Talking ETFs With Morgan's Paul Mazzilli

by: IndexUniverse

Paul Mazzilli has one of the best-known names in ETF research, and his team's reports are widely read by industry participants. He is an executive director at Morgan Stanley and is the director of the Exchange-Traded Fund Research Team.

He spoke recently with assistant editor Heather Bell about what's happening in the ETF industry.

Index Universe: What you do think the major issues facing ETF providers are?

Mazzilli: I guess I would say their biggest concern is getting their share of a rapidly growing market. And the competition is pretty hot. When you say ETF providers, those include some powerhouses like Barclays and State Street and then there's some wannabes. You can't put them all in the same category.

Index Universe: What do you think about the large numbers of ETFs coming out right now?

Mazzilli: I think there's a lot of little, really specific ETFs that are coming out. Unless it's a macro trend, they aren't going to gather a lot of assets. And as you drill down into smaller and smaller sectors, you also get things that are extremely volatile. Some of the very isolated little sector ETFs, you can see one go down 30% in a month.

They're putting in a big push on municipals, and municipal is a huge market on tap by ETFs. I think that will gather some assets. Many of the most successful ETFs have come out when there's just been a huge on-tap demand—like gold, silver, and oil (U.S. Oil Fund; Amex: USO), which is not a great ETF, but it gathers some assets. Global real estate was a good asset gatherer when it came out last year near the peak of the market.

Index Universe: Are these very specific, smaller funds that have come out something that an institutional investor is going to be interested in, or are they more for retail investors?

Mazzilli: I don't see institutions being interested. If you look at the major volume, the top 20 ETFs make up the majority of the volume, and they're primarily based on very well-known indices from S&P, MSCI, Dow Jones and Russell.

Index Universe: With so many ETFs being launched now and so many in registration, is there going to be a "weeding out" period?

Mazzilli: I think so. I see your list published on for all the registrations, and a lot of them are just sitting there. When they finally get a product that they really like, like municipal bond ETFs, approved, they bring it out right away.

Index Universe: How important are retail investors going to be for the continued growth of the ETF industry?

Mazzilli: Some of the people getting in at the bottom are those that might have been selling units trusts to retail investors, and now they're doing it in ETF spaces because it's hot. They're using their distribution systems in little niches. They have the customer relationship base that might have been based on unit trusts. Companies like that include First Trust and Claymore. They have decent distribution systems for other products, and they're using them for ETFs now.

Index Universe: Do you think ETFs will break into the 401(k) industry?

Mazzilli: I personally don't, and I'll tell you why. The people who are trying to break in are trying to sell asset allocation models where they're doing groups of ETFs, or they're also actually trying to sell ways for people in 401(k)s to buy and process ETFs, where they essentially split the commissions up across multiple accounts.

Major 401(k) plans such as Fidelity and others offer very low-cost index funds. For example, my wife works for a national nonprofit organization, and in her plan they have a whole bunch of Fidelity index funds, including an international Spartan fund with a fee of 10 basis points. The second-largest ETF now is the iShares MSCI EAFE ETF (NYSE: EFA), which has an expense ratio of 35 basis points.

And Fidelity also provides all the 401(k) record keeping. Actually, Fidelity brought out one ETF a number of years ago, and I guess they were getting positioned to be a big thing in the market. I think they got their toehold into ETFs figuring that they could get into actively managed ETFs.

They were also thought to be looking at competing in the ETF space on fees to get even lower-fee products out there than Vanguard, and they evidently decided against that. There's also some licensing issues under which they can sell products and 401(k) plans with indexes but not in the ETF world. Barclays has locked up a lot of them.

Index Universe: What do you think of actively managed ETFs? Is that going to be a possibility?

Mazzilli: I know there are people out there like the Amex and Gary Gastineau saying the major problem with active ETFs is having to disclose your portfolios.

I have what are called separately managed accounts from major institutional managers in my own brokerage account. Major firms like Morgan Stanley, Smith Barney, Merrill Lynch and UBS will sell you essentially what's called a separately managed account, and you're getting your pick of outside asset managers. Essentially what they're doing is they're giving a buy list to Morgan Stanley, and Morgan Stanley buys them in my own account. So I see every single day what these major managers are buying and selling, and so do tons of people who have those types of accounts.

I think the reason of having to disclose your portfolio every day is nonsense. The initial concept of the ETFs was low-cost, passive and tax-efficient, and if you're a really good active manager, why would you want to enter the low-cost arena? And if you're looking for passive management and low cost, why would you want an active manager? Now there may be some small exceptions, like Bear Stearns, which has some sort of money-market-type ETF product in which they actively manage short-term securities.

Index Universe: So the thing that's keeping actively managed out of the ETF environment isn't necessarily the disclosure issue but more an issue of motivation?

Mazzilli: That's my own view. The best active managers are even shutting down business and saying they don't want any more money. So why would they want to go into a low-fee product space?

When I first looked at the issue I was told it wasn't a legal problem. The SEC would let people do it. There's ways to do it; people have just not wanted to. And the wannabes are not famous asset managers.

I've actually seen people who are good active managers looking to get into the ETF space, but as an indexer, like AIM did through acquiring PowerShares.

Index Universe: Lately one of the controversies has been that the new indexes are almost "active" indexes.

Mazzilli: They're managed indexes. I don't want to call them active: Something that rebalances once a quarter in a black box is not active to me.

Index Universe: Do you see any areas of the market, any asset classes or sectors that haven't been covered?

Mazzilli: Well, with regard to the big asset classes, Barclays has filed for a small-cap international ETF. WisdomTree has one, but uses their dividend-paying approach. There's global bond or non-U.S. bond funds, which I think are easy to do at the investor-grade, government level. PowerShares has an emerging market debt filing—I think a global, high-quality, non-U.S.-dollar-denominated fund would be okay. These leveraged and inverse products are taking in a huge amount of money with Pro Funds, and now Rydex is trying to do it too.

Index Universe: Do you have any ETFs that you favor?

Mazzilli: If you look at our most recent quarterly report, we say we like large-cap growth and we like the iShares Russell 1000 Growth (NYSE Arca: IWF) or the iShares S&P 500 Growth (NYSE: IVW). We like certain industries like aerospace, semiconductors, U.S. oil and gas exploration, and transportation. We like certain countries like Hong Kong and Japan. We are overweight emerging markets and high-quality bonds, like the iShares Lehman Aggregate Bond Fund (NYSE Arca: AGG). We like the iShares Lehman TIPS Bond Fund (NYSE: TIP) for inflation protection.

Index Universe: Are average ETF fees going up?

Mazzilli: We used to publish average fee, and now we publish weighted average fee also. We saw that the average fee was going up and up and up, but it was including new products like HealthShares that have no assets but have an 80-basis-point fee. So in our last monthly update, we had weighted average, which is back in line. It used to be that all U.S. equity ETFs were about 30 basis points. Now the average is 53, and the range is 7 to 95. But the weighted average is 30, where the numerical average used to be.

Index Universe: What kind of trends are you seeing in the kinds of ETFs that are coming out? Are there any that you feel are interesting?

Mazzilli: I liked international real estate when the first ETF on it came out from State Street, and there was demand for it. Regretfully, real estate hasn't done well with the subprime crisis, and now there's a bunch of different flavors of it. The concept of commodity ETFs was great when it started out, but then you find out there's all sorts of tracking errors in commodities and futures and all sorts of tax and accounting issues or complications.

Index Universe: Where is the tracking error the greatest usually? What types of ETFs tend to have the most?

Mazzilli: Well, currently the oil one, USO, has had the worst tracking error.

In the cases of the biggest tracking error, we have two things. One is forced diversification. For example, in the telecom ETF (iShares Dow Jones U.S. Telecommunications Index Fund; NYSE: IYZ) you can't have more than 25% in the top name and 5% names can't be more than 50% of the index. But the three top names make up 70% of the industry. I call that forced diversification. And then you have optimization. For example, the iShares MSCI Emerging Markets Index Fund (NYSE: EEM) has had what we consider to be significant tracking error due to the fact that they don't buy all the stocks in the index.

Index Universe: What do you consider acceptable tracking error?

Mazzilli: For us, the acceptable tracking error is your tracking error equals your fee, and the rest of it you track perfectly. The biggest source of tracking error on average is fees. Any index product is designed to underperform its index by the amount of its fees. We do a study each year on tracking error, and it's republished in the Journal of Indexes. (You can read the most recent report here.)

Index Universe: Where do you think the growth in the ETF industry will come from in the future as far as assets are concerned?

Mazzilli: I think it's going to come from existing investors investing more money and new people coming into the area. I think ETFs are taking money away from open-end funds, active managers and stock pickers, and that's a trend that's going to continue. I don't think it taking away from 401(k) plans, and open-end funds are never going to go away because the majority of money going into 401(k)s is taken out of people's payroll each week.