IU: How will new ETF products get to market with seed capital so scarce, and with markets so beaten up?

Dallmer: During a period in which markets are down 4% or more a day, and asset pricing levels down by 20% to 40%, your vetting process for new products changes, with "fourth or fifth fund into a category" typically thrown out. The ETF market has been historically long-only, but already we are seeing the movement to products noncorrelated to equities—such as fixed income, commodities and currency. Even before the market sell-off, there were strong inflows of cash to those ETF categories. Ultimately, I don't believe ETF success will be about the availability of seed capital or market conditions. It's about gathering assets. Developing a distribution channel for a fund before it launches has been a strong theme for successful ETF launches in 2008.

IU: How can ETFs with a low level of assets ride out the current market downturn?

Dallmer: To the extent that a fund provider has certain fixed costs, it becomes increasingly difficult to support small asset bases in a down market. There have been some liquidations already, in cases where ETF groups were not finding it cost-effective to keep portfolios trading. But the market structure that provides efficiency of trading is the same regardless of asset size—the market rules the same for a $5 billion ETF and a $10 million one. Also, an important difference between ETFs and traditional open-end funds is the lower fixed-cost structure for ETFs. There are no transfer agency costs and no shareholder record-keeping costs. From that perspective, an ETF provider with a low level of assets has fewer hurdles than a small open-end mutual fund.

No doubt, a very large ETF provider with existing economies of scale to support its fixed costs will more easily be able to add new portfolios, especially in cases where the strategies are more niche and where $100 to $200 million might be a very successful launch. It's no different than any other business: One revenue stream can't support multiple pieces. And yet, keep in mind that we've had ETF providers like WisdomTree Investments and ProShares grow extensively over a relatively short period of time.

IU: Do you expect that the current market environment will slow the growth of ETFs?

Dallmer: The mass exodus has been from open-end mutual funds. ETFs have not seen those same outflows, and their design has enabled investors to buy into, or exit exposures, intraday. That has been a valuable feature in this market. When we come to the end of the year, I think comparison of index mutual funds and index ETFs that track the same index will show wide divergence, based on tax efficiency, in the performance of ETFs versus open-end funds. Heavy turnover creates a situation in which investors using ETFs can really outperform similar open-end fund investors. And remember, all those investors leaving open-end funds in droves, they will eventually go back into the markets to reinvest. Maybe it was seven to 10 years ago that they first invested, and there was not even an ETF available to them. Now those investors are taking their capital gains hits and when they head back into the markets, it may be into ETFs and not back into open-end funds. So that's a big opportunity for ETF companies.

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