At the recent celebration of the PowerShares QQQ (QQQQ), I had the chance to interview Bruce Bond, the president and CEO of Invesco PowerShares Capital Management and John Jacobs, the executive vice president of NASDAQ OMX Global Index Group.
Q: What do think are the biggest challenges in the ETF industry today?
John Jacobs: ETFs have proven themselves to be viable products, but they have never experienced a more challenging or interesting time in their history. This economy is testing their ability to survive and grow. We are seeing that ETFs need a certain size to weather the storm. And this size issue is making it harder for the niche ETF players to launch niche products.
Bruce Bond: The biggest challenge to the ETF industry is to continue growing its business. Some smaller firms have had trouble growing volume. The challenge is a lot of money is not going into equities and some firms need this to have a sustainable platform going forward. However, we see a lot of new assets going into fixed income. So even as assets fell, ETFs have seen the most inflows compared to other products, which have seen outflows. ETFs as products have shown sustainability in the market, and ETFs’ liquidity and flexibility will help them be a viable product into the future.
We believe this means not only will ETFs likely survive, but it highlights some of the key benefits, such as transparency and liquidity. Transparency is very important to know what you hold in any investment product. Liquidity is important because people don’t want to be locked into anything now. We believe ETFs will excel when the market ramps up because of their being more liquid. You can quickly get into the market. In addition, the ETFs generally have potential tax benefits because of the in-kind creation/redemption process. And you don’t have to pick stocks. So, they eliminate the single stock risk. And this is an environment where people realize the risk of picking individual stocks.
Q: Have you seen the bid/ask spreads on ETFs widening during the financial crisis?
Bond: In the fall of 2008, the market saw the spreads widen in a lot of sectors. As spreads widened on underlying stocks, they widened on the ETFs. But today you see the ETF spreads are much smaller than they were in September. In some ETFs, such as the PowerShares WilderHill Clean Energy ETF (PBW), we have seen even better liquidity than in the underlying securities. And this is a good example that if you have tighter spreads in the ETF, it can help the spreads on the underlying stocks.
Q: Do you think ETFs have taken volatility out of the market?
Bond: We believe that because the ETF holds the shares, it may take some volatility out of the market. When you see 30% of the stock market’s volume across the exchanges is now in ETFs, that is volume that would otherwise have happened in the underlying securities. So pulling the stocks out reduced the volume and volatility in the underlying securities.
Jacobs: They have helped the market by taking volatility out. The creation/redemption process dampens volatility by taking stocks out of the float. Previously, we had program trading and that hurt stocks and increased volatility. Now you don’t have to deal with it, because the program trades aren’t there as much. The creation/redemption acts as a regulator of the underlying securities because they trade at the NAV after 4:15 p.m. This removes the pressure to move the stocks up and down during the session on program trading.
Q: Do you think there will be long-term repercussions from the consolidation going on in the industry? Is it stopping firms from growing?
Bond: The ETF industry’s consolidation is a normal business process. The time when you can bring an ETF to market and just get assets has ended. Each new ETF needs to be compelling. They need to have a good distribution and marketing effort to help it to survive. Some of the pure ETF firms are asking themselves — are we getting any traction? Commodities and fixed income have done very well in this market by giving access and safe exposure, so some are.
Q: How do you think financial crisis is affecting investor attitudes toward ETFs?
Bond: We think that what is happening in the broader market has truncated the adoption of the ETF among the investment professional community. They are saying, ‘I need to evaluate things because the products I’m currently using have problems. I want to use these ETFs, so I’m going to get as educated as I can. That way when I want to use them I will be able to intelligently.’ I think this process would have taken longer in a slower market. This has accentuated the process of adoptions.
Bobby Brooks, senior vice president director of sales, Invesco PowerShares Capital Management: We believe that the ETF industry may be poised for growth because most areas of the market are increasing their usage of ETFs. We’ve broken the market into two sectors, retail including financial advisors, and institutions. We break down the institutional market into traders, hedge funds, endowment funds and asset managers. Both retail and institutions have seen percentage increases in usage across the board. We are educating the RIAs and the appetite for education is huge.