By John Spence, Associate Editor

At the recent seminar in San Francisco entitled "Asset Allocation: Theories vs. Realities," representatives from the industry outlined the benefits of using exchanged-traded funds (ETFs) in portfolio management strategies. Many of the institutional investors who attended the conference were trustees or appointed board members of retirement and pension funds. The seminar was presented by Dow Jones Indexes along with The National Association of Investment Fiduciaries.

When the floor was opened for discussion, some institutional investors expressed a concern that is a common reaction to the concept of the exchange-traded fund: that they are the tool of the speculator and market-timer. They claimed, as many have, that ETFs are not an investment product designed for long-term buy-and-hold investors, but rather an instrument for exploiting discounts and premiums.

"What benefit do these products have for society?" asked one institutional investor. "The capital being invested in ETFs is not being applied to real products, real workers."

This pension fund trustee also made the claim that ETFs are more like "casino chips" than a long-term investment.

As usual, the most informative portion of the session occurred during this Q&A format when investors were able to interact directly with the speakers.

"An ETF represents the same sort of collective account as a mutual fund," explained Brad Zigler, Principal of Marketing and Education for Barclays Global Investors (BGI). "You might think that ETFs are used as trading tools, but the research seems to indicate otherwise. A recent Financial Research Corporation study reports that 75% of people that invest in ETFs or plan to invest in ETFs are doing so with a buy-and-hold strategy, while the remaining 25% said they would use them for a mix of both long-term and trading-oriented strategies."

Many investors are spooked by the fact that arbitrage opportunities with ETFs, which sometimes become available when an ETF trades above or below its fair market value, are the mechanism that determines share prices.

"There is the arbitrage opportunity [with ETFs], which tends to keep the prices of the ETFs shares and the portfolio value in line," said Zigler.

Gus Fleites, Director of ETFs for State Street Global Advisor (SSgA), further outlined why ETFs are appropriate for the long-term investor, retail or institutional.

"Whether you like it or not, the market is made up of buy-and-hold investors, traders, and speculators," said Fleites. "Before ETFs were available, it was very difficult to remove the impact of the speculator and the trader from the products retail investors were buying. The instruments that some of the aggressive traders are using are either the derivative market or mutual index funds. The fact that they were using index funds caused great havoc for the buy-and-hold investors [in the form of distributions]. What this product does very successfully is marry all of the camps because you need all three parties to have an efficient market. With ETFs, buy-and-hold investors aren't going to pay for the sins, if you will, of the people who are going to trade aggressively. There's been a lot of attention given to the high turnover of these products. The truth is that you could have 300% turnover and it's not going to hurt the buy-and-hold investor who is looking to invest 5, 10, or 20 years."

In his presentation about iShares ETFs and the market in general, BGI's Zigler pointed out that, unlike mutual funds, ETF investors don't interact with the fund itself.

"When ETF shares are created, the creator doesn't hand the fund cash as in a traditional mutual fund environment, but instead hands the component securities as dictated by the daily portfolio creation file that's put out by the fund's manager," said Zigler. "Instead of getting back cash when you turn in ETF shares you're going to get back the same holdings that make up the index portfolio. There is very little interaction with capital markets in managing an ETF portfolio. The one case where the fund will have to access capital markets [other than in the creation/redemption and in the actual trading of the fund itself] to buy or sell securities is during an index reconstitution."

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