Gus Fleites Interview By Jim Wiandt September 26, 2000

"I think it's safe to say ETFs now probably represent somewhere between 5 and 10 percent of indexed mutual fund assets with assets at about $50 billion. I think it's probably fair to say that percentage will double in the next 5 years."

Gus Fleites is a Principal of State Street Global Advisors (SSgA). He is responsible for the development and implementation of exchange-traded funds (ETFs) and offshore investment products. At the 2nd Annual Exchange-Traded Fund & Index Share Forum, Gus sat down with Managing Editor Jim Wiandt to discuss the future of exchange-traded funds and SSgA's recent moves to establish itself in this growing market.

Jim Wiandt: I've been in Barclays captivity all morning at an ETF conference, so. . .

Gus Fleites: Poor you. You can quote me on that one too.

JW: I will. We'll start with a very basic question. What do you see as the most significant benefits of investing with ETFs?

GF: A couple of things. One is the ability to transact throughout the day; the fact that you can trade the fund just like an ordinary equity. More importantly, you are able to put in stop loss limits for any ETF compared to a mutual fund, which you can't transact in. Number two would be tax efficiency. I think the retail market is beginning to understand the advantages of retail investing. That is, the whole concept of having a diversified portfolio of securities, a lower turnover, etc. But I think what retail investors don't understand is that the low turnover is compromised in a traditional index mutual fund, because the mutual fund must still provide the liquidity for people coming in and out. That's going to create turnover, which will have an impact on the fund's ability to track the index. Turnover creates a distribution of taxable gains, which an index fund - if it is has a true buy and hold strategy - shouldn't be experiencing.

Turnover also causes transaction costs, which will affect tracking error, and also lead to capital gains. So I think that the ETF is proficient at ensuring the true advantages of index investing for the retail investor in a way that the traditional mutual fund can't.

JW: On the tax issue, with the Barclays iShares, you can reinvest the dividends. A couple angles on that:

1) Are you looking in some way to alter the structure of your funds so that you can pull that off, and
2) Do you think it's very significant?

GF: There is a lot of bad information going around out there on this subject. The issue basically involves the difference between the Unit Investment Trust structure and the open-ended fund structure. The only funds we have out there right now that are Unit Investment Trusts are the Spider (SPDRs) and the Dow Diamond. All of the other funds that we have are actually open-ended funds. When dividends are received, the fund has to hold onto that money as cash until the dividend is declared by the fund and distributed to shareholders.

JW: Yes, it's a quarterly drag.

GF: It's a quarterly drag, but it's sort of a nonevent for an S&P 500 fund. If you look at the yield of the S&P 500 now, it's about 1%. Assuming that dividend is paid out quarterly throughout the year, you would get 25 basis points of income each quarter. That income tends to be received around the same dates, since companies distribute their income roughly around the same dates every quarter. The fund pays out that income fairly quickly after it's received within the fund. So the period that cash is held within the fund is not the full three months.
It's definitely not the full 12 months. It's a small fraction of the year. The cash drag as a result of that is going to be insignificant.

For example, if you look at the return of the Spider and compare it to the S&P 500, you'll notice that if there is any dividend drag, it's almost impossible to measure. It's more of an issue when you're talking about indexes that have higher yields, as in the case of a utilities fund or a real estate fund. The Unit Investment Trust would not be the right vehicle for those funds. In fact, if you look at all of our other products, we don't use the Unit Investment Trust structure anymore. It's for that reason, as well as a slew of other reasons.

The fact of the matter, though, is that when the Spider was launched in 1993, the Unit Investment Structure was the only structure that the regulators were comfortable with in approving an ETF, so it's the legacy issue of being the first in the marketplace.

JW: Do you think you'll be able to change them [regulators] over?

GF: We have a filing out there to get exemptive relief to allow for the reinvestment of dividends. We're optimistic that we'll be able to get that through, but we're only doing that in the event that yields go back up to more meaningful levels. We're looking forward to the day where the yield goes back up to 4 or 5 percent, but right now it's really a nonevent.

JW: Do you anticipate renewing the fee waiver on the sector Spiders?

GF: Yes, we do.

JW: What is State Street looking to do in the way of new products? Any fixed income or international regional funds?

GF: Well, on Friday we're launching 10 new funds. Four of them will be Dow products. There will be a Dow Jones large value, Dow Jones small value, Dow Jones large growth, and Dow Jones small growth. We know that these are actually better style indexes than what's out there. The ones that are out there right now are Russell indexes, the S&P indexes, and the Barra indexes. Dow Jones recently launched indexes that we created about 15 years ago, and we sold the rights to Dow Jones so that they could market them more aggressively. When we constructed those indexes, what we tried to come up with was a better way of defining the style. If you talk to professional investors, I think you'll find that one of the biggest concerns investors have with the indexes that are out there right now is that they have significant turnover. Most of this turnover is caused by the fact that they have one or two criteria to define value and growth, so what you have is a lot of companies switching back and forth. I think the Russell indexes are renowned for this.

JW: So the Dows don't split them right down the middle?

GF: No. What we do is we create a buffer zone, so the securities in the middle don't go into either. So what that does is prevent the companies that don't know what they want to be when they grow up from switching back and forth. As a result, you end up having companies that truly reflect style biases in the indexes. Instead of looking at one or two criteria, we look at 4 or 5 criteria, and what that does is provide more stability in the style biases we're looking for. So they're much better biases in capturing style and much better indexes for managing money, because they're going to have much lower turnover.

One of the other funds we'll be launching on Friday will be the Dow Jones Global Titans. That will be the first time that you'll see a global fund trading in the U.S. We also have the Morgan Stanley Technology and Morgan Stanley Internet coming out Friday and probably the following week you'll see two Fortune funds come out: the Fortune 500 and the E-50.

JW: Are you working on active funds? There are significant problems with trying to get the NAV out without revealing the portfolio.

GF: Yes, and that's a serious issue. The other issue with the active products is turnover. Some people are talking about dealing with turnover through special baskets. The problem is that if you don't have enough trading and enough creation/redemption, the portfolio manager is eventually going to have to trade to reflect his or her view of the composition of the portfolio, and that's going to take away a lot of the tax efficiency of the vehicle. The transparency issue is going to be a problem. The manager is not going to want to disclose the composition of the portfolio every day because he doesn't want to have people front-running him. So those are all big disclosure issues.

The last issue that people are losing sight of is the tremendous popularity of ETFs. What it really comes down to is people being comfortable with the benchmark that's being used. For example, the Spider is as successful because people know that it's going to look and behave just like the S&P 500, so they can use it as a proxy for the investment.

The exchange-traded fund is a product that's going to be marketed to a niche crowd. At the end of the day, what makes the ETF such an attractive product is the fact that investors can use it for so many different applications. And that's what creates liquidity in the market. The minute you start fragmenting the market and defining it very finely, you're going to start to lose a lot of that trading liquidity.

JW: Any comments on the Australia fund you launched? I think you caught a lot of people by surprise.

GF: I think we did. We signed a memorandum of understanding with the Sydney Stock Exchange to launch a product next year and we've started working with them very diligently to get that product together. The Australian market is very mature and sophisticated, so we're very excited about launching a product there.

JW: Do you see State Street continuing to make a strong push on foreign-based ETFs?

GF: Absolutely. In fact, State Street was the first to launch a foreign-based ETF. The ETFs in Canada were actually the first ETFs in the world, and last year we launched the Hong Kong fund with $4.5 billion in assets. We believe we have the experience and the results to launch more international ETFs.

You'll see us be a bit more cautious in launching products that trade in the U.S. and invest offshore like the WEBS. Our philosophy here is that for a product to work as well, as the Spider does here or the Tracker in Hong Kong, it's important for the underlying stocks to trade at the same time as the ETF trades. That's really what closes the arbitrage loop. The minute you can't track the stock at the same time you trade the ETF, you create the opportunity for mispricing, and that's really going to take liquidity away from the product. It's a complicated product. I'm not saying it's a bad idea, but it's very difficult to manage, and it's going to create pricing gaps that are very difficult to explain.

GF: We'd like to focus our attention on ways for U.S. investors to be able to trade on those markets, because you'll find that if you go to the markets where the liquidity is really there, the investors are better served. Not that we aren't looking into it - we are coming out with the Global Titans - but we have to work on some fairly innovative features to ensure that they trade at a fair price. If push comes to shove, though, we'd rather develop the products in the local markets where the securities are trading.

JW: Do you see ETFs chipping significantly into the mutual fund industry, or do you see them remaining a niche player?

GF: Well, that's the million dollar question, isn't it? I don't see them as a direct competitor to the mutual fund industry. I do see them as a next-generation index fund product, so I think what you'll see is investors who have historically used the index mutual fund start to come into the ETF structure. In fact, if you look at companies who offer index mutual funds, I think they're all out there looking to launch their own ETFs. I think it is an evolution of the index mutual fund in that the greatest source of tracking error and tax inefficiency is shareholder activity. The ETF is successful in taking shareholder activity from the fund and putting it into the stock market, so from that point it's a better mousetrap.

There are some instances where the mutual fund might still be preferable. It might not make sense, for example, for a small dollar cost-averaging investor to use ETFs. But some of these Internet-based brokerages may institute plans where people are able to invest in ETFs in that manner more reasonably, so a lot of those disadvantages may start to disappear.

JW: Any projections for net assets of State Street funds in the next 5 years?

GF: I think it's probably safe to say ETFs now probably represent somewhere between 5 and 10 percent of indexed mutual fund assets with assets at about $50 billion. I think it's probably fair to say that percentage will double in the next 5 years. It will all be based on how well index funds continue to do,
and unfortunately much of it will be based on performance. You know, as much as I hate to admit it, we like to think that index funds have grown because people understand what index investing is all about. But in actuality, the returns have really driven investment. So if the S&P continues to do as well as it's done, we could have $100 billion in these products in 5 years. If not, it might be well south of that - but the market's really going to determine that.