Leverage to Move the World

05/07/2009 9:04 am EST

Focus: GLOBAL

Matt Hougan

CEO, Inside ETFs

The ETF industry won't easily give up gains made during the recent bear market, says IndexUniverse.com editor Matt Hougan

Q. ProShares recently announced plans to launch 94 new inverse and leveraged ETFs, many tied to overseas markets. Is this the final frontier? Once I can triple-short Malaysia, the industry will have run out of ideas, right?

A. I’m putting all my retirement on triple-short Malaysia, aren’t you? We can laugh, but the truth is that investors (or at least traders) are embracing these funds. Leveraged and inverse ETFs accounted for the bulk of positive inflows into the ETF space in the first quarter of 2009. They are wildly successful. Whether or not they are a good idea for most investors is another question entirely.

Q. Barclays (London: BARC; NYSE: BCS) recently sold its iShares ETF business. Does this say more about Barclays or future profits for ETF issuers? At least from the issuer's perspective, is it starting to seem like a pretty crowded party?

A. I think it says everything about Barclays and very little about iShares, really. Barclays’ management wanted to avoid going on the government payroll, so they could retain discretion over compensation and the direction of the firm. The iShares sale will boost their balance sheet. Why else would they sell a crown jewel at depressed prices? iShares has a dominant position in the fastest growing segment of the financial services industry.

Q. What are some of your favorite international ETFs? Least favorite? Why?

I’m not a financial advisor; I’m an ETF analyst. With that caveat, I personally think that China continues to look attractive on a relative basis. I’m a fan of the SPDR S&P China ETF (NYSE: GXC). On the flipside, I worry deeply about Europe.

Q. You've written extensively about tracking, liquidity, and tax pitfalls facing an ETF investor. Has the quality of the offerings generally improved as kinks have been worked out, or declined as new entrants have piled in? Are there any ETFs out there to be avoided on principle?

A. Liquidity and bid-ask spreads have improved greatly over the past year, as ETF companies have directed significant efforts to monitoring spreads and working with specialists to keep spreads tight. A lot of people suffer slippage from bad trading in ETFs. It’s getting better, but there is still a ways to go.

As for ETFs I would avoid on principle, I would be very concerned in a taxable account holding a leveraged or inverse ETF in December, as they can have some very large short-term capital gains distributions at the end of the year. The distributions can be punitive if you’re not careful.

Q. While ETF assets held up much better than the stock market last year, some of that seems to have been the result of increased trading associated with the huge market volatility. Will growth slow as markets calm down?

A. ETFs have become a huge trading tool, and it’s absolutely true that some of the asset growth has been due to trading. Moreover, a lot of investors migrated to ETFs from mutual funds because they realized that they needed intraday control over their portfolios. But history suggests that the assets that come over to ETFs during market crises are sticky. That’s what we saw during the tech bubble, during the mutual fund timing scandals, and during other difficult periods. I bet that’s what we will see again.

Q. The case for a good mutual fund over an ETF is arguably stronger for international investments, since timely information can be harder to come by and the quality of the companies constituting a national market can vary widely. Agree or disagree? More generally, is there any reason to invest in a mutual fund (implicitly, over an ETF) these days?

A. The idea that active fund managers have better luck overseas is disproven by the data. For the five years ending on December 31, 2008, 83.5% of all actively managed international mutual funds trailed the Standard & Poor’s benchmark (S&P 700 Index), according to S&P. 89.8% of emerging market mutual funds trailed their benchmark (S&P/IFCI Composite).

As for mutual funds over ETFs, absolutely. For investors making small, regular investments, mutual funds often have the lowest total costs. You can’t just look at the expense ratio: You need to consider trading commissions, spreads, and other fees. Personally, I’d consider mutual funds in certain fixed-income and commodity futures categories. too, where the case for indexing is less strong.

Q. ETFs have already made the world seem a much smaller place. Where do you see the industry heading in the future?

A. I think that, eventually, ETFs will outstrip mutual funds in total assets. I think that, soon, ETFs will come to represent 50% of all trading volume on the exchanges.

Q. Thank you.

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