Fighting Fire With Fire
Sandra Ward
Nov 15, 1999
With their sales increasingly under pressure from investor demand for individual stocks and exchange-traded index funds such as SPDRS, Webs and Diamonds, fund companies appear to be getting ready to strike back.
Major fund companies have been holding talks with the American Stock Exchange and industry consultants to explore ways of extending their existing product lines by creating replicas of their funds that would trade throughout the day. Not just index funds, though they pose fewer complications and will likely be the first to appear. Those close to the discussions predict we'll also see the launch of replicas of actively managed funds within the next 18 months. The new products would likely carry the same names as the existing funds, but be treated as an additional class of shares.
This could give fund companies a potential new avenue of growth and a way to retain customers they might be losing, especially as the cost of buying and selling stocks has decreased markedly in the past few years, thanks to online trading. Brokerage commissions are much lower now, too. Moreover, consumers are catching on to the tax efficiencies of individual stocks and exchange-traded funds, so this is a way for fund companies to respond. Another attraction; exchange-traded funds can be sold short on downticks.
Though an exchange-traded actively managed fund wouldn't be as tax-efficient as its index counterpart, it would be more so than the mutual fund on which it is based. Fund companies, too, don't want to be left behind if such exchange-traded funds become the next big thing, so the motivation is partly defensive. Adding to their nervousness is a formidable lineup of such funds coming from Barclays Global Investors, the world's largest manager of indexed assets.
Barclays plans to roll out 51 new funds based on major indexes, slicing and dicing them along the lines of growth, value and market capitalization. That will bring to 81 the number available for trading throughout the day. The firm, which is the underlying manager of Webs, or world equity benchmark shares, also plans to add 11 more countries to its Webs line.
It's a view of the fund industry's future that Barron's envisioned in a cover article in April 1998.
It's no wonder other companies are sitting up and taking notice. Certainly, Vanguard is feeling the heat, as its entire branding strategy revolves around being the low-cost provider of index funds. "The whole issue involving exchange-traded funds remains under study," says a Vanguard Group spokesman.
"We're watching developments with those funds closely, but we have no immediate plans at this time to introduce them," says a Fidelity Investments spokesman. When asked if the firm has held talks with the American Stock Exchange about the possibility of launching such funds, he adds: "We have discussions with all the exchanges all the time, and I'm not sure if this has been a specific topic of discussion."
"It is a growing interest," says Steven Bloom, a product-innovation specialist and principal of Capmark, a consulting firm in Springfield, New Jersey, and one of the creators of the now hugely popular SPDR index fund. "Several of the top 10 fund companies have considered this seriously, in one form or another adding an exchange-traded fund to their product lines."
Gary Gastineau, head of new-product development at the Amex, would reveal only that "we've had conversations with a number of fund companies and some of them have expressed interest in doing something like that, but nothing has been officially filed with the SEC." Amex officials have met with SEC officials in the past few months, he says, to explain how the product line might develop and to outline what issues were outstanding and how they could be resolved.
The biggest hangup, of course, involves the actively managed funds and the reluctance of portfolio managers to disclose their positions. But the product developers pushing for exchange-traded funds say those concerns can be overcome by creating a portfolio around the core holdings that resembles closely the actual portfolio. In addition, only the nation's biggest funds would likely qualify as candidates for exchange-traded funds because they tend to hold more large-cap stocks that are more liquid.
Vanguard founder and outgoing chairman Jack Bogle is a fan of exchange-traded index funds, such as the SPDR, based on the S&P 500 Index. He calls investing in such instruments a "perfectly intelligent thing to do," but is concerned that exchange-traded funds might appeal more to speculators than to long-term investors. Furthermore, he's worried that such funds could, under certain circumstances, create pressures on the mutual fund they are replicating. "I'd be somewhat questionable," he says.
Others dismiss the criticism, maintaining there's no evidence that either a diversified liquid portfolio or the portfolio it resembles would be at risk. In the SPDR universe, arbitrage players tend to appear to take advantage of any price deviations, which minimizes any tracking deviation.
Already, there are financial advisers running portfolios constructed entirely of exchange-traded funds. Says Thomas Mench, chairman and chief investment officer of Mench Financial in Cincinnati, "We are selling the product as a complete tool." An added benefit to advisers: The cost benefits of such a strategy tend to accrue to them.
In a sign of the times, Charles Schwab -- which is establishing itself as a force in index funds -- included a panel discussion on the topic at its recent annual conference for financial advisers.
But reflecting the tensions that exist between those in the mainstream mutual-fund business and those pushing these maverick products, participants noted (in the tones of conspiracy theorists) that the room the discussion was to be held in was switched at the last minute, and no handouts or slides were available. But they also pointed out the parallel to the advent of index funds in the late 'Seventies, when critics dismissed them for their lack of brand recognition and lack of active management. Index funds are now the industry's fastest-growing segment.
A nyone thinking of doing business with M.D. Sass & Co. would be well-served to study the brief but tortured history of the Corporate Renaissance closed-end fund. Then they might think again.
Visit Barron's at www.barrons.com for the latest financial analysis and commentary, updated daily.
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