Lee Kranefuss Interview By Jim Wiandt September 25, 2000

Lee Kranefuss, CEO of U.S. Individual Investor Business at Barclays Global Investors, recently sat down with IndexFunds.com's Jim Wiandt to discuss the proliferation of iShares and the future of exchange-traded funds (ETFs).

IF.com: What do you see as the most significant benefits of investing with exchange-traded funds (ETFs)?

LK: It's really the fact that they're a combination of the features of stocks and funds. You're getting the professional management and diversification you'd expect with a fund and, at the same time, you're getting the portability and flexibility of a stock you can buy and sell at any brokerage account. And in many dimensions, the fact that you can buy and sell it during the day if you use margin or short dimensions, for example hedging, you're able to do those as well. You can borrow against it. So it's really the best of both worlds.

IF.com: What do you see as situations where investors might do better with a traditional open-ended mutual fund?

LK: Probably the simplest situation is if you're doing very small dollar cost averaging as a starting-out investor. Unless you're in an account with unlimited trading privileges, you're going to pay a transaction charge, a commission every time you buy and sell. So if you're putting in $200, even then an $18 trade is a big piece of it. So ETFs are probably not right for the small dollar cost averagers or starting-out investor. They're for somebody who already has a reasonable portfolio of stocks and/or funds and needs to look at ETFs as a fair alternative.

IF.com: Has Barclays looked at any way to get into the 401(k) market, or is it just that the structure's not friendly to it?

LK: Well, I don't know if it's friendly or unfriendly. Right now we are concentrating on getting out there to the retail and institutional markets and over time we'll look more carefully at how we could get into some of the other markets, if it makes sense.

IF.com: Is Barclay's working to narrow ETF premiums and discounts underlying net asset value(NAV)? Are you satisfied with the levels of transparency?

LK: There's a lot of misinformation about what goes on and the importance of current price or last trade versus net asset value. If I could take a couple minutes, I'll take you through a little bit of some of the practical issues that go into that and why that may not be as big a concern as some have made it out to be.

The first thing to know is that NAV is cut at 4:00 p.m. EST on most funds. But there's no reason it has to be. As far as I know, it's done that way by convention because that is the last trade of the major exchanges for stock. The first thing to note about this is that ETFs continue trading; I think all U.S. ETFs trade until 4:15. So if a fund is active and it's got a lot of trades going on . . .

IF.com: It'll pass the NAV?

LK: Yes, you're trading past the time when the NAV was calculated. So suppose that new information comes out on the top holding in the fund - at 4:02 p.m. a big announcement is made. You would expect the ETF to change in price to reflect the announcement, and that traders would take that into account and re-price the ETF. So there's one case where you're going to see movement away from NAV.

IF.com: Right, it goes the other way too. If it's a very lightly traded fund and the last trade was at 11:00, the 4:00 NAV could be significantly different.

LK: That's precisely right, and there's a fair number of those, and more specialized funds, so it could be hours since the last trade took place. And that's just on domestics. On internationals, where large NAV discrepancies are reported, remember that you're dealing with stale prices in many cases. So let's take a Japan fund today, at 4:00 today an NAV will be cut on, for example, the iShares MSCI Japan. That's based on closing market prices in Japan, which will have been approximately 16 hours earlier.

IF.com: Right.

LK: That's true of international funds in general - the challenge of international funds is that the NAV is very stale because the stock hasn't been trading. Now, what will happen is the Japan iShare is trading and people are looking at it and seeing the changing value, which is what it should be doing.

IF.com: Absolutely, based on currency trading.

LK: Currency, and also where the U.S. market is, depending on the levels of correlation. What we would expect is that it's being priced properly by 4:00 or 4:15, since Tokyo is going to open in another hour and three-quarters, it should be pretty close to where people expect the open in Tokyo to be on the stocks - not where the close was 22 hours or 16 or 18 hours earlier. So I often point out to people that if the NAV is always the same as the last reported trade on any ETF, particularly an international one, that would be an indication that the interday pricing mechanism is not working properly. It would be a defect - there would be something wrong. The fact that they diverge is indicative of the fact that there is price discovery taking place and that everything doesn't happen at 4:00.

IF.com: What do you propose as a more accurate representation in terms of when they're reported?

LK: I'm not sure I have a perfect proposal. One thing I encourage people to do, and what I do myself, is look at the midpoint of the bid, ask, and spread at 4:00 and compare that to NAV. That gives you a better picture because you know at 4:00 you could go and buy or sell at the bid or ask, so halfway between is some indication of what the market is currently asking for it. And you can compare that to the NAV.

IF.com: Is Barclays doing anything to minimize the trauma caused by some of the international funds - and some of the sector funds in the U.S. - based on the 25 percent, 5/25 limitations? Do you try to foresee where the index is going?

LK: What we try to do is use our experiences as a worldwide index manager to make intelligent trade-offs. There are a number of different approaches that one can take to dealing with the issue in the optimization or sampling process. And we do our best to try and make decisions to make them track the index as closely as possible. The reality is that it's not an ETF problem. If it's driven by SEC and IRS regulations, it would happen to any other fund product, mutual fund or otherwise. And that's inherent in the nature of the indexes.

IF.com: Where are iShares going in the future? Are you going to move into 16 more international regional funds, international size, value, growth sector funds? Anything like that?

LK: Sure. The angles that we'll be pursuing are, number one, to continue expansion of both domestic and international equity funds. There's a lot of demand out there for more products. We have announced the intention to launch the S&P Global 100, which will be traded on the New York Stock Exchange. And we'll be looking at more opportunities there for both domestic and international index funds, although none are filed as of yet. The next step in general product evolution is probably fixed income. I don't know if you're aware, but we're in the process of launching in Canada the first fixed income exchange-traded fund. So we have that going up there. Canada tends to lead the US in exchange-traded funds. It's a little known fact that the spreader was preceded by the Canadian products. Essentially the HIPs have been around since the late '80s, they're now part of our I-60. So they were first to market again with fixed income, but we would hope to bring up fixed income products in due course. And then the final step in the product evolution would be active funds.

IF.com: I was going to ask you about that.

LK: Both fixed income and active pose some unique challenges. Different, but unique from both an operational and regulatory perspective, and we're looking at that and we hope to be the first with funds out there. We now have 56 of the 69 funds in the US, and we consider ourselves a leader and we'd like to have the first ones out. But it's going to take a lot more work.

IF.com: What are the main obstacles in the actively traded ETFs?

LK: The biggest obstacle in active is pretty simple. With the normal exchange-traded fund, the way it maintains its value during the day is through the arbitrage mechanism. That requires you to post what securities are in the portfolio every day. Most active managers consider it a gross violation of their privacy to have to disclose twice a year what the holdings are. So the concept of posting the basket every day,of revealing what a fund is holding - it's unlikely to fly for most managers.

IF.com: Is there a way to post the NAV without having to disclose what it consists of?

LK: That's where a lot of the research is going in, not only here but in other firms. Is there a way to make changes in a basket or an index that would be close enough, and you could still post the NAV, find a way to take in securities, continue to ensure that the arbitrage mechanism works, and at the same time not have to give away all the holdings every day? That's going to take some more work on an operational basis and it's also going to take some work in the regulatory front to get that through. Because no one's tried doing it yet.

IF.com: A couple of questions on the competition. Any comments on Vanguard's assertions that the trading costs make ETFs more expensive than open-ended funds for many smaller buy-and-hold investors?

LK: Again, with any investment product, any investor ought to assess the costs, the benefits, and the tradeoffs between alternatives and pick what's best for them. No single product in investments or anywhere else is right for everyone. We already talked about the small dollar cost averager, for example, as somebody who is probably not going to benefit from the exchange-traded fund. That having been said, you have to look at each individual situation. The primary benefit of exchange-traded funds is that they have very low costs and very high tax efficiency. And if you are holding for the long term, the actual cost of the brokerage commission - which is definitely going to be there unless you're in an unlimited trading account which are increasing in popularity, but let's assume you're not - you're going to have to pay that. The tradeoff is going to be how long you're staying in the fund, how much you're saving, and how much you're paying for that trade.

IF.com: Vanguard is saying that, on the average, you lose a half point or a point.

LK: But there's no free lunch in the securities market. If you're a mutual fund investor, somebody has to pay the bid/ask spread. And you may not pay it when you go into a mutual fund, per se, you may not see it, but the fund pays it.

IF.com: I guess Vanguard's basic point is for a retail investor, you're more likely to get the lower end of the ask/bid spread than a large institutional investor.

LK: Why?

IF.com: Because with volume, you can narrow down the ask/bid spread and get closer to the middle.

LK: The market that institutions are trading in on the floor of the exchange is the same market that the individuals are trading in, and it's quoted there. And there are exchange rules that cover all equity and exchange listed securities, that try to ensure fairness between retail investors and large institutions. You'd have to talk to the American Stock Exchange. But that's an important part of exchange regulations: ensuring that institutions are not always getting better execution than the retail public. And so, there are no free lunches when it comes to transactions cost in that sense. Now with the ETF, you may see it when you actually go purchase the ETF, but the good news is that the portfolio didn't have to just go purchase securities and pay a bid/ask spread. So you have to take all of the costs and benefits into account, including the holding period. Also you need to take into account the relative tax efficiency, because that matters too.

IF.com: Especially in terms of redemptions, that's where you can take a big hit on the open-ended funds more than on the ETFs.

LK: Mutual funds also. Many still have their own transaction fees for entry and exit that have to be taken into account, that get ignored sometimes. We all know about fund supermarkets, which have no transaction fees. And if you have an account with the fund company or you have a no transaction fee supermarket where the fund you want is offered, then you don't pay any fee. But a fair number of investors do pay a purchase charge on standard mutual funds. And what we're seeing a lot of is if you are in a fund supermarket that does not have the fund that you want, and you know particular index funds tend not to be in the transaction fee supermarkets, then you are going to pay a commission essentially - a trading fee to purchase the fund.

My point is that one does need to take into account an apples-to-apples comparison relative to your own situation in terms of investment horizon, the cost of the transaction, the relative savings, and other fees. You really need to account for all those factors carefully and make the best choice. And an ETF may not be the best choice for some people and a traditional fund may not be the best choice for other people.

IF.com: Any comments on State Street's strong move into the international market? Is Barclays going to continue to move aggressively in international, both in terms of U.S.-traded international and foreign-based ETFs?

LK: We are currently the only manager, to the best of my knowledge, who is offering any international products. We offer what is now 21 country funds, I believe, and two European funds, as well. And more, including the S&P Global 100, are on the way. So when it comes to international, we're the only ones offering product right now. When it comes to the foreign markets, we have product running in London and we've made announcements about our intent in Japan. But we intend to be the world leader. Right now there are 69 funds in the U.S., and we manage 56 of them. As for the rest of the world, there's one in Canada. There's one in London. And I believe there are two in Germany. So there's four more around the world.

IF.com: It seems like every day you get a couple new ones popping up.

LK: The market is clearly one that has caught people's attention. Since 1996, when we started with the country funds, we've been pointing out that these are very efficient ways to invest. And you're definitely seeing that the rest of the world has taken notice of this in the last two months. But right now, we lead international in investments and we intend to continue to be the strategic leader in this market.

IF.com: Who do you see as the main competition?

LK: I don't really think much about who is the main competition in that way. We have such a broad product set, we have really the only one that covers all the different sizes - mid, large, and small cap, as well as style, value, and growth. We have a complete set of Dow sectors. We have the international funds. So the product set is just so much broader than what anyone else is offering that it's just very different.

IF.com: Do you think ETFs are going to remain a niche market or do you think that the mutual fund industry is going to completely evolve?

LK: I don't know, time will tell what's going to happen there. Have you seen the FRC study yet? There's a great study out from the Financial Research Corporation, they say from their broker surveys that actively-managed ETFs will have 16.5 percent of equity fund assets by the year 2007. It's a very compelling product and there are a number of advantages. You can buy it in any brokerage account you want, and you can use it the same way as equity. Mutual funds are a little bit inflexible in some ways, they cannot by bought and sold during the day. They're relatively difficult to borrow against if you have a margin account and you just want to raise cash against them. They're just a different beast.

IF.com: Where do you see the iShares being five years down the road in terms of net assets?

LK: That's very hard to say because it's going to depend a lot on what the overall market does, and how aggressively people adopt ETFs as an alternative. We think that this is going to be a market that continues to grow. We ended 1998 at about $15 billion in assets, and we're up to about $40 billion to $50 billion right now. And so it's a market that's growing fairly quickly as more and more people find out about the benefits.

IF.com: It looks to me like a lot of other players are trying to step in now.

LK: There's certainly a lot of attention and it validates what we've been saying for a number of years that these are great products. And so time will tell what the competitive landscape looks like, what investor demand looks like. We think it's a great product for us to be aligned with as the world's largest indexer, the world's second largest money manager, the largest institutional manager. It's a great product that features what we bring to the table: scale, technology, and low cost, for individual investors as well as institutions.