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September 9, 2009

Appetite Grows For ETFs

Traditional Asset Managers Increase Their Holdings

By James Ramage

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Knight Capital Group's hire in June of 15 exchange-traded fund traders and salespeople from Newedge USA, the U.S. arm of the big French derivatives and commodities brokerage, highlights the growing interest from traditional asset managers in the products. The giant institutional brokerage and market maker has seen a tidal wave of volume and liquidity in the ETF space. But Knight has also taken note of the rise of a new ETF customer base: traditional asset managers.

"As mutual fund assets transfer into lower expense ratio exchange-traded funds, we're witnessing a growing trend of asset managers listing ETFs," said Reginald Browne, co-head of the ETF team at Knight Equity Markets.

The increased ETF investment adds up to new trading customers for Knight, Browne said. And asset managers' growing interest in listing ETFs should be a lasting trend in the mutual fund industry, he added.

"If you compare the ETF industry versus the mutual fund industry, there are some 8,000 mutual funds with about $10 trillion in them--half of which is cash money markets," he said. "I think you'll see more of a trend of those 8,000 into the ETF format."

Traditional asset managers' ETF use has grown steadily over the past few years, industry execs say. The money managers have mostly used them for quick exposure to the market.

"We're seeing an increase in [ETF] usage among more traditional asset managers, such as long-onlys and registered investment advisers--and it's been steady over time," said Matt Duffy, director of U.S. ETF trading at Citi. "They use them for core holdings, beta exposure, alpha generation, various hedging strategies. Whether you're bottom-up or top-down, they can be very useful."

For fund managers, ETFs are also a good tool for forming sector rotation, Duffy said. They allow for immediate exposure, to help managers during the transitions.

Since their creation in the early 1990s, ETFs have long been popular with retail customers because of their tax advantages over mutual funds. Hedge funds and global macro funds led the institutional charge into the space. In recent years, traditional money managers, such as mutual funds, have begun to join them in larger numbers, trading execs say.

ETFs are similar to index-based mutual funds, but trade on exchanges like stocks. The reasons ETFs have attracted long-only managers are the same ones that drew in early adopters: their structure. They're index-based, cheap to trade and allow for easy diversification. And highly liquid ETFs offer the flexibility to get in and out of big positions during times of uncertainty.

For traditional asset managers, ETFs help them manage their cash flows. Instead of trading out of securities as money flows into a mutual fund, ETFs that follow the underlying portfolio give managers easy exposure.

Ira Walker, UBS