money.cnn.com/ontv/themoneygang/. March 2004-ETF Q&A Spotlight

When you have an inefficient market, you have the potential for using knowledge to your advantage.

Q: In the past 3 years, ETFs have experienced rapid growth domestically and internationally despite difficult market conditions. Nevertheless, assets seem to be concentrated in a few benchmarks. Can you give us any insights as to why sectors have not been as successful?

MC: There are several reasons sectors didn’t grow rapidly. To begin with, there were problems with their definition. Their original construction was changed, so that they did not link up historically with the originally traded sectors. In my opinion, the sectors were not designed properly. Some companies in a sector are incomparable. Somebody’s got to design sectors so they can be used in actively managed strategies. There are researchers out there that have a better handle on what should be done than are reflected in the existing indexes. The way

they were advertised was another problem. Sectors are more an institutional type product and the institutionals didn’t warm up to them as well as they warmed up to other ETFs like SPDRS, iShares’ IVV, Diamonds and the Cubes. That’s very important to know. If equitization of cash is an important item, you’ve got to expect that institutions are going to equitize their cash with the bigger funds, not sectors.

Q. Do you think the distribution of ETFs assets in broad benchmarks will change?

MC: Unquestionably, as investors become more sophisticated, they look for different asset classes to satisfy their investment needs. Also, technology has vastly improved in the area of portfolio optimization, and Advisors can use this technology to design portfolios that more directly meet their clients’ specific needs. As more Advisors use this technology, other asset classes will gain popularity.

Q. In Europe many sponsors have shut down ETF sector funds. Do you think this trend will reverse?

MC: The general consensus at the last European ETF Conference in Rome was that there were just too many sector ETFs being offered. Some were not commercially viable and therefore had to be terminated. The current number is probably more manageable, but, if and when, the sector definitions are improved it’s possible that the mix will change. Some of the newly defined sectors will replace some of the old ones.

Q: Why do you think ETFs are becoming such a popular investment vehicle worldwide?

MC: They have many advantages over standard investments. Individual stocks are sometimes deemed too risky, mutual funds as too expensive. Indexed ETFs tend to outperform most active equity managers in the long run. That’s a big advantage for ETFs. They are also very low cost and tax efficient. You get better entry and exit prices as a result of their being priced continuously throughout the trading day. There are so many advantages to them that investors and their advisors are naturally taking to them. I also agree with Herb Blank’s point made in the January Q&A as to why ETFs have become so popular. He recognized their worldwide acceptance as being the result of different national prospectives and the value of ETFs in those nations. Now that more people are understanding ETFs, more people are accepting them.

Q: The mutual fund industry in the US is undergoing considerable scrutiny regarding after market trading, accurate pricing of foreign securities in daily NAV evaluations, and other ethical issues. Can you comment on how ETF architecture addresses these issues?

MC: Unfortunately, investors didn’t realize that a few privileged investors could take advantage of the difference between end-of-day NAV pricing and changes that would be reflected in NAV the next day. The fact that a few unscrupulous investors sought to benefit at the expense of shareholders causes some investors to believe mutual fund trading is rigged. Fortunately, the regulatory agencies and legislature is aware of this and will, no doubt, take appropriate actions. Meanwhile, investors are best advised to use ETFs. Because of the “in-kind” feature in creating and redeeming ETFs and the fact that all creations and redemptions by authorized participants must be authenticated by the Distributor, the late trading practices associated with mutual funds are not possible with ETFs.

Q: Do you think the end of the mutual fund is near?

MC: No, fund managers with the proper academic background, proper professional experience, who is willing to work hard at identifying stocks and investments that are going to outperform the average can do so. It’s not easy and these people are rare. You don’t have 8,000 smart portfolio managers out there. I think you do have enough of them who will specialize in certain niches that become profitable. For example, many small cap managers tend to outperform small cap indexes because small cap sector is generally thought to be a more inefficient market. When you have an inefficient market, you have the potential for using knowledge to your advantage. It’s the same way with any inefficient segment of the market. Good portfolio managers can beat the indexes, so there is a place for the mutual funds they manage.

Q: What changes would you like to see in the ETF industry?

MC: I wouldn’t change the regulatory structure. I think the regulatory structure recognizes that active ETFs are going to come into play. If anything, I would like to see more of the general public get an understanding of products. As soon as they do, the sooner they’ll be able to evaluate more clearly whether mutual funds or ETFs are more appropriate for their investment goals. When that happens, I think there is going to be a massive shift towards ETFs. One thing that many people haven’t picked up on was that in 2002, net cash flow into ETFs totaled $45.3 billion, while conventional equity mutual funds had a net outflow of $27.1 billion. That’s saying a lot about the public’s acceptance of ETFs and it is a significant event. That tells you that there are some people out there who really are thinking about what they want to do with their investments. I would like to see more of that kind of recognition

Q. Do you see any evolution in ETFs that will make it a better product?

MC: Most definitely. As these financial products evolve towards active ETFs I think it will be a better product. Because investors will know what they are buying in terms of the portfolio. By the way, I find the people involved in designing ETFs- are always thinking about new ways of making these products work. I was just speaking to someone today. He asked. “Why not a closed-end fund of ETFs?” They will have low expenses on the ETF side. The portfolio can be optimized to a point on the “efficient frontier” and all holdings are highly liquid. Such a fund might be worth a perpetual premium. The development of other markets; single stock futures, single ETF futures, and options will make these things traders’ tools. So, ETFs are getting more popular simply because there are a growing number of alternatives for using them.

Q. When was New Millenium Advisors founded?

MC: It was founded twice. The first time it was started was in 1991. However, I closed the firm to become the Director of Closed End Funds Research & Strategies at a large wire-house where I got new insights as to the proper way to run the business and succeed with smaller accounts, smaller pension accounts, and high net worth individuals. I started again in 1996.

Q. What role will New Millenium Advisors play in further ETF developments?

MC: Hopefully, on the active management side. We have a rigorous quantitative discipline to identify stocks according to their investment styles, e.g. large-cap, mid-cap, small-cap, growth and value. We believe that our indexes have better characteristics than those currently out there. We also have a rating system to identify those stocks that can outperform the average in their peer group. We will optimize portfolios in such a way that these portfolios will match the relevant benchmarks while providing an excessive return above them. We think the next big wave in ETFS will be actively managed enhanced index funds and we intend to be a part of it.

Q: If you hadn’t become an investment manager, what would you have done?

MC: A pilot of high performance aircraft.

Michael is the founder of New Millennium Advisors, a New York City-based active equity and balanced investment management firm with a value-oriented approach to growth stock selection. He and his associates use proprietary and quantitative disciplines to manage pension plans, and individual accounts, which often utilize exchange-traded funds (“ETFs”). These disciplines include state-of-the-art portfolio optimization techniques to control risk, and advanced rebalancing methods to reduce turnover.

Michael has over twenty-five years’ experience on Wall Street as a market strategist and portfolio manager developing forecasting models of the economy, the stock market and numerous industries. He authored numerous articles on investment strategy, economic activity and financial markets; lectured before professional societies and other organizations, is frequently quoted in the financial press, and appears regularly on CNNfn.

Formerly a senior portfolio manager and associate research chairman at Value Line, he managed $650 million in total assets, including the Value Line Centurion Fund ranked by Lipper Analytical Services as the best performing variable annuity growth fund in 1990 and for the combined period of 1989 and 1990. Also, the Value Line Fund, which ranked among the top fifteen best-performing growth and income funds.

If you have comments or have a question you would like addressed, contact New Millennium Advisors or email Michael Carty

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