John Gabriel of Morningstar Analyzes New Interest in ETF's
Tuesday, October 06, 2009PAUL KANGAS: Exchange traded funds or ETF's blasted through another barrier last month. Morningstar reported today that for the first time, the total amount of money in exchange traded products topped $700 billion. Joining us to discuss this and other developments in ETF's is John Gabriel, ETF analyst at Morningstar. John, welcome.
JOHN GABRIEL, ETF ANALYST, MORNINGSTAR: Thanks, Paul.
KANGAS: First, what's behind the increasing flow of money into ETF's and what types of ETF's are people buying?
GABRIEL: There's a number of factors that are driving growth for ETF's, but I think really we can tie it to increased adoption among investors and financial advisors alike who appreciate the flexibility that ETF's allow them in creating asset allocation portfolios. And furthermore these are low cost tax efficient and fully transparent products. But looking at the products year to date, that's where the money has flown. It's actually going. It's fixed income commodities and international stocks are the three categories that investors are flocking to and actually domestic equity is the only category that we saw outflows in.
KANGAS: Like mutual funds, ETF's combine different securities as you've mentioned and their prices are also supposed to reflect their assets. But recently some commodity ETF's traded at a big premium to their net asset value. How did that happen?
GABRIEL: Yeah, actually those premiums we saw developed were direct function of the fund companies themselves halted share creations on those ETF's. And that was in response to the CFTC's probe, which is the Commodity Futures Trading Commission and now they are looking at excessive speculation in the commodities market and they're looking at these ETF's and considering putting position limits on. So without creating new shares, the in kind creation redemption mechanism that makes ETF's stay close to their NAVs is virtually out the door and they trade like closed end funds without that.
KANGAS: Right. Now there's also been some controversy over leverage of ETF's with regulators questioning their suitability for individual investors. What's the story on that?
GABRIEL: Right. Earlier this summer FINRA issued an investor notice regarding the suitability and sales practices of those leveraged ETF's and in response to that, we saw a lot of financial advisor platforms actually impose restrictions and even ban those products from the use in their portfolios with their advisors. So we actually saw outflows of the fund for a few years. But really the problem with leveraged ETF's stems from investors' expectations. Really, these are designed to provide leverage for one day. They're just 200 percent, 300 percent or even inverse exposure, but only for one given day. So over a longer period of time, your returns can get eroded by volatility drag or negative compounding. And that's something that a lot of individual investors never considered before getting into the funds and that's why FINRA had to step in.
KANGAS: John, will ETF's continue to keep taking business away from mutual funds?
GABRIEL: I think ETF's are certainly going to continue their growth and there's a lot of tail winds that are going to help propel them going forward. But the ETF-mutual fund comparison comes up a lot and I just think it's not necessarily the right comparison to make. They work so well together. They compliment each other very well. And because as we look over the past year, it's interesting, ETF's actually made up 30 to 40 percent of the volume on the exchanges which tells me really that they're a substitute for individual stock investing as opposed to mutual fund investing.
KANGAS: John, that is very interesting and I want to thank you for your insights into the ETF market.
GABRIEL: Great to be here, thanks, Paul.
KANGAS: My guest John Gabriel of Morningstar.
