that we are accustomed to in ETF land. I think once, when and if, that makes its way through the SEC, I think then and probably only then will you really begin to see a true ramp in active ETFs.

Glaser: What does this mean for investors? Should they be excited about these active ETFs? Are there advantages over an open-end mutual fund?

Johnson: There's a lot of potential there. There's the potential to really sort of turn fund distribution on its head because at the end of the day the ETF is just a vehicle. It's just a means of distribution. And some of the benefits of it are that it could potentially take things like record-keeping costs out of the equation. And if those costs and those cost savings could be shared with the end investor, I think that would be a very beneficial thing.

I think if the way that ETF shares are sort of created and redeemed, if that could externalize some of the costs of turnover in portfolios, I think that could be another positive development. But I'm still skeptical because I feel like some of these costs might be sort of the classic balloon example, where you push the balloon down in one spot, only to see it pop up somewhere else.

I think the costs could pop up when you bring these funds on an exchange in the form of wide bid-ask spreads because it would be difficult I think for many market makers to make orderly markets in these fund shares. And I think also depending on the way these fund shares are created and redeemed that the externalization of trading costs might not ultimately manifest itself, if there are no baskets or cash creations taking place whereby the manager is going to have to go up about making those trades anyway.

There is promise there. I'm still a bit skeptical, and I think everyone's really just waiting on the SEC and their opinion on nontransparent active ETFs.

Glaser: Ben. I appreciate your thoughts today.

Johnson: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.