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This is part two of a two-part story. Part one ran on Friday.

Building A Better Mousetrap

The secret to the success of ETFs is that it is one of the few packaged investments in which individuals and institutions pay the same price, according to Michael Latham, U.S. CEO of iShares. “ETFs truly are a better mousetrap,” he said. “It is just a really good idea to trade a basket of securities intraday. We find that liquidity appeals to both institutions and individuals, and that liquidity keeps spreads tight.”

The liquidity and flexibility also gives institutions plenty of possibilities for shorts, either buying the inverse fund or actually selling the long fund short. Latham said many investors of all sizes like the simplicity and protection afforded by the inverse, as opposed to the upside risk of a true short, but he noted that buying the inverse is not exactly the same because it cannot exactly replicate the performance.

Long or short, Latham noted that the low cost and ease of use appeal to all investors. “Institutions are very much attuned to trading costs and management fees, so there is huge value to institutional investors,” he said. “That gives a very important advantage in gathering the liquidity for the sponsor who is first to market.”

That ease of entry, and exit, has led to some fears that ETF investments are hot money, just chasing the flavor of the month. “Institutions do use ETFs for short-term purposes,”

Latham emphasized. “It is important for them to know that they can get out quickly if they want to, but that does not mean that they will. The same could be said of traditional equities. I don’t buy the argument that ETFs are just for trading geeks. Far and away the majority of investments are medium to long term. We can tell by the number of shareholders we have and the turnover.”

Latham also dismissed the idea that, even with low costs, ETFs are at a disadvantage to futures, which can essentially be bought for free. “We heard that argument when we first launched ETFs,” he said. In practice, though, investors have felt just the opposite. “With ETFs, you get better liquidity and better execution. There are costs, but they are low and are well worth every penny.”

At the moment, Latham sees something of a transition in ETF buying trends. “If you look at the last six months, fixed-income funds were gathering much more assets, but last year it was non-U.S. equities,” he noted. “Looking ahead, fixed income will still be in strong demand, and commodities - both long and short - will be growing.”

To meet that demand, Latham said iShares will be launching dozens of new products over the next few years. As did other sponsors, he declined to specify, citing regulatory restrictions.

Latham noted, however, that new issues also are necessary to keep pace with the

competition. “It is inevitable that we will get a lot of new entrants, but these markets are pretty efficient,” he said. “The majority of assets will end up with very few providers. The 80/20 rule will prevail.”

Maintaining Flexibility

The flexibility so popular with investors comes directly from the flexibility enjoyed by fund managers, according to Kris Rollenhagen, director of closed-end funds and ETFs at Oppenheimer & Co. “Shares can be created or redeemed by the authorized participants, and institutions can do transactions in kind,” he said. “That enables the market makers to create or redeem based on demand, as long as there are underlying securities.” That accordion works in both directions, he noted, adding that one sponsor had to close 11 ETFs a few months ago.

Rollenhagen also noted that inverse ETFs have added a great deal of utility to short strategies. “The newest give you two times the inverse of what the index did that day, so it is not cumulative as true short sales are,” he said. “Of course, the sponsor has some counterparty risk, but so far the system has worked beautifully.” The expectation is that counterparties are laying off pieces of their risk.

Like settlers coming to a frontier, there seems to be plenty of room for all the newcomers. And while ETFs have been around for a decade and a half, Rollenhagen had the thrill

of invention when he came to Oppenheimer recently. “I got here a year ago and no one had done anything on ETFs,” he said. “I had the excitement of starting from scratch. First, we created a primer on ETFs that has become extraordinarily popular. Now, we also publish a quarterly on the ETF universe and provide research for asset allocations.”

That growth will include actively managed ETFs, but Rollenhagen is withholding judgment on those for the time being. “There are not enough of them out there to make a determination,” he said. He also is a rare voice with some reservations about commodity ETFs. “Conventional ETFs are based on underlying issues, but many commodity funds are based on futures,” he noted. “That is a twist, but so far it has worked. Some funds have been big winners.”

Whichever route the pioneers take next, there is a lot more room in the ETF universe. “As long as indices can be created and back tested - and there are plenty being tested right now – growth will continue,” Rollenhagen said. “Some entries will be too narrow and won’t be taken up, but the clients get their net asset value back when an ETF folds. The growth in the sector has been phenomenal and will continue.”

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