IU: Are retail investors going to drive the growth going forward?

Rochte: We look at the market in three core pockets. We think 50% of the market is pure institutional; we think 40% is reached through the advisory market or intermediaries; we think the remaining 10% is probably self-directed retail. As you know, our focus is on the 90%-the advisors and the institutions. I still think institutions are important; I think the growth in the advisory marketplace is probably moving at a little quicker clip, and what we're seeing is a convergence between the commission-based advisor and the fee-based advisor.

What's at the center of that convergence is ETFs, because that's really what's fueling this. For the next five years, all of the major brokerage firms are building unified managed accounts that now include mutual funds, SMAs and ETFs, so I think you're going to see probably the greatest percentage of growth through the intermediary or the advisory marketplace, and that probably trickles down to the self-directed.

Ross: I'm going to take a little bit different tack with this but not disagree with Tony. I actually agree with him and think a good part of growth is going to be fueled by the intermediate marketplace. However, it's going to be fueled from the bottom up too. In the retail marketplace, some people will belong to the 10% that Tony was talking about, which is people that want to go on E*Trade and buy and do this themselves. That community reads about ETFs; they're into the markets; they get this stuff. If they want to go set up their own portfolio, that's great. There is also a community out there that cares about ETFs, but doesn't really want to do their own investing, doesn't want to take over their own portfolio, but is going to their advisor's office and asking them about these ETFs they are hearing about. From that perspective, the increasing awareness of ETFs is really pushing the advisor to answer questions and has them exploring ETFs. I think that helps drive intermediary growth as well.

IU: Do you have any thoughts on what will be the next big area in ETFs?

Ross: There are definitely some different areas-and Tony talked about some of them broadly-where you're going to see additional products. With fixed income, I agree: It's still a space that's relatively wide open, even though there is already a baseline of products. However, I also think you're going to see people slice and dice the world in different ways and you're going to see people looking for different ways of getting non-U.S. exposure. Investors are increasingly looking at the economic environment in the U.S. and, especially lately, the relative strength of the U.S. dollar. Providing access to investments with a historically low correlation to the U.S. dollar-such as metals like gold, or with international treasury bonds-can be very successful. People are going to continue to look for themes like that. You're probably going to see an additional focus on some of what I would call the more quirky types of products, and then on some fundamental, good core products as providers try to expand the traditional opportunities set for ETFs in the marketplace.

IU: What do you think is going to happen with actively managed ETFs? [This interview was conducted before SSgA filed for actively managed target date ETFs.]

Rochte: We look at all things exchange-traded, so active ETFs is definitely a space that we have looked at and will continue to look at. I can't say much more than that, but it's interesting. I look at the active ETF space, and I see a lot of headlines on it, and a lot of people think that there may be significant demand. I don't necessarily disagree with that, but what I've seen in the marketplace today that people have talked about are model-driven products. I don't know that they're a leap forward, and I'm not sure that they have significant asset-gathering capabilities based on, in most cases, their quantitatively driven themes-there's already products out there doing that using quantitatively driven indexes.

Where I believe you would see significant dollars is if you take the Fidelity Magellan Fund and get that listed and traded on the New York Stock Exchange so that the portfolio manager doesn't have to disclose his portfolio and the market makers and specialists, if they still exist, can actually make high-quality, liquid markets around that price. I think that would be a home run. I think that is still years away, and what we're seeing today that may make it to market soon is the most transparent version of an active fund. The first few active products brought to the marketplace have a chance of being somewhat disappointing.

IU: What are your opinions on fundamental indexing and strategy indexing?

Rochte: Let's just forget product for a minute: The issue that Jim and I, and many others within State Street, have is that fundamentally weighting an index in and of itself is not a bad thing. In fact, if you look at the backtested data, it's quite attractive, but we also believe that you inherently overweight value and small-cap in this kind of index. We feel that as an advisor or an institution or an individual, you can express that view of the market much in the same fashion with our product list. You might have to use a couple of SPDRs to do so, but you can actually get that exposure.

Ross: Plus, you get that exposure at a lower cost, both on a fee basis and on a trading basis, because inherently if you are not using a market-cap index, you will have additional transaction costs that aren't appearing in your expense ratio but are more in the tracking of your funds.

Rochte: I don't think Jim and I have any disagreement over the concept of fundamentally weighting an index. There's plenty of merit in the investment case, but as it relates to the execution case, we think you can do that very efficiently and very precisely with existing ETFs offered within the industry.

IU: How important a consideration anymore is liquidity? Is it something that you consider when you're creating a new product?

Ross: Yes, there's a few key elements of liquidity that you must consider. The liquidity of the underlying is extremely important to the overall liquidity of your ETF. If you're looking at a segment that has less liquidity, then the cost of buying and selling that ETF is going to be higher. Your bid/ask spread has to be higher. The SPDR S&P 500 is the most liquid equity security in the world; its underlying is probably the 500 most liquid securities in the world. That's the reason a trade can be done at a penny or a half-penny spread. With international small cap or emerging markets products, you're never going to have that kind of underlying liquidity, so the cost of trading expressed through the spread is probably going to be higher.

Additionally, you have to be confident that when you construct products, you can effectively track the benchmark index. Failure to track can seriously hinder investor confidence, and that may, in turn, diminish volume and widen spreads. You need to have conviction and belief in the operations and trading expertise of your portfolio management teams, which I'm very happy to say we have here. That allows you to be very confident that you will actually track the underlying indexes of your products. It's not as easy as some people make it out to be. We have some of the most sophisticated technology systems in the world here at State Street because we manage hundreds of billions of dollars of index assets.

Rochte: There are products that Jim and I would love to launch in ETF format, but when you look at the underlying, you just can't—not in an ETF.

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