Nobel Laureate

Nuveen's Gary Gastineau Talks About ETFs, Silent Indexes, and His New Book

Nobel Laureate

Gary Gastineau is a managing director at Nuveen Investments, where he is responsible for the development and introduction of Nuveen's new open-end exchange-traded funds. He penned a book that was recently released entitled The Exchange-Traded Funds Manual.

The book is a comprehensive look at the history and applications of the relatively new investment products that have attracted investors of all stripes. Gastineau covers every conceivable topic of interest that could arise for the investor or advisor interested in ETFs. The book is a practical guide on how to compare and use ETFs in a portfolio, focusing specifically on asset allocation, risk, and reward. Gastineau explains why ETFs are cheaper, more flexible, and more tax efficient than traditional open-end index funds. However, the book goes beyond the basics and gets into the strategy and tactics involved in building an ETF portfolio.

Gastineau is also critical of existing index-linked equity ETFs and makes the case for more "fund friendly" indexes, an idea we looked at in a previous article. He took time to chat recently with associate editor John Spence.

IF: Why are ETFs the most important financial innovation of the last 30 years? In other words, what are their key advantages?

GG: ETFs overcome many of the major disadvantages of conventional mutual funds. First, ETFs permit investors to buy and sell shares at any time during the trading day at a price that is usually very close to the intra-day value of the underlying portfolio. Transaction costs are low for most - but not all - funds.

Second, ETFs provide the opportunity to achieve a degree of tax efficiency that is not possible in any other fund structure and that is comparable to what can be obtained in a separate stock portfolio.

Finally, a less widely appreciated feature of ETFs is that they protect ongoing shareholders in the fund from the trading costs as well as the tax impact of shareholders entering and leaving the fund. The net effect is that the buyer and seller of fund shares pay transaction costs which are appropriate to his activity; the ongoing shareholder pays transaction costs appropriate to his inactivity. In addition, the ongoing shareholder gets the benefit of the tax deferral associated with in-kind redemption.

IF: We've had a big jump in ETF assets in the past few years. Will it continue and can ETFs pose a significant threat to traditional open-end mutual funds?

GG: The precise growth pattern in ETF assets over the next few years is difficult to estimate; one unknown is the number of applications for new funds that will be filed and approved by the SEC. Clearly, the rate of growth will decline from the triple digits of the late nineties, but it will be substantially higher than the growth rate of traditional open-end mutual funds. Money now in actively-managed open-end mutual funds is unlikely to convert to ETFs at a rapid pace. For any index application and most actively-managed fund applications, I would expect most new money to go into open-end ETFs eventually. There will always be some open-end funds that will continue to attract new money in the conventional mutual fund format. Aside from a few tax-exempt applications like 401(k)'s, I would not expect much growth in conventional index funds.

IF: So far, we've seen two firms, State Street Global Advisors and Barclays Global Investors, dominate the scene, with Vanguard stepping in recently. Will this area be dominated by the big firms, or is there room for smaller niche players?

GG: I would not agree that State Street and Barclays "dominate" the ETF market, and I am reluctant to speculate about the prospects of competitors. I will say that I believe there will always be room for a well-designed, well-managed fund - just as there has been in the conventional mutual fund market.

IF: You've been a vocal critic of existing index-linked funds and ETFs, and you've outlined a solution to the problems they face. How have regulators and the fund industry received your idea?

GG: My criticism of equity index ETFs and conventional index funds based on benchmark indexes is really quite simple. I find it difficult to understand why sensible investors are expected to tolerate a situation in which the transactions which are to be made by an index fund are widely publicized and various attempts are made to front run the fund's trading by speculators, arbitrageurs and competitive funds benchmarked to the same index. No actively-managed fund or any other kind of fund operates under such a disadvantage.

My proposed solution to this is the Silent Index - an index which would be designed specifically for a single index fund, almost certainly an ETF, and which would not announce changes in the index until after the fund had an opportunity to modify its portfolio to reflect the new index structure. I cannot say that everyone I have discussed this issue with is predicting a mass movement from benchmark indexes to Silent Indexes - a step which will require approval by the SEC in any event. I outlined this proposal in my comments on the SEC's Active Management Concept Release and in a paper published in the Winter 2002 Journal of Portfolio Management under the title "Equity Index Funds Have Lost Their Way." I hope to discuss this issue with the Commission in the coming months.

Most investors find the idea of a Silent Index attractive. Individuals associated with major pension plans and other institutional investors often feel that the wide acceptance of a benchmark index will keep most institutional investors from making a change. However, when I state the case in terms of avoidable transaction costs, I find almost universal agreement that something needs to be done. The basic issue in my mind is that no other fund anywhere in the world is required to trade only after its trading plans and requirements have been announced to the public and widely disseminated. The backseat which the investors in a benchmark index fund are required to take to other users of that index puts them at a substantial, if not a precisely measurable, disadvantage. I see no reason for such a disadvantageous structure. I expect it will take time, but I think ultimately benchmark indexes will be used less frequently and with less confidence as templates for index funds.

IF: What are some of the most common uses for ETFs? Do you see much potential interest on the retail side or are these products mainly geared to institutional investors?

GG: The uses for ETFs are essentially the same as the uses for conventional mutual funds and for a variety of structured products which have some kind of an index component. Hopefully, we will soon see fixed income ETFs and actively-managed ETFs, and by that time, the substitutes for conventional funds will run the gamut.

I see no reason why a traditional institutional investor would have a strong interest in today's equity index ETFs, except perhaps as part of a transition trade, say, in a manager or a strategy change. If a pension plan has a portfolio indexed to a traditional benchmark they can almost always obtain portfolio management at a lower cost from one of the traditional benchmark index managers than they can obtain that service from an ETF.

The persistent widespread conviction that today's ETFs are used mainly by institutional investors is unfounded, although there are a few cases where, for various reasons, the principal holders of an existing ETF are institutional investors. For the most part, if you look at the 13D and 13F reports which are the definitive measure of what institutions hold various securities, you will find that ETF institutional holdings are far below those that you would find in virtually any stock, approximately 35% on average. Retail investors hold most of the balance of the shares. The lion's share of ETF trading is done by brokerage firms acting as market makers or as part of their risk management activities and by hedge funds who use these products in a variety of ways for a variety of purposes. The dominant holders, however, remain individual investors.

I believe that if a series of Silent Index ETFs are successfully launched, they might appeal to institutional investors. These funds will give institutions an alternative to benchmark indexing and its associated built-in transaction costs. The Silent Index ETF will deliver a portfolio the institution could not obtain elsewhere and the use of the index by the fund may give it a degree of acceptability comparable to a benchmark index.

IF: What's the motivation for introducing actively-managed ETFs and how would they be used?

GG: The motivation for introducing actively-managed ETFs is essentially the same as the motivation for introducing indexed ETFs, both in fixed income markets and equity markets. Active ETFs should enjoy the same intra-day trading opportunities; the same tax advantages and the same transaction cost allocation advantages. The greater transparency of ETFs will permit far more useful and sophisticated fund research than anything being done today.

Of special importance for active ETFs is the finding in recent academic research that active mutual fund performance is hurt by in-and-out traders who buy at net asset value, much to the disadvantage of the ongoing shareholders of the fund. I think it will be some time before the full range of active management techniques available in conventional mutual funds is available in actively-managed ETFs, but I am hopeful that the SEC will permit the introduction of actively-managed ETFs in the relatively near future.

IF: You're a foremost expert on ETFs. How has your experience and your firm's background in closed-end funds prepared you to enter the ETF arena?

GG: My experience at the AMEX has given me, I think, a somewhat better than average understanding of the structure, function and features of the ETF vehicle - where it works, how it works and where and how it doesn't work.

Nuveen's background in closed-end funds is relevant in two areas. First, Nuveen has a long history of managing fixed-income portfolios. This will be of considerable help to us both in our initial, fixed-income index funds and in actively-managed fixed income funds we hope to introduce in the future. Second, Nuveen's marketing focus on supporting advisors in the closed-end municipal fund market and in separate accounts will be most useful to us as we introduce actively-managed ETFs, hopefully, in the relatively near future.