ConvergEx’s Colas: $200B In 2013 ETF Flows

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The record $188 billion inflows into ETFs in 2012 looks like it could be the start of a whole new chapter of ETF development, CovergEx Chief Market Strategist Nicholas Colas says-meaning, don't be fooled by the record number of ETF closures last year; that's nothing more than a healthy sign of an industry focused on the bottom line.

The big marketing guns are starting to emerge, as last autumn's iShares slick ads touting the company's new inexpensive "Core" lineup of ETFs made clear, said Colas, who will speak on the macroeconomic outlook at IndexUniverse's Inside ETFs conference next month in Hollywood, Fla.

With ETFs gaining momentum, inflows could reach $200 billion in 2013, Colas told IndexUniverse.com Managing Editor Olly Ludwig. Colas also said stressed that the popularity of new fixed-income strategies last year should serve as notice that bond ETFs are just getting started. In the end, they'll soon have all the momentum of equity ETFs, which got their start 20 years ago this month with the launch of the now-$130 billion SPDR S&P 500 ETF (NYSEArca:SPY).

Ludwig:So let's talk about record flows in 2012. Any general observations?

Colas: The first point is we've had two very high years of inflows-2008 and 2012. Two more different years in capital markets you could not imagine. To me, it's really interesting that we've had this record year and a very different environment from what we had in 2008. But what happened with ETFs in 2012 is more relevant, probably, in 2013, than the 2008 experience was.

Ludwig:Which is to say-what?-that there's a normalization that's taking shape in the economy?

Colas: Yes, from a variety of perspectives. You see it in everything from a relatively low CBOE VIX Index, which indicates the emotional fear of the market is lower than average. Also, 2012 was a relatively good performance year in terms of the S&P being up 16 percent, and equities overall are doing well. Even European equities are doing OK, albeit with a lot more volatility, a more "normal" year than any of the last three or four.

And in that normal year, we have very high money flows into ETFs. To me, that says the ETF industry has hit some kind of new, faster level of growth in a more normal environment.

I think you could have looked at 2008 and said, "Oh, that's a function of all the volatility and people looking for lower-cost-structure funds, and some new funds opening up. And therefore, 2008 was an anomaly." You could have said that accurately-until 2012. Now, in 2012, we know that this is not an anomaly anymore. Again, this looks like a new higher level of growth for ETFs.

Ludwig:One area I wanted to hear you speak to is that as ETFs gain assets, mutual funds are losing assets, in equities anyway. Can you tease out some of the important themes going on there?

Colas: Absolutely. The mutual fund money flows picture is really a story of rotation, because overall, mutual fund flows are a positive. It's just in equities that they're negative. But if you add in fixed-income mutual funds, there are positive flows. So it's almost like a two-for-one thing. You see $1 of equities go out, and you see $2 of equity go into fixed-income mutual funds.

Then you add the ETF equation on top of it, and you can kind of see where about half of the equity flows go, assuming one-for-one substitution between mutual funds and ETFs. But ETF money flows still do tend to be an equity-centric direction.

Colas (cont'd.): The bigger picture around it is that it's not like money is leaving capital markets overall. Money is actually going into capital markets. The preferred instrument for equity investing has, over the past few years has very clearly been ETFs. But there's also been a big move into fixed-income, generally. You see positive fixed-income flows of ETFs, obviously. And you see positive flows in fixed-income mutual funds as well.

Ludwig:So, as you said, something is changing here on the eve of the 20 th anniversary of SPY. But there are some cross-currents. What I mean to say is that, while ETF inflows reached a record in 2012 and total ETF assets ended near all-time highs, there was also a record number of closures last year, as well as clear deceleration of launches from late spring onward. What did that mean to you?

Colas: First, I think it's important to put the bright outlook for ETFs into a broader context. And the broader context in financial services is that there aren't a lot of bright spots in financial services. So even if you're running a very successful ETF development group and an ETF division of a larger organization, you're still very cognizant of the fact that the overall picture for financial services products isn't that good. That forces you to be fairly strict about what stays open, and what closes, how selective you are in adding new products, where you focus your resources and how aggressive you are with the product suite that you have.

The ETF development cycle is not like mutual funds in the '80s and '90s. It's happening at an accelerated rate. It's happening at warp speed, where the mutual fund cycle happened more at steam-locomotive speed.

Ludwig:I find myself thinking about Joseph Schumpeter, and his idea of "creative destruction." So, record closures, and the decelerating launches are really two sides of the same coin, and, overall, this industry is very focused on staying competitive, staying profitable-things that, from a strict business perspective, are quite positive.

Colas: Yes, they are, absolutely. It says that the right things are happening, and that the right things are happening quickly. With ETFs being mostly index-based, a lot of smart people aren't distracted by stock picking either, like:"Hey, should I buy or sell GM today?"

Ludwig:Some say that with ETFs, advisors can put together these beta building blocks and create alpha-generating asset-allocation arrangements. Could that mean that the goose is cooked for active ETFs before the game even really starts?

Colas: You know as well as I how many hurdles the active ETF structure still has to clamber over before it can get done. But I think your underlying point, at least the one that I hear, is also quite sound. The definition of efficiency has become no sustainable way to find the arbitrages that create the alpha.

That's true even for people with access to information. There's nobody that has better information than a John Paulson or a George Soros or a Paul Tudor Jones. These guys have not only a lot of intelligence, but a lot of access to information. All of them shut down because they couldn't find the opportunities. So I think that sends all kinds of signals to everybody in our business that says, "Hey, picking stocks is just really hard."

Ludwig:All these people you cited, you read their 13F filings, and you see that they're traveling increasingly in the ETF traffic, too, to get what they're trying to get at, which is an interesting concept in and of itself.

Colas: Everything in our business comes full circle. I'm sure that there will be a new crop of mutual fund managers that find a better way to pick stocks. It might be through some kind of automation. It might be through things they haven't even considered yet. Everything always comes full circle, to your point about creative destruction. But the mutual fund side and active management, generally, has to make a better argument:There is a sustainable way to generate alpha.

Ludwig:Turning to a forward look, there is some suspicion out there that Fidelity is about to flood the zone with a lot of active strategies. If any company could carry this off, it's probably Fidelity Investments. Stop people on the street, and they still remember the Magellan Fund. Or they talk about the Contra Fund. Do you have any thoughts about Fidelity and ETFs?

Colas: Sure. What I would say is, first of all, obviously Fidelity is a powerhouse in the business. And if anybody can make a difference, it's them. There are a handful of firms that have the resources to do a great job, and Fidelity is clearly on that list. So you can't discount anything you're hearing about it, because that's an important name in our business.

The second point I would make is that Fidelity also has the additional benefit of being a major 401(k) platform. We use them as a 401(k) platform. So they have the additional benefit, not only of having the firepower to create the active ETFs, but to have a national platform to promote them.

But there is a little bit of self-cannibalization risk. You're familiar with "The Innovator's Dilemma," the Clayton Christensen book?

Ludwig:Yes. He talks about companies like GM that can't stop making big cars and pickup trucks because it's their gravy train, but that it ends up getting them into trouble.

Colas: Yes. Basically, the idea is that a business dies because it does all the right things.

The ETF business is basically the disruption to the mutual fund business, where you started off with index products being the part that the active manager saw he didn't make very much money from.

And so SPY, 20 years ago, was the original wedge. It was the original "innovator's dilemma" product, because it was an index product where active managers don't really make any money off of that. And so Fidelity said, "Forget it. Give that part of the business to the ETF guys because we don't care." And now, 20 years on, provided that you're right about Fidelity, we may be at the crux where the ETF structure finally takes over the highest value-added piece of the puzzle, which is the structure of active management.

Ludwig:Now, what about fixed income and ETFs? You talked about the mutual fund business, where there's a vibrant fixed-income franchise that's still alive and well there. And in the ETF world, virtually all the top 10 launches of 2012 were in the fixed-income space. What's the outlook for fixed-income ETFs relative to fixed-income mutual funds?

Colas: I think that the growth will, to some degree, mirror what we've seen already in equities. It's just a later start. It's maybe five years behind, just in terms of recognition.

But I think the piece of the puzzle-why I'm confident ETF growth will continue at the 2012 rate or greater this year and that would take it to something closer to $200 billion in inflows this year-is that you have more and more really competent distributors and wholesalers marketing ETFs to the institutional community.

Ludwig:And who's on that list of competent distributors?

Colas: Vanguard and iShares, for example. They'll send scores of really high-quality salespeople out into the field, training RIAs. Once they're in branch office training RIAs, and the product suite is fixed income, bond funds will begin to catch up.

The natural edge ETFs have right now is that they're hiring a lot of good people in the marketing and sales groups. I remember vividly when I started at Alliance Capital, the first print ads, which were at the end of, I think, 1988, when everything had gone off the charts. We took out the entire back page of the Wall Street Journal, and it was a big step.

And then, when I saw the first iShares ads on TV during the World Series, I had this flashback to thinking about the Alliance Capital print ads.

Ludwig:Right. Those iShares ads for their 10 Core funds were impressive-very high quality.

Colas: It was nicely done and felt like the old Merrill Lynch's "Bullish on America," or the old Prudential Rock ads. There's something to be said when an industry sort of hits the media full force, and starts broad-scale advertising, something has happened. It recognizes that the entire viewing world in the World Series is potentially a customer. And they also recognize that building a brand is just as important as building a product.

Ludwig:So what you're saying is that the whole experience you had with the iShares commercials spoke to you more about the ETF industry than about BlackRock?

Colas: Yes. It came out of one company, but it signaled to me that the industry is coming of age. I also know that IndexIQ is advertising on Bloomberg Radio, and I know they get a lot of uptake from those ads. They get responses. They get inbound calls. People are really listening. They're engaging with the message.

Ludwig:That brings me back to the whole SPY-at-20 thing. What does the 20 th birthday of the oldest ETF represent to you?

Colas: To me, it comes back to this Christensen notion of disruption and of "The Innovator's Dilemma." When you see something new come into a space, no one really knows what to make of it, knows what to do with it, how to think about it. And it takes time. And somebody's got to go first. And that was the first.

Ludwig:Right. And you talk to the people who actually launched SPY and they tell you they had no idea this was going to happen. I guess that's life!

Colas: Yes. How many great ideas die a natural death and don't ever see something to fruition? And this one happened to survive. It happened to grow. I think part of it was also that it was launched during an equity bull market. There was a high level of attention about equities. People were interested in finding new ways to invest-a very high-quality and low-cost way to invest in a broad, well-known index. And so it really engaged the imagination of the public.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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