From the March 2009 issue of Research Magazine • Subscribe!

SPDR Sense: State Street ETFs Finds Sucess in a Tough Market

Despite the worst year for stocks since 1931, net inflows into 70 of the 80 SPDR ETFs (87.5 percent) posted positive cash flows during 2008. And the translation couldn't be clearer: Financial professionals and investors are making ETFs a larger portion of their investments.

After a steep drop in stock prices, demand has been especially strong for fixed income ETFs like the SPDR Barclays Aggregate Bond ETF (LAG) and SPDR Barclays 1-3 Month T-Bill ETF (BIL). Also, the SPDR Gold Shares (GLD) saw its assets climb by 29 percent.

Another hidden contributing factor to the success of SPDR ETFs was the lackluster performance of actively managed funds. According to Bloomberg data, 62 percent of U.S. large-cap funds lagged behind the S&P in 2008, along with 63 percent of all U.S. diversified equity funds. Even worse were small-cap managers where 72 percent failed to beat their index benchmarks.

All of this re-confirms the time-tested investment strategy of indexing portfolios, which SPDR ETFs help do. State Street ended 2008 with $159.49 billion in ETF assets.

What's in store for investors and the ETF marketplace in 2009? Anthony Rochte, senior managing director at State Street Global Advisors, distributor of the SPDR family of ETFs, shares his views with Research magazine.

Despite an uncooperative stock market in 2008, ETFs still attracted over $178 billion of net inflows. How does this compare to other financial products, and are investors investing differently?

The growth of the ETF industry in 2008, amid unprecedented market volatility, is a testament to how these innovative investment vehicles are changing the way financial advisors and investors construct and manage portfolios. During the year, ETFs accounted for approximately 25 percent of all equity trading volume, and in some weeks spiked as high as 40 percent of total equity trading volume. These high levels of trading volume and strong inflows help to underscore the widespread adoption of ETFs and growing demand for transparency among all types of investors.

In 2008, net inflows into State Street's family of 80 SPDR ETFs reached a record high of $70.1 billion. A significant portion of these flows can be attributed to the increasing number of financial advisors who are turning to SPDR ETFs to gain exposure to core and hard-to-reach assets classes while simultaneously managing portfolio challenges and costs amid rising market volatility. Net inflows into SPDR ETFs were particularly strong in the fourth quarter of 2008, a period of time marked by dramatic volatility in the markets.

Millions of buy-and-hold mutual fund investors got blindsided with an unexpected 2008 capital gain distribution even though their funds may have lost money. How can financial advisors help their clients to avoid becoming tax victims?

Unexpected capital gains distributions are clearly a source of frustration in this market, and there's no question that the inherent tax efficiency of ETFs is a benefit that is resonating with investors in these turbulent times.

For example, in 2008 just four of State Street's 80 SPDR ETFs realized capital gains distributions. However, with more and more fund families entering the ETF market, it has become increasingly important that financial advisors take a very close look at both the index methodology and tax efficiency of each product, as some ETF providers have proven to be considerably more tax efficient than others.

Close to 40 percent of all ETFs have less than $100 million in assets and a number of funds have recently folded. Is there a desirable asset threshold for ETFs in order to achieve economy of scale?

There is no universal asset threshold that ultimately determines the success or failure of an ETF, as there are simply too many variables that must be taken into account.

At State Street, our goal is to provide a comprehensive family of ETFs to investors seeking more precise exposure to the U.S. and global markets. Since launching the world's first ETF in 1993, our product development has grown with the demands of our investors, who often contact us seeking exchange-traded products that provide access to hard-to-reach corners of the market. In looking at the number of ETFs currently in the market or registration across the entire industry, it's clear that not every ETF provider shares a similar approach. However, it's not our place to judge the merits of products introduced by other providers. Ultimately, investors have the last word on which of the industry's ETFs and fund providers are built to last.

In November 2008, the SPDR Gold Trust (GLD) celebrated its 4th anniversary. With $21 billion in assets, GLD ended last year as the third largest ETF. What's contributed to its success?

As the first U.S. exchange-traded product to provide exposure to the benefits of gold, the success of the SPDR Gold Trust can be attributed to several factors including ease of access it provides to an asset class that was traditionally hard to reach, cost-efficiency and liquidity.

Gold has long been viewed as an asset that could provide protection from falling currencies, inflation and economic downturns, but prior to the launch of GLD, the logistics of buying, storing and insuring the physical commodity prevented many investors from adding gold to their portfolios.

In 2008, GLD assets surpassed $22 billion and average daily trading volume topped 13 million shares, as investors increased their appetite for assets that are not closely correlated to equities.

The chaos in the credit market caused some fixed-income ETFs to experience noticeable discounts and premiums to their underlying net asset value (NAV). Is this a structural problem at the ETF product level or is it because of other issues?

While information flow is often less efficient during periods of extreme volatility, we continue to believe that ETFs are valuable tools in all types of markets.

In some instances, widening premiums and discounts are a function of ETFs serving as price discovery tools when the underlying liquidity for an asset class is missing. Our Strategy and Research Group has published several papers analyzing the performance of ETFs in volatile times, such as the reopening of the stock market after September 11, 2001 and the unprecedented market events that occurred in September and October 2008. Investment professionals who are interested in reviewing this research can log on to www.spdru.com.

Barclays Capital took over Lehman's indexing business. How has this affected State Street's bond ETFs?

The names of several fixed-income SPDR ETFs have changed as a result of this acquisition; however, no action was required by investors.

What sort of impact, if any, will ETFs make on the 401(k) retirement landscape in the future?

While ETFs are making inroads into 401(k) plans as a growing number of financial advisors and investors embrace their benefits, several challenges need to be overcome before they become a staple in this marketplace. One of the most significant obstacles slowing this integration is a record-keeping issue, as many platforms don't have systems in place that can incorporate ETFs. We're confident that ETFs will become a major participant in the 401(k) market; however, it will not occur overnight.

What big trends do you see for the ETF marketplace heading into 2009?

Despite the tremendous growth of the industry in recent years, ETFs remain a relatively new investment class with plenty of room for growth.

While the pace of new ETF launches could continue to slow in the short term as smaller providers exit the business, the industry's success and growth potential will undoubtedly continue to encourage other fund families to enter the market. Looking ahead, we expect demand for fixed-income, commodity and inverse and leveraged ETFs will continue to remain strong throughout 2009.

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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