Jim Ross: ETFs Have Room to Grow

State Street executive says these funds are not just for traders.

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The investment firm that cooked up the first U.S. exchange-traded fund didn't do so with individual investors in mind. The SPDR S&P 500—which spawned today's burgeoning ETF industry—was created in 1993 for the investment banks and pension funds of the world. What's more, the architects' original vision included just two or three ETFs that tracked major indexes, says Jim Ross, senior managing director of State Street Global Advisers (technically, SPDR is the product of a partnership between State Street and the American Stock Exchange). Ross recently gave U.S. News an insider's view of the industry. Excerpts:

Are exchange-traded funds a growing threat to mutual funds?
I sit in a unique spot, because I'm responsible for a mutual fund and an ETF business. Competitors might disagree, but I think traditional active management will continue to have a following. People think of ETFs as passive index-based products, but they've grown to be used in the active implementation of a portfolio strategy. For example, you may prefer holding an active small-cap fund because you've found a manager you like, but maybe you haven't found that in a large-cap core fund. That's where an ETF could come in.

What are the biggest misconceptions about ETFs?
The trading feature sometimes gets overplayed. Just because they trade like stocks doesn't mean you have to trade them 10 times a day; you can buy one today and hold it 20 years. Still, the trading feature makes it simpler for someone who has a traditional brokerage account. Instead of holding five tech stocks, I can get the diversification of many stocks within the sector, in one trade. You can buy and hold forever, or you can buy and sell in 10 minutes (I'm not advocating that last one).

Transparency is also important today; you need to understand what you're buying. Some of the newer funds incorporate complex components like leverage. The bottom line is that you need to know how they're getting that return. If an ETF tells you it's going to deliver the performance of the S&P, you need to ask how it does that.

Are there any new frontiers left for ETF developers to conquer?
There's probably going to be more product development in the fixed-income space. Right now, the universe is 85 to 90 percent weighted towards equity. And I think you'll see more products like target-date ETFs and those that package existing ETFs into all-in-one funds.

What about actively managed ETFs? Can they work?
They have a long way to go. It doesn't work well for an active manager to be fully transparent. His advantage is his methodology to outperform [the market], and that goes away when he has to tell the world every day what he just did.

If you have just a couple of thousand dollars to invest, are ETFs a good idea?
It depends on how much you plan on trading. If you have $2,000 and are planning on buying one building-block ETF and holding it, a $9 commission goes away pretty quickly. But if you're buying five different funds, it's a little more cost prohibitive. If I had $2,000, I'd look for one or two ETFs that would get me the whole U.S. market and the whole world.

What will the ETF industry look like in 10 years?
It'll be significantly larger than it is today in terms of assets and products. The major question is whether it will stay as independent as it is now or if you'll see more asset managers and fund complexes buying up ETFs. Different ETFs are for different audiences, but I think you'll see a continued shakeout, and not in any particular type of fund. Just as anyone can launch a mutual fund, pretty much anyone can launch an ETF. But your idea has to have some merit and be marketable.