They can open new markets to small investors, even though they sound complicated

Washington Post

May 12, 2013

Michael Sapir, 54, is founder and chairman of Bethesda, Md.-based ProShares, the nearly $29 billion asset management firm that he co-founded in 1997. The firm has become widely known for the creation of exchange-traded funds, known as ETFs. The ETFs constitute the vast majority, more than $24 billion, of assets the firm manages.

Sapir has created many ETFs, including those that seek to mirror investments in hedge funds and private equity, which have been historically inaccessible to retail and private investors.

Q: What are exchange-traded funds?

A: In essence it is a mutual fund that trades on a stock exchange. So ETFs end up having greater liquidity during the hours of the day than a mutual fund that you generally can only come in and out of one time a day. You trade exchange-traded funds like a stock. Generally speaking, ETFs are passively managed or indexed.

Exchange-traded funds present varied advantages to investors, including generally being lower-cost, transparent and providing access to a wide range of parts of the investment landscape. We think investors find that attractive for their retirement accounts, as well as for their general investment accounts.

Q: What are the dangers in owning ETFs?

A: Each ETF, like each investment, has its potential risk and rewards. ETFs are a delivery vehicle for a particular investment strategy, so it’s imperative that the investor or his financial adviser understands the exchange-traded-fund structure but also the particular investment strategy that it is seeking to deliver.

There is a wide spectrum of strategies that ETFs follow. Exchange-traded funds can go from a basic S&P 500 large-cap index strategy to emerging market debt to various sectors like health care to commodities like gold or currency to very conservative investments like we introduced last year. One thing that ETFs have done for investors is to democratize the access to different slices and parts of the economic landscape.

Q: Why are there so many ETFs? It’s confusing.

A: To put things in perspective, there are probably six or seven times as many mutual funds as exchange-traded funds. So think of ETFs like tools in a toolbox. Some ETFs are basic tools that you might use every day. A large-cap index might be equivalent to a flat-head screwdriver that you use on a regular basis.

Then there are ETFs that most investors would never use but more sophisticated investors find useful. Just like when you go to Home Depot, there are some tools that a basic do-it-yourselfer would use. But there are other tools that more-sophisticated contractors would use.

Q: How many ETF s should the average investor own to be properly diversified?

A: That’s a very good question. Many investors are giving up trying to pick the stock or the active manager who will outperform the index. Because study after study shows that active managers don’t beat passively managed portfolios, you see more portfolios composed of assets with building blocks of ETFs.

There’s no magic number of ETFs to achieve the appropriate level of diversification for all investors. That evaluation is a fact-and-circumstances analysis based on the objective of a particular investor, their risk profile and lots of other factors.

It would be surprising to see a well-diversified portfolio with less than four or five exchange-traded funds. One element that we see increasingly being a slice of a well-diversified portfolio is alternative investments. These are investments that are other than what is traditionally long-only equities and fixed income and cash.

Q: ETFs have grown rapidly over the past 10 years. Do you foresee ETFs supplanting traditional mutual funds in the future?

A: [Long pause.] Time will tell. But what I will say is, in terms of a vehicle to deliver passive or index strategy, I think the handwriting is on the wall. Exchange-traded funds have virtually won that contest.

I think the harder question is whether exchange-traded funds that offer an actively managed strategy are going to be able to deliver that sort of strategy and to compete mano a mano with mutual funds. So far, few ETFs that are actively managed have been successful.

Q: Have ETFs helped investors become more successful?

A: ETFs are the most important investment vehicle developed in 50 years.

ETFs have come along during an inflection point in how investors look at investing. What we see investors wanting is a realistic return while trying to reduce the volatility of ups and downs in their portfolio. Many studies have shown that it’s much more important as to what parts of the market, what slices of the economic landscape are in your portfolio than what particular companies are represented.

The issue a lot of investors run in to is if they have just one or two companies in their portfolio representing a sector, they are subject to the particular success or lack of success of that company.

On the other hand, if you have a well-diversified portfolio representing a sector, like an ETF that holds 20, 30, 40 companies, you are not subject nearly as much to the success of a company. You are essentially buying that market, and if that part of the market does well, you do well. Generally speaking, if you put together different parts of a market and different slices of the economy, the more diversified you are and the less vulnerable your portfolio will be.

Q: Do you think that investors have a good understanding how leveraged ETFs differ from ETFs that seek to match plain-vanilla, market-cap-weighted indexes?

A: There is a wide spectrum of ETFs offered. They include equity ETFs in African countries to rare-metal offerings like palladium to products that we offer called geared ETFs. They provide magnified or inverse — some people call it “short” — exposure to a wide variety of parts of the market. These ETFs, like many other ETFs, are designed primarily for educated investors and professional investors. They are not for mom-and-pop investors. From all indications, our shareholder base is very sophisticated and understands how these products work. It’s important to understand that the objective of these funds is to produce a daily result and the performance over different periods may be different.

Q: What risks face the ETF industry?

A: The number one challenge is investor education. ETFs differ in important aspects from mutual funds. If you don’t feel like you understand what you are investing in after doing your homework, don’t invest in it. Or hire a financial professional to help you.

Q: Why are investors flocking to ETFs?

A: First, many investors are giving up on buying individual stocks and pieces of fixed income, and they want to buy a broadly diversified piece of the market. The move to passive investing has been like a tsunami. Investors see that investing in an active manager frequently gets them not-as-good returns, and they pay more for it.

Since the market crises of ‘08 and ‘09, investors are more and more suspicious of investments that are black boxes where you don’t know what your portfolio manager is doing. They want liquidity so they can come in and out of the investments. And they see that lower costs of management over the long term can have a dramatic effect on their portfolios. ETFs answer all those concerns.

Q: Since the financial crisis, many average investors remain hesitant to take on risk. What is your message to them?

A: That’s a serious concern of ours. We may lose a whole generation or two of investors who effectively, like the Great Depression kids, just want to put their money under a mattress. That would be a shame. Over the long run, it’s our belief that investors who continue to be in the market and well-diversified portfolios that include alternatives will end up better off than someone who simply puts money in a mattress.

Q: What do you invest in?

A: I’m a true believer in passive and index investing. And I think I’m like most investors these days, which is I’m okay with a fair level of return as long as the volatility, in other words the ups and downs in the portfolio, are reasonable.