IU: So, because brokers now have a financial incentive, it's paved the way for a philosophical shift?

Clements: That is exactly what has happened. I can sit there and write clever articles about indexing until I'm blue in the face, but my articles are never going to have the impact that hundreds of thousands of brokers are going to have cold calling customers around the country. Now that you have a financial incentive for brokers to sell index funds, it's having a huge impact on the way people invest.

IU: Do you think indexing is the way to go in all cases? Do you think it's the best way to gain exposure to an asset class, or are there some asset classes where you should look at an active tilt to it?

Clements: If there's an asset class in which an index fund is available, my first inclination would be to buy the index fund. I know the argument is made that, in an inefficient market, an active manager can add value. But you have to think about why an inefficient market is inefficient. It's inefficient because it costs so much to trade and it costs so much to gather information. If the market really is inefficient because of those two factors, then indexing makes even more sense, because you're not going to incur the hefty investment costs from trading and from gathering information.

IU: Besides reversing broker attitudes about indexing, how have ETFs changed things?

Clements: There are two great things about ETFs. First, you separated the cost of management from the cost of distribution. That means that people don't have to go to one particular mutual fund company in order to get these index funds. Anybody who's able to sell investments can sell ETFs.

The second thing about ETFs that's revolutionary is the ease with which they can be introduced. You don't have a single firm responsible for distributing these funds, servicing shareholders and building up a critical mass of assets. We've seen these things introduced by not just the dozen, but 50 at a time. That means there's a lot of innovation going on in the ETF area. Thanks to ETFs, we can now tap into asset classes that index funds investors weren't previously able to tap into.

There has, of course, also been a slew of really stupid innovations. There are a lot of ETFs out there that I can't imagine anybody would want to own as part of a diversified portfolio. As you know, we're in the land-grab stage of the ETF revolution. Everybody is throwing ETFs out there, hoping to score a big win and gather a lot of assets. In the process, a lot of nutty ideas have been produced. Still, for the intelligent investor looking to build that globally diversified, low-cost portfolio, ETFs have been a bonanza.

IU: What are the negatives of launching so many ETFs covering obscure portions of the market?

Clements: There are really two worries about the foolish ETF concept. One, investors can now buy these narrowly sliced funds that aren't suitable for a well-diversified portfolio. They're highly volatile funds and investors could end up losing a lot of money.

The second issue is, how many of these ETFs are going to survive? One of the big advantages of ETFs is they should be highly tax efficient. But if you buy an ETF that doesn't gather enough assets and ends up getting liquidated, at that point the tax efficiency is over. We haven't seen many ETF liquidations so far. [Editor's Note: This interview was conducted before Claymore announced the closure of 11 funds.] But with all the funds that have been introduced in the recent years, you've got to presume that some won't survive.

IU: Do you think that ETFs could actually replace mutual funds? Jack Bogle, for one, does not seem too fond of them, despite the fact that they are index-based funds.

Clements: I understand Jack's concerns. There are a lot of stupid ETFs being introduced and a lot of people are trading these things like crazy. With an index fund, the idea is that you buy a broad slice of the market and you sit there quietly for years and years. There's a lot of nonsense going on in the ETF area. Nonetheless, there's also a lot of good stuff going on.

Will they eventually replace conventional index mutual funds? I think ETFs will likely grow to be larger than conventional index mutual funds, but for a lot of people, conventional index mutual fund will remain a much better investment option. Even if you're paying $5 a trade, it's still very costly to build a portfolio of ETFs if you're only investing $100 or $200 at a time. For the ordinary investor who is dollar-cost averaging into the market, ETF trading costs are really prohibitive, and that investor should be buying index mutual funds.

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