What's Driving the Growth of ETFs?

Paul Justice: The ever-changing exchange-traded fund investing landscape. I am Paul Justice with Morningstar, today I am joined with an ETF visionary, Jonathan Steinberg from WisdomTree Investments, CEO. Thank you for joining me.

Jonathan Steinberg: Thank you, Paul.

Justice: We see many more traditional mutual fund companies really giving the ETF space a hard look these days. Even we see some index providers who have been jumping into this space, most recently Russell Investments has launched some funds on some pretty exotic beta indexes. You did this long before anybody, and these companies really jumped into it. Could you talk about why you thought ETF's would be successful and do you think there is a lot of room for more players?

Steinberg: So the reason for the success of the ETF industry is that it serves the investor better. So the hallmark of ETFs is that every ETF ever launched is fully transparent with intraday liquidity and in many cases better tax efficiency. So it is in the enlightened self interest of all investors to be using more and more ETFs. And it's incumbent on the industry to educate intermediaries and the end investor, and I think we are doing it, though we can do much better.

With the growth rates, though you are seeing a lot of activity recently, it's taken us about 18 years as an industry to break a trillion dollars. If you look at the inflows, we had a wonderful 2008, right into the crisis. ETFs took in about $180 billion of inflows and mutual funds saw about $225 billion of outflows. But in 2009 and 2010, with ETFs versus mutual funds, ETFs only took in about one third. As an industry we need to reverse that. We need to be two thirds of the inflows, and it's starting to happen.

There are a couple of catalysts that could drive that. One is education for sure. Two is that we as an industry now have diversified the product offerings so that we are competing in virtually every asset class and strategy that investors have had access to in other structures. And then three is maybe the evolution of the business model of the intermediary, moving more to fee-based program. Those should be catalysts for growth, but it just makes sense. And from a slightly cynical standpoint, if you had asked any of the heads of any of the large traditional mutual fund companies in 1993 when the first ETF was launched, "Do you think it's serves investors to invest with transparency, with greater liquidity, or greater tax efficiency?" Anyone who is honest would say yes. Where were they? Very few showed up. So even today even though we have a lot of activity, there are only like 33, 34, or 35 sponsors, and we have a 1,000 ETFs that compares with like 9,000 mutual funds. It's incredible how slow they have been to come into the industry.

Justice: Well, that seems to be changing now. Last month we had a pretty large filing, say Bill Gross from PIMCO is going to launch his Total Return fund in the ETF wrapper. Now clearly this is a recognition, at least by Bill Gross, that ETFs are pretty significant at this point in time. It's my opinion that he is probably choosing to do this because of this distribution channel that available through ETFs. Could you talk a little bit about the difference of how mutual funds are brought to investors versus ETFs?

Steinberg: Well, I mean some of this is really inside baseball like how the mutual fund industry seeds their own fund and we get outside seeding, but that's really not of relevance. I believe that Bill Gross has said that he made a mistake and that he should have entered the ETF industry earlier. The reason to do this is because if you launch a mutual fund today, no matter how good your strategy, you are launching a black-and-white TV, an older technology that just will not hold up over the tough competition that will emerge, if it isn't already there, from ETFs. If you want to have a fund that can be an end-game player, it has to be in this transparent, liquid, tax-efficient structure.

What Bill gross is doing is very, very interesting. This is the first time you've had a celebrity investor, a broad-named investor, coming into the ETF structure in active ETFs, and so I think he will be very, very successful there. The media has been somewhat skeptical at the pace of growth that active ETFs have attracted assets, but when you're active, meaning you're not beta, you need to build your track record, which takes time, or you need a Bill Gross. So this is a very exciting development I think for ETFs, and I think he will be very successful at it.

Justice: Now you brought up two interesting points talking about the move to fee-based investing, and, I guess this will be my point, a more regulated fiduciary world by financial advisors. Why would those factors contribute to the growth of ETFs?

Steinberg: I think it is that they would be serving their clients better if they are using these transparent, tax-efficient, more liquid products. First of all, you've had some very successful mutual funds over long periods of time. You get very comfortable with the brands that you have used. Your clients get very comfortable, and it's not always easy to change. But really evolution is necessary, and you see it in every other industry where the new technology, if it is better, transforms.

It has not been the case, however, in ETFs. We are gaining traction, but it's still stubbornly slow in my opinion. And where we really seem to accelerate is in moments of crisis. When you have a crisis, it puts stress on the structure, and the inferior structures start to show. And that's where we start to really show up in a very positive light. So I am optimistic, but we as an industry have a lot more to do.

Justice: Great. Well, I appreciate your insights onto the ETF industry, and wish you success going forward.

Steinberg: Thank you so much, Paul.