From the December 2007 issue of Research Magazine • Subscribe!

A Boon to Investors and Advisors

There is a bit of down-home feel about my lunch with Noel C. Archard, Head of Product Development at iShares. The restaurant serves traditional Neapolitan food and the chef emerges from the kitchen to chat with us in Italian, seemingly indifferent to whether or not we understand him. Archard doesn't speak Italian, but he has ordered gnocchi, or potato dumplings. He can't resist trying gnocchi whenever he eats at an Italian restaurant, he explains, in the hope of finding something that tastes as good as the ones his Italian grandmother used to make.

But there is nothing down-home about his company, iShares. It is the largest player in the exchange-traded funds (ETFs) market segment, probably the fastest growing asset class in the U.S. market over the past two years. The number of ETFs rocketed from under 100 at the start of 2006 to 546 in August 2007, based on data from the Investment Company Institute. The number of sponsors has proliferated, too, issuing an ever-growing number of ETFs tied to a baffling variety of indices and investment strategies.

---

Who: Noel C. Archard, CFA, Head of Product Development, iShares, Barclays Global Investors

Where: Ottimo, 6 W. 24th St, New York

On the Menu: Gnochetti al pesto, zuppa del giorno and information geared to FAs' clients

---

Among them, iShares, part of San Francisco-based Barclays Global Investors, which in turn is a unit of Barclays, the U.K. bank, is a giant, controlling over 55 percent of assets under management in the industry. In large part thanks to iShares, Barclays Global Investors is the largest asset management company in the world.

Archard, whose background is in mutual funds, says he still finds new features to admire in ETFs, the kind of flexibility, transparency, cost effectiveness and tax efficiency they provide for investors, as well as convenience in running their business for financial advisors. While Barclays' iShares conducts extensive market research and identifies the universe of potential users of its new funds before launching them, Archard also says that there are often surprises.

For example, in September iShares wheeled out a pioneering new product, a municipal bond fund. The fund, (AMEX:MUD), which beat out by a few days a rival by State Street, tracks the price and yield performance of a Standard & Poor's municipal bond index of over 3,000 issues in the highly fragmented muni market.

"In addition to the usual suspects," says Archard, "we saw interest from foreign investors. It turns out that the bond issued by the state of California is treated by some foreign investors as sovereign debt -- due to the size of the state's economy."

Shielding From VolatilityThe diversity of users -- and the variety of investment strategies ETFs allow investors to implement in a cost-effective way -- has been a positive factor for the ETF market, especially in the current period of heightened volatility.

"If you look at the ETF sector over the past 10-to-12 years," asserts Archard, "it has been a straight-up progression -- even though we have been through some dire markets over this time period."

In particular, this year volatility has increased and Wall Street suffered several fairly severe bouts of selling, especially in early March and in July-August. This has not kept new ETFs from coming to the market in substantial numbers.

Moreover, Archard believes that ETFs provide a stabilizing influence for the overall market. True, the number of ETFs -- and assets involved -- trail far behind the mutual fund industry. There are some 11,500 mutual funds according to the Investment Company Institute, holding a combined total of nearly $11.5 trillion in assets -- which dwarfs the mere half-trillion in assets amassed so far by ETFs, based on August 2007 data. However, ETFs have not merely diverted clients from traditional mutual funds, says Archard. Rather, they have attracted new clients, both among institutions and individuals who wouldn't have otherwise invested in funds.

The diversification of the investor base not only ensures that ETFs remain attractive in different market environments, but also that the market itself is shielded from even greater volatility.

Emulating Hedge FundsIn this market environment, ETFs based on exotic strategies have been garnering much publicity and investor interest. For instance, when ProShares pioneered leveraged, inverse and inverse-leveraged ETFs in mid-2006, allowing investors to use margin to maximize returns as well as to short the broad market cheaply and easily, the firm's lineup accumulated $2 billion in assets within the first two months of the funds' introduction.

iShares has not rushed in to introduce similar funds. The reason, according to Archard, has been technical. His firm found that the way the funds are structured, they do not track the underlying indices very closely. When the broad market declines 20 percent, for example, the return on the ETF may be in a fairly wide range around this figure. It's not good enough for iShares.

"We may be leaving some money on the table, but we won't come out with a product unless we can do it right," says Archard.

Nevertheless, the company is constantly looking to adopt new strategies, often ones used by hedge funds and other highly sophisticated investors, but which would allow investors to emulate their strategies at lower cost. Hedge funds, for instance, have long been striving to hedge their investments with assets that are not at all correlated to overall markets. Financial advisors can put their high-net-worth individuals into such strategies while using more cost-efficient instruments.

Listening to FAsAs ETFs scale the curve of increasingly complex strategies and esoteric benchmarks, Archard stresses the importance of communicating with financial advisors, getting their feedback and understanding their needs. One request he hears from FAs is to provide more information geared not to advisors themselves but to their clients.

"We often hear from advisors: 'A client trusts me to put him into this or that fund, but it would also be nice if he could understand the product himself.'"

The convenience and the flexibility that ETFs provide for financial advisors in running their own business is an important factor ensuring that the industry will continue to grow. But ETFs will never be all things for all people, Archard readily admits, and investors and financial advisors will continue to use other asset classes and combinations of assets to meet their clients' individual needs. However, the growth of the past two years has not been a fluke. It is just a start.

Which is not to say that there will not be a shakeout in the industry, especially if the market environment remains volatile. Moreover, many of the sponsors who have come to the market in recent months have been clearly searching for a buyer, rather than hoping to build a viable independent franchise.

"ETFs are an inexpensive product, but they are not cheap. You have to invest if you want to do things right," asserts Archard.

ETFs particularly favor economies of scale. Not surprisingly, the four top issuers control over 90 percent of all industry assets. This is unlikely to change going forward, and if anything, industry concentration is likely to grow in the future.

---

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007

Reprints Discuss this story
This is where the comments go.