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.
What in the history of the ETF industry has surprised you the most?
I would say the uptake of ETFs has been extraordinarily strong, particularly outside the U.S. Even in my early days, I could see a good growth rate, but there was a lot of doubt that ETFs would work everywhere. To see the continued success in every geographic market has been a little surprising.
Another thing that surprised me is the way the industry became very stale around and after the financial crisis. It doesn't seem like anything new came out after about 2007—it has been incredibly stagnant. I know that the financial crisis cut back on resources, and a lot of people are in sink-or-swim mode, but the intellectual capital on how to provide better tools so investors can be better investors seems to have come to a grinding halt.
Do any products that have launched stand out to you as examples of the innovation you are seeking?
I was on the board of the Russell Funds, so I'm a little bit biased here, but I think innovation has been more around factors, and factor building. What Russell was doing was around the factor story, and honestly, it was probably ahead of its time, but that is a direction that aligns with where real research is going and where the pros are trading.
Nowadays you go into a hedge fund and active manager and they talk about the momentum trade all the time. They measure it. But most people don't ever get to see it. The momentum factor is something that has to be traded or invested in, and that doesn't show up for the rest of us. This has been where there has been the biggest gap between implementation institutionally and broader awareness among investors. We are still years behind coming up with new ideas on that front.
Do you think that ETFs will replace or overshadow mutual funds?
In the long run, ETFs will become the preferred form of distribution for all mutual funds. I think that is why people are interested in active management. Why would you limit yourself to the traditional fund? I learned this myself in 1987. I put my money into an index fund in the beginning of the year, but I got nervous later on in the year, and someone tells me, "The market is crashing," so I decided to get out. I ran up to the investor center and I said, "Can I sell my shares now?" They said, "We can take your order now and at 4:00 p.m., we'll pool this with all the other orders and sell it, and then we'll give you your share."
I am thinking to myself, "The mutual fund is the only product in the world where it's like going and buying a car." They have it right there on the showroom for you, but you ask how much it is, and they tell you, "We don't know, but here is what somebody paid yesterday, and what we do is at the end of the day, we'll add up the cost of the bolts, the muffler, the lever and the engine, and that will be your price." Will it be pretty close to the price yesterday? No one knows.
The mutual fund is a very archaic idea. With an ETF, you can arrange with a broker to settle an ETF now if you want it. You have the ability, and much more control, much more portability than with a mutual fund. It's sort of a modern-day way of thinking about the distribution of the mutual fund. You'll see everything migrate toward ETFs in time.
Do you think that the approval of nontransparent active ETFs is what is needed for active ETFs to truly take off?
The approval is needed, but I don't think it is going to be a push for a take-off. "Taking off" is a funny term anyway, because ETFs were driven by being a superior vehicle that was low cost, portable and ubiquitous, that happened to be an index fund. Indexing didn't drive ETFs. ETFs drove indexing. It's amazing how much ETFs increased the amount of indexing in the world in aggregate, and that includes the institutional market.
On the other hand, what is going to happen with active ETFs is that existing active managers are going to want to offer ETFs for their features. So, existing managers and funds are going to drive the ETF and ETF volume, but there are internal challenges and conflicts that need to be worked out. Now, if nontransparent ETFs get approved, I expect every active manager will start offering some of their strategies in ETF format.
What is the biggest mistake that investors still make, in your opinion?
Hunting for alpha. Individuals spend too much time chasing alpha rather than thinking in terms of risk/ return. There are times you can do it, but they are rare. I actually believe there is alpha—as we think of it—out there, but when most people think of alpha or active, they are thinking fundamental, and to me, that means a portfolio manager who believes he can better read the body language of a CEO than other guys doing the same thing. Investors spend way too much time thinking there are such people who have information that no one else has, and they'll sell it to them for 212 basis points at $19.95 a trade. But if they really knew anything, they wouldn't tell you. They would be running a hedge fund.