This is the tenth in a series of interviews with some of the most influential people in the field of indexing and index-based investment. The interviews are also published in the November/December 2014 issue of the Journal of Indexes.
While at Barclays Global Investors, Lee Kranefuss was the architect of the iShares family of ETFs, which launched in 2000, and headed up the unit until 2010, shortly after BGI was acquired from Barclays by BlackRock. By the time he departed, iShares had roughly $600 billion in assets under management and was the largest ETF provider in the world. For much of that time, he also oversaw more than $1.5 trillion in assets under management through BGI's other business units.
Kranefuss is now an executive-in-residence at private equity firm Warburg Pincus, where he works to identify opportunities in the financial industry, particularly in ETFs. In this role, he also serves as executive chairman of London-based ETF provider Source, in which Warburg Pincus owns a majority stake. Source recently entered the U.S. market with the launch of the Source Euro Stoxx 50 ETF (ESTX).
Would you talk a little about guiding Source into the U.S. market?
Source is unique in the sense that five trading houses—Bank of America Merrill Lynch, Goldman Sachs, Morgan Stanley, J.P. Morgan and Nomura—decided they didn't need to create ETFs individually, but that it would be ideal if they had an interest in the industry. So, they created a company that could be their strategic platform for ETFs, and that's Source. That structure harnesses the power of all these companies when it comes to product development. Now, Source is the No. 5 European exchange-traded product provider by assets.
Source's plans are focused on building out Europe, which is a lopsided game right now with one player at roughly 50 percent of the market. However, the ETF distribution opportunity is global. The U.S. is a different market, very crowded. But there is a lot of room in the U.S. for new-generation index products, both in structure and content, where the market has become incredibly stale. A lot of money is still flowing into indexes that we were using 20 years ago, and they aren't as relevant today to investors.
Where do you see the space for innovation in the ETF market?
There are three ways in which I see space for innovation. First, people need to stop talking about alpha versus beta, and active versus passive; it's too simplistic. Understanding the in-between is the most important innovation that is going to happen.
Secondly, people need to stop using the term "smart beta." There is active and passive; there is tilted beta that outperforms and tilted beta that underperforms. This idea of "smart beta" needs to be retired.
The third big innovation will be constructing a new language, a new set of concepts and a new philosophy around investment portfolio instruments and underlying tools. Indexes were created before there were computers as we know them, and research on indexing was done around indexes that existed because the data existed. The S&P 500, for example, measured something 25 years ago that investors think they are still getting when they buy that benchmark today. They're buying the U.S. market, right? But on average, more than half the revenue now comes from outside the U.S.
Today we have building blocks in the market that seem to stand for something, but actually deliver something else. We need to rethink what the fundamental building blocks are of constructing a portfolio, and provide ETFs as tools to implement a portfolio strategy based on those building blocks. There are a lot of asset classes where people would benefit from being able to invest directly in that market through an ETF, and that is one of the more interesting innovations going forward.
You see ETFs as the perfect vehicle for that reframing of perspective?
Yes. ETFs are building blocks like Lego that comes in a wide variety of shapes and sizes, and you can use them to "put on" positions or build portfolios for the short and long term. But right now, a lot of strategy is driven by a very loose correlation between what we think a current ETFs is—say, the S&P 500 is domestic exposure—and some equally loose concept about what we want the portfolio to be, say, domestic. We need to fine-tune the building blocks.
The growth of ETF strategists has largely been driven by the fact that it is not a simple job to use the current ETFs and get a domestic portfolio, for example. There are a number of funds out there that rely on old definitions, and people need professional advice to understand what they thought they knew.