Former iShares Chief Executive Officer Lee Kranefuss took time away from work he’s doing on sustainability issues and spent time with IndexUniverse.com Managing Editor Olivier Ludwig to talk about the ETF industry hitting the $1 trillion milestone last week.

Kranefuss said the industry is just gathering momentum as the importance of asset allocation—as opposed to stock picking—gains greater currency among financial advisors, and as the industry turns its attention to creating actively managed ETFs.

Ludwig: So, how do you begin to explain the success of ETFs and the industry reaching the $1 trillion milestone?

Kranefuss: The ETF is just a much more appealing package. The thing that amazes me is why it hasn’t in some ways moved even further, faster. I think it takes a while.

Ludwig: I’m reminded of that Bill Gates quote to the effect that people overestimate the speed with which technological change is adopted and underestimate the ultimate consequences of the changes.

Kranefuss: He’s definitely right. You have a few early adopters, and there’s a critical tipping point. The critical tipping point is when ETFs become common knowledge and there’s acceptance that the thing is out there.

Ludwig: How do you see the tipping point materializing?

Kranefuss: There’s a slow secular trend that keeps going as people and advisors think less about security selection. Instead, it’s far more important to have your portfolio’s asset allocation right than it is to pick which of five companies in a field are going to outperform over the next year. What’s really more important is to understand your portfolio overall in terms of bonds, in terms of stock and in terms of its expressed outcomes. To what degree do you hedge against inflation or a downturn or be exposed to a sector?

It means you’re thinking more about emerging markets, and you’re also thinking more about portfolios diversification vs. return. That was one of the reasons we were so excited to bring out some of the commodity ETFs. It’s not that you’re betting necessarily on the appreciation of gold; it’s not that you’re betting on the appreciation of China. The answer is that, at the time, China’s correlation with other emerging markets was sufficiently low that it provided the opportunity for enhanced risk and return on the overall portfolio.

It may be another 10 years or so before an awful lot of people accept that as the fundamental investment premise. Certainly, every large institution accepts that as the investor premise.

Ludwig: They’re doing indexes, whether it’s with an ETF or futures or some other mechanism?

Kranefuss: Yes. If they’re a large pension fund, then typically they’re 50 percent or more indexed properly.

The other thing that could drive ETFs forward, and this is most exciting because it’s much more dynamic, is that ETFs did something in addition to the inherent benefits of the ETF—i.e., the tax efficiency—they democratized the distribution of investment strategies. And that’s very important as you get into ETFs that aren’t pure index ETFs.

What it’s done is taken investments from an account basis—a brokerage and custodial account—and taken it onto the exchange. The same was always true of stock, so it’s repackaged diversified investment—whether it’s active or indexed—into something which has the portability or ubiquity feature of individual securities. It doesn’t matter who my broker is whether I’m self-directed or advised. Stocks have always had that; liquid bonds have always had that. It’s funny that mutual funds are one of the things that didn’t have it. And ETFs have taken advantage of that.

Ludwig: How do you respond to someone like John Bogle, who argues that the tradability of ETFs can be tantamount to letting an alcoholic run a liquor store?

Kranefuss: Well, 95 percent of ETF trading volume comes from 5 percent of the assets. That’s primarily institutional money being used largely, not to take positions, but to hedge.

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