Straight From The Source: James Ross And Anthony Rochte

James Ross and Anthony Rochte are senior managing directors at State Street Global Advisors responsible for the SPDR family of ETFs. Recently, IndexUniverse.com assistant editor Heather Bell talked with them about what goes into creating a successful family of exchange-traded funds.

Index Universe (IU): What has State Street's strategy been in the area of ETFs?

James Ross (Ross): We focus really on three very important areas. One is product. We want to bring precise, quality products to the marketplace. We spent a lot of last year rounding out our product lineup—I think we launched a total of 25 funds in 2007. The major emphasis was to offer a full suite of international and fixed-income products that are really focused on investor needs.

We also focus significantly on communications and on developing our SPDR family of ETFs ... talking to advisors and the rest of the investment community to explain who we are and what we're doing, why we think these products are world class. We do that through strong marketing and branding.

Anthony Rochte (Rochte): The third leg of the stool is a very strong and efficient distribution force. As of today, we have 60 dedicated sales professionals, client service professionals and strategists who actually help service the intermediary community.

In the last 18 months, we've doubled the number of SPDRs products: We've gone from 32 to 65 U.S.-listed ETFs, and our assets have grown from $85 billion about 20 months ago to over $158 billion at year-end. The industry last year grew at 45%; we're happy to report that we grew somewhere in the 54%-55% range.

IU: How do you take market share if you're not first to market with an ETF that covers a certain asset class?

Ross: There's a couple ways that we look at that. Being first is great, but you're not always going to be first. You have to ask yourself, can I bring a quality product with a real quality index behind it that I think investors will be interested in? One that might be better constructed than the product that made it first to market?

That's our first focus, and then obviously we have the ability here through a skilled distribution force and our marketing capabilities to get that information out to the investor. This can be a successful strategy in that we give them a choice to consider that we believe might be better constructed and have better characteristics than a fund that might have made it to market first.

Rochte: Just building on what Jim said, there are a number of single-country ETFs that have been in the market for quite some time. Our strategy, as we began building our international ETF family, was not to go at it from a single-country point of view, but to go at it from a regional point of view. The reason we did that wasn't simply because these products weren't out there, it was because when you look at the way Wall Street research is done today and when you look at globalization trends, most of the research done is at a region level, not at a single-country level. One example is BRIC-Brazil, Russia, India, China-where we weren't first to market. But we accumulated almost $300 million in nine months in our BRIC ETF. Another example would be emerging Asia or emerging Europe. You can buy single-country ETFs in Europe or you can buy emerging Europe, which I think recently topped $100 million in assets.

Ross: We've actually used both approaches. We use the regional strategy in general, but for China-where we saw there was significant demand and only one product-we felt there was a better way of covering that marketplace with a better, broader index. So we brought to market a China product that has a much broader index, and we've really worked to ensure that it's a world-class product. It has started to gain significant traction in the marketplace, where there are now multiple products.

China is obviously a pretty hot area for investing, and it's not always a takeaway game. You're not necessarily trying to take assets from the existing providers in the marketplace, but you want to give the investor and the advisor a choice on their next trade or their next asset. It's not necessarily that we're trying to say, "Sell what you bought three months ago and buy this." More importantly, we're saying, "Next time you're thinking about investing one of your clients' assets in China, there's another opportunity for you, and we think this is a better product."

IU: In general, what do you think determines the success or failure of an ETF?

Rochte: This is the question that I think every sponsor debates behind closed doors: What's the next billion-dollar ETF? The one thing that I think Jim and I both believe strongly is that any successful ETF has to meet the demand of investors in several different market segments. You take any billion-dollar ETF, and with certainty, there's probably a trading community that would trade it and create volume. There's probably a strategic case, and there's advisors out there who may use it in a tactical manner. The third element is the institutional demand.

If you have the trading community, if you have the wealth manager and advisory community owning it in strategic or tactical fashion, and if you have institutions who might use an ETF because there's not a derivative or any other way to access that market, that to me is probably the perfect recipe for the next billion-dollar ETF. When you look at some of the most successful ETFs, I think you can check the box on all three of those market segments, and when you look at some of the ETFs that haven't done as well-and every firm has them-it's probably because you didn't have all three of those market segments engaged.

Ross: I agree with Tony there. The other thing that you have to look at is not just the product itself, but the support you can bring around that product, the education you can give to advisors, the support you can give them through materials, the Web site, the general information flow. This is probably less about the success of one ETF and more about the prospect of being successful in the overall business. Is the quality of the product very important? It's no question that it is, but being able to provide a high-level quality of support is also very important. Having size allows you to do that, because you don't need every ETF to be successful. We know we have launched product that we want in our family lineup and that we believe should be there to have a complete family. Because of competitive reasons or other reasons, that product might not ever be that successful an ETF in terms of its AUM, but it's very important for us to have it in our lineup. We can support that, because offsetting that is $120+ billion of assets in other SPDR ETFs. That really helps balance it out.

IU: Looking back over 2007, what do you think were the biggest developments or trends in the ETF market?

Rochte: Consider the fact that the U.S. fixed-income market is larger than the U.S. equity market and the fact that there's only $35 billion in ETFs relative to a $600 billion ETF marketplace. Entering 2007, there was only one provider of fixed-income ETFs, but during 2007, more than two major providers came in with quality product.

We launched the industry's first Lehman-benchmarked municipal bond ETF. I think munis are a category that is probably not unlike gold and some of the other products that have been launched. There was a huge demand from advisors who wanted access to a transparent, liquid way to buy and sell munis. To me, 2007 was the year of the fixed-income ETF and the year of international ETFs.

Ross: I would agree with that. I think the market will continue to expand into fixed-income arenas and start to focus more on the international fixed-income arenas. We launched the first international fixed-income product in October 2007, the SPDR Lehman International Treasury Bond [AMEX: BWX], and it has really garnered some attention in the marketplace. A lot of advisors and investors have asked us to create investment vehicles that don't correlate well to the U.S. market and U.S. dollar, so I think that product really answered that need.

Another trend is obviously the overall amount of new product that's been brought to the market. It's been significant in the last 18 months-probably more than doubling what was existing. I'm not sure if that's a good trend, a bad trend or just an ugly trend, but it's definitely a trend.

Rochte: Without a doubt, our single most successful fixed-income ETF last year was the SPDR Lehman International Treasury Bond, and it is just shy of $300 million right now. [BWX's assets have increased from the date of the interview to $621 million as of March 11, 2008.]

IU: Was there a reason for last year's competition to launch municipal bonds? Was it just that that asset class was seeing new interest?

Ross: The simple answer there is that the regulatory relief necessary to do those products came about in May 2007. I think many sponsors wanted to do municipal ETFs, and once that change was made, it was really a race to develop the product, select the right index provider and get the product to market. Because many sponsors were eager to tap this segment, a lot of product came very quickly.

Some people have looked at that and say potentially we were all wrong, that it hasn't grown, hasn't exploded the way I think some people may have thought it would. But I think that munis represent a deep but opportunistic market that will grow at a very, very good pace over years. It's not a hot market; it's not China. It is a steady-growth business where people who invest in it will be long-term investors for years. It doesn't have the trading component to it that Tony talked about with what I would consider the home-run ETFs. The SPDR S&P 500 trades $19 billion a day. GLD is significantly liquid. Some of those products simply have that kind of amazing liquidity, but munis are probably never going to have that level of liquidity because of the trading nature of the underlying bonds. They're very, very good long-term, buy-and-hold products, and they are also cost-effective for the investor.

Rochte: Munis couldn't have been more out of favor in the third and fourth quarter of 2007, and I think growing from $20 million to $107 million is actually impressive. [TFI's assets have increased from the date of the interview to $200 million as of March 11, 2008.] I think if and when munis are in the crosshair of advisors, all muni providers who have an ETF are going to benefit.

Ross: Having disciplined product development means you're going to launch products even if it's not the most favorable market addition for that product because you want that product in your lineup when that market condition changes. The regulatory process is a long cycle, and if you wait for perfect market conditions to start your filing, you're going to miss it.

IU: Last year saw a lot of product launches in the ETF market. Was it too much, too fast?

Rochte: I think the rigor and the discipline that Jim was talking about is something we take a lot of pride in at State Street. We launch quality products; we're not going to just launch anything. What some investors may not recognize is virtually all of our ETFs, with the exception of a few first-generation ones, have a board. We work with our board, and we talk about new product development. We feel we have an obligation not only to prospective shareholders with these new ideas, but also to existing shareholders. I think we've done a good job in launching good, quality product and not just putting too many products out there to see what works.

IU: Where do you see the ETF industry in the next five years in terms of maybe assets and number of funds?

Ross: There are over 400 still in filing, so the number's probably going up.

Rochte: Yes, I think the number's going up, and the traction of the ETF business is going to continue to grow. I was down at the Inside ETFs conference, and the number of advisors in that room who were new to ETFs amazed all of us. There were a lot of new folks there, so I think it shows that we've all done a good job of getting the word out and educating a very large audience of advisors about the products. But, we still have a lot of work to do, and that's a very positive growth trend. Knowing that there are more advisors out there means it's not a market share game, it's a growth game. I think that's significantly better than if your goal is to take market share from the folks next to you in a situation where the whole pie is known.

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.

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.

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.