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Interview with Patrick O'Connor, Index Portfolio Manager at Barclays Global Investors

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If you have unanswered questions about the complex inner workings of exchange-traded funds, then look no further.

Patrick O'Connor is head of U.S. mutual fund portfolio management within the equity index portfolio management group at Barclays Global Investors. He is currently responsible for the management of 44 U.S. equity iShares funds and 38 equity index mutual funds.

Below he offers a unique insider's perspective on what goes into running an ETF on a daily basis, and also discusses the intense preparation that leads up to trading the upcoming annual Russell index rebalance.

Q: Individual stock liquidity is usually measured by volume of trading, while an ETF's liquidity is best measured by the liquidity of its underlying constituents. Can you explain why this is so?

A: The individual stock liquidity of the stocks in the portfolio is the key when analyzing ETFs. For example, the iShares S&P 500 (IVV) may trade 100,000 shares a day or even less. But that isn't an indication of exactly what it could potentially trade. Specialists are willing to put up around half a million shares on each side of the bid/ask. They can do that because they know the underlying liquidity of the stock is considerably more liquid than what the ETF volume is showing.

The ETF create and redeem mechanism provides an arbitrage situation. This allows the specialist to sell shares to an investor knowing that as long as he can get his hands on the underlying stock, he will be able to create more ETF shares.

It's not surprising that there's a lot of confusion on this issue, because in equities people look at trading volume as an indication of liquidity. ETFs do trade like stocks, but their liquidity is determined by more than their just trading volume.

Q: Can you explain how the ETF creation/redemption process and arbitrage reduce premiums and discounts to the net asset value (NAV)?

A: Arbitrage definitely exists and it's probably one of the more interesting features of the ETF structure. Remember, the liquidity of the ETF is based on the individual stocks, and the ability to price the basket of stocks versus the ETF share allows the arbitrage mechanism to happen.

Closed-end funds often trade away from the NAV of the underlying portfolio. If the ETF was to trade at a significant discount to NAV, for example, an arbitrageur could come in and buy the underlying ETF share, sell short the underlying stocks in the basket, and redeem the ETF share on the close. After delivering up the redeemed shares and covering the short, the arbitrageur would lock in a profit from the discount to NAV.

The chances for those arbitrage opportunities, because of the ETF transparency, do not happen frequently, and if they do it's short-lived.

Q: How do ETF in-kind redemptions protect investors from capital gains, compared to mutual funds?

A: The ETF in-kind is not deemed a transaction for tax purposes. Mutual fund shareholders purchase and redeem shares from the fund. If the fund manager needs cash to meet investors' redemptions, they may have to liquidate holdings in the portfolio, possibly generating a capital gain. And the consequences of the shareholder redemption - capital gains - are passed along to all other shareholders.

ETF investors buy and sell from one another on an exchange; not with the fund. Thus ETF shareholders have more control over their tax destiny because they are not impacted by other shareholders' actions.

Q: Can you explain how international ETFs trade in the U.S. while the underlying markets are closed?

A: Let's take for example our iShare that tracks the MSCI EAFE index, which has stocks from many developed countries outside the U.S. When the exchange closes, in essence the stocks from that country are frozen at the NAV. However, you may see some slight variation around the NAV that's due to more than just the value of the stocks. When international markets are closed, events happen that allow investors in the U.S. to anticipate how the international markets will open the following day, possibly resulting in an ETF trading away from NAV.

Q: The widely followed Russell indices rebalance once a year on June 30, which results in a more dramatic index effect. Is this the most difficult index reconstitution that you face?

A: We're gearing up for it right now. The Russell rebalance is probably the most significant trading event of the year for indexing. Every year it has its own flavors; this year it seems that brokers are expecting a smaller rebalance. However, that can translate into more volatility. We haven't seen a pronounced 'Russell effect' occurring yet. In other words, we haven't noticed brokers putting up big positions. This inactivity so far could lead to a major focus around June.

Frankly, what makes the Russell 2000 rebalance difficult for us is the large amount of assets we have tracking the Russell 2000 and its growth and value indexes. In small-caps there are liquidity concerns. Since BGI is so large, we have to be very careful that we trade the rebalance properly. We want to trade the rebalance without impacting the market, while at the same time minimizing index tracking error. That's really the toughest part of the Russell rebalance.

Compared to last year, the Russell 2000 turnover is projected to be down to 17%, but that's still sizable turnover in a $2 billion iShares fund.

Q: How much preparation goes into the Russell rebalance?

A: Well, BGI is the largest Russell manager with about $70 billion in assets under management. We started preparing for this year's rebalance last year; we start running projections and looking at liquidity very early. Every year the planning for Russell reconstitution happens earlier and earlier, and we always have to be thinking about trading strategies. For example, we may consider trading a very small portion of illiquid delete names early. But we always have an eye on understanding the risks of a move like that, and how it would affect index tracking. There's always a trade-off that involves market impact, tracking error, and taxes. If you don't manage the tax strategies correctly throughout the year - for example harvesting losses when possible - you could find yourself in a bad position.

Q: In terms of managing ETFs, what are some the things you have to worry about to run the fund at maximum efficiency?

A: Again, taxes are important. The common perception is that index funds don't have a lot of turnover so they're automatically tax efficient. But in reality our portfolio management team is looking at every corporate action and every delete in every benchmark we track. We need to understand if it's a gain or a loss. We ask if there's a strategy we can employ to maintain index tracking while not realizing that gain or loss.

Another factor that helps us run the funds efficiently is our knowledge and understanding of the benchmark methodologies. We have an index research group that supports the portfolio managers. We also have relationships with the index providers. We usually take part in the discussions whenever an index provider is considering a major methodology change.

Finally, our size allows us to do a lot of internal crossing of trades, which results in more efficiency in the individual funds.