American Enterprise Institute

April 26, 2006

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Introduction:	Peter J. Wallison, AEI
2:15	Panel:	Industry Statistics
		T. Neil Bathon, Financial Research Corporation
		Separately Managed Accounts and ETFs
		Sander Gerber, XTF Advisors and Hudson Bay Capital LP
		Folios
		Steven Wallman, FOLIO fn Exchange Traded Funds Todd J. Broms and Gary L. Gastineau, Managed ETFs, LLC
	Moderators:	Robert E. Litan, Brookings Institution
		Peter J. Wallison, AEI
4:00	Adjournment

Proceedings:

Peter J. Wallison:  Okay, I think we will get started.  I’m Peter Wallison, I’m a resident fellow here at the American Enterprise Institute, and I want to welcome all of you to what is I think our eighth conference on the question, is there a better way to regulate mutual funds?  I’ll introduce my colleague who is just to my right here, Bob Litan, after I finish with the introduction, and then we will give each of our panelists an opportunity to make a presentation.  We will then, as we usually do, have a discussion among the panelists and then go to questions from the floor.  So if you have some questions as things go along, please make a note of them so when we get to the question period, you can ask your question. 

One of the most important benefits offered to investors by mutual funds is the opportunity at a limited cost to achieve diversification, and thus limit their investment risk.  One of the lessons of Enron and WorldCom is that investors can protect themselves against fraud and business collapse through diversification.  In this conference, we want to look at competition for conventional mutual funds from other kinds of investment vehicles that also offer diversification, and sometimes more. 

It may at first seem anomalous to be considering whether there is serious competition for an industry that has almost $9 trillion dollars in assets and over 90 million customers.  There is no doubt that mutual funds are today the dominant form of equity and fixed income investment for Americans.  It may also seem anomalous to consider whether changes in regulation are necessary for such an industry, since regulation cannot be much of a problem for an industry that has grown so large and so successful.  But regulation has a way of stifling innovation and stifling change in a regulated industry, leaving the field open to competition from less regulated or unregulated alternatives.  This is especially true when the market undergoes a profound change, but regulation does not keep pace. 

Indeed, alternatives often develop because the regulated industry cannot serve a demonstrated need or adapt to a new technology.  What this often means is that talented people in the industry go elsewhere, and the industry stops growing and improving.  The people who are hurt in this process are the customers who don’t have the knowledge to get out as the industry provides less and less value to its customers.  What we should want are industries that are free to change in response to consumer demands, to offer their products in new ways in order to avoid the danger of obsolescence in a constantly evolving market.  Accordingly, any study of regulation must also consider whether the regulated industry has the flexibility under its regulatory framework to change and innovate in order to meet new competition. 

In today’s conference, we will look at some of the new competitors for the conventional mutual fund. Exchange-traded funds, or ETFs, are a relatively recent innovation, and are regulated under the Investment Company Act of 1940.  They offer the diversification to the same advantage as mutual funds and also address some of the tax and other deficiencies that some investors find in mutual funds.  ETFs are currently based on indexes, but could be managed like conventional mutual funds if the SEC approves various exemptions from the Investment Company Act.  Separately managed accounts and FOLIO fn are both ways for investors to achieve diversification through customized portfolios that meet their specific investment objectives. 

What we are likely to see today is that while mutual funds are currently the dominant form of investment for the retail investor who is looking for diversification, ETFs and customized portfolios of various kinds are growing faster than conventional mutual funds.  If we subtract out of the mutual funds’ market share the investments made by pension plans and similar collective retirement vehicles, we will probably see that these customized competitors are capturing now, and are likely to capture in the future, a much larger portion of the retail investor market than the gross numbers suggest.  This should be a warning signal for those concerned about excessive, or excessively rigid, regulation.  If mutual funds are not meeting the needs of a substantial body of retail investors, something significant is going on.  It seems clear that retail investors are increasingly willing to pay for individualized advice in the management of their assets.  This is a major change in the market and has profound implications. 

For years, mutual fund groups have been proliferating various kinds of funds — balanced funds, bond funds, index funds, income funds, small-cap, large-cap, growth funds, aggressive funds, maybe even passive-aggressive funds — but it appears that all of these specialized funds are not sufficiently personalized to meet the needs of today’s sophisticated investors, who seem to want something even more tailored and customized.  Perhaps this is a passing phase, or maybe there is only a relatively small group of investors who want and are willing to pay for this kind of specialized service.  Maybe the growth of alternative investment vehicles will stop as they mine the opportunities in this limited group.  But as Americans become more affluent and sophisticated about what the financial world offers, it may well be that they will not be satisfied with the fund categories that the mutual fund industry is economically capable of offering in its current structure. 

It is important to keep in mind that it is expensive to create a mutual fund.  A mutual fund is a corporation which must comply with the full panoply of costs that are borne by all corporations that offer their shares to the public — even Sarbanes-Oxley.  It is hard to imagine that it could be profitable for the mutual fund industry to continue to set up more and more corporations to meet the demands of investors for more and more specialized and individualized-type portfolios.  At some point, it may be necessary to authorize a less expensive alternative to the corporate form, which is the only form currently recognized by the Investment Company

Act.  That is why an important component of any study of mutual fund regulation has to consider the competitive position of the industry and what is happening in its market.  Thank you. 

Bob Litan and I have been doing this together and we are privileged today as we have not often been to have Bob here as a co-moderator and I’m very happy to make an introduction.  Bob is the co-director of the AEI-Brookings Joint Center on regulatory studies.  He is also the vice president for research and policy at the Kauffman Foundation in Kansas City and a senior fellow in economics studies at the Brookings Institution.  He is an economist and attorney who has practiced law and taught banking law at Yale Law School.  He is the author or co-author of numerous books and articles on financial institutions, international trade, and regulatory issues.  He was formally an associate director of the Office of Management and Budget, deputy assistant, attorney general in the antitrust division of Department of Justice, and a regulatory specialist for the President’s Council of Economic Advisors.  That was all in the Clinton administration.  Was it not?

Robert E. Litan:  The CEA was Carter.

Peter J. Wallison:  Carter.

Robert E. Litan:  Ancient.

Peter J. Wallison:  Oh, my God.  You were a child.  Okay.  Well, that is… this is Bob Litan, and he will be interrupting as I will be during the presentations that we will hear today.  Our first presentation will be by Neil Bathon.  I hope I’m pronouncing that right, Neil.  Neil founded the Financial Research Corporation in 1987 in order to enhance the decision making of investment managers by improving their competitive intelligence, product, and sales trend analyses and overall market place awareness.  The clients of FRC include traditional mutual fund groups, banks, insurance companies, brokerage firms, accounting firms, law firms, and institutional money managers.  He has an MBA from DePaul University in 1983, after which he went to Camper Financial Services where he was in product development and finally founded, as I indicated, the Financial Research Corporation.  I should say that there are much more detailed background materials for each of our panelists in your folders and I’m only giving some of the high points of what are in those bios. 

Neil, up to you.  And Robert, would you like to say a thing?

Robert E. Litan:  No.

Peter J. Wallison:  Something before we start?

Robert E. Litan:  I just agree with everything you say.

Peter J. Wallison:  Good.  Neil?

T. Neil Bathon:  All right.  Thank you very much for having me.  I’m going to take about 15 or 20 minutes of your time to give you a cross-section of the competitive positioning of mutual funds vis-à-vis variable annuities, ETFs, separate accounts, and those other categories in particular.  So with that, I think the only point of FRC which will become eminently clear is that we are a research firm largely based in a kind of quantitative survey research that comes through pretty clearly with each slide you are about to see.  We work across, as he mentioned, we are reasonably indifferent about product structures, so with a separate account or ETF or variable annuities or collective trust, the research that we do and the work that we provide for the clients crosses all different structures. 

I think first, to just give you a sense of one of the most influential factors driving the competition between product types though, I’ll just give you a sense of how things are changing for distributors that often are responsible for carrying a product to the end client.  So just a few quick bullet points here.  The brokerage firms have actively been working to evolve their reps into financial planners.  There are various stages about having accomplished this, but certainly from 15 years ago where we had brokers who sold products, now we are closer and closer to having advisers who provide financial planning solutions.  It is still a goal for some firms, but others are quite far along. 

The fee-based approach is something that has been worked into the model for the last few years.  It was not very long ago, the bulk of investment products provided to individual investors were done through transactions, front loads, those types of conventions, and today much more of a wrap fee environment exists as certainly never before. 

The due diligence teams - this is a pretty significant change.  A few years ago, you might have been on the right track if you assumed that the due diligence efforts in terms of evaluating outside managers was something of a rubberstamp for most distributors, and other influences like the amount of sales and marketing support you can provide were a little bit more influential in determining which asset managers got access to different distribution platforms.  Today, the due diligence teams have emerged.  It is an important force that takes the asset managers to a much more rigorous evaluation and, really, ultimately decides based on merit of one’s investment management process who gets in and who gets access to the distribution system. 

And the final one is it was not too long ago that we were largely a fund family -- certainly in the mutual fund side of things -- we thought of ourselves as fund families and when a firm went to a distributor to get access, in a sense, the whole family was granted access.  And today, I think we are beginning to see that the distributors are much more selective in the products that they are allowing on, so they might only take a few funds from any individual fund group and they are looking much more for boutiques and specialist firms and not for these big, brand-massive entities that in the past would have claimed to manage all types of assets across all different types of categories.  So these are some of the shifting points. 

Just a couple data points to support it; fee-based assets at distributor firms are up to 44 percent versus the assets that came in through a commission-type relationship.  So again, maybe seven or eight years ago, this was in single digits.  And just to give you a sense on how the due diligence groups have evolved and would likely to continue to evolve, it used to be that each product structure had its own research group that evaluate them.  There was not a lot of consistency.  The variable annuity mutual fund and separately managed account areas were separate and distinct. 

So what has happened over the last, maybe just two years, is that these groups have all merged together into one kind of super centralized, turbo-charged due diligence team.  They have been populated with institutional consultants from the Wilshire’s and Russell’s and Mercers and Callans of the world.  So they are really illegitimate, high-end institutional consultants within the brokerage firm.  I think where they are going, certainly their influence, as I mentioned, is expanding but ultimately, I think they get much more tightly involved in picking the securities or the managers or the products that the reps will provide. 

So I think they are going to be a centralized solutions group where they decide what the appropriate mix of products are for the client given their risk profile and their goals and their timeframes.  And I think you will see that the reps and the advisors, the planners are becoming more and more comfortable that they can turn over this responsibility to the home office where in the past, their egos as well as their sense of their value add had them believing that they were the central to picking managers and providing better alternate results.  I think that has been disproven over and over again.

 All right, so in the product review section, the main force behind everyone’s interest in terms of building products and structuring position products was the rollover money.  There is $2 trillion that is going to roll out of 401k programs over the next few years, and there is a mad scramble among asset management and distributors to figure out how they can position themselves to take advantage of this wave of money that is in motion, thus the slide title.

Robert E. Litan:  Okay.  Can you be just a little bit more specific what you mean by rollover?  I mean people retiring or people changing jobs?  What are you talking about?

T. Neil Bathon:  Most of it is retirement.  But there is a fair amount and maybe 20 percent of the dollars here that are job changers. 

Peter J. Wallison:  What about new flows?  New money flows?  Not just rollovers but additional money that is coming in from investments?

T. Neil Bathon:  Into the 401k platforms or just in general?

Peter J. Wallison:  Or in general?

T. Neil Bathon:  Oh, yes.  That is what a…

Peter J. Wallison:  Is that included in the 1.9?

T. Neil Bathon:  No, this is just a rollover.

Peter J. Wallison:  Uh-huh.

T. Neil Bathon:  So, there is certainly another source of cash that is quite significant.

Robert E. Litan:  This is just 401Ks?

T. Neil Bathon:  Yes.

Peter J. Wallison:  And will go in IRAs. 

T. Neil Bathon:  Yes, right.  Exactly.

Peter J. Wallison:  Wow.

T. Neil Bathon:  So.

Peter J. Wallison:  Adds up, does it not?

T. Neil Bathon:  You have to be a research firm not to just make it $2 trillion, right?

Peter J. Wallison:  Yes.

T. Neil Bathon:  Because 1.9 is …

[cross-talking].

Robert E. Litan:  That is right.

T. Neil Bathon:  All right.  So then, into the individual product profiles, this just gives you a sense of the assets across different categories as it stands today.  So the categories are, from left to right, separately managed accounts, variable annuities, fixed annuities, hedge funds, closed-end funds, ETFs, 529 plans, mutual funds, and the split there is long term versus money market and the individual securities held by individual investors.  That split is equity and bond.

Peter J. Wallison:  One thing, Neil.  Is there any way to split out the amount within the mutual fund category as between those things that are part of pension funds or other retirement accounts from those things that are retail investors’ investments?

T. Neil Bathon:  I’m sure there is.  Not…

Peter J. Wallison:  Any sense of that what that might be?

T. Neil Bathon:  I have a sense of flows more than to the assets, but I can certainly add it to the presentation and send it back.  I know we have that data.

Peter J. Wallison:  Okay.

T. Neil Bathon:  But I think 50 percent of mutual fund flows are tied to retirement tax advantaged investments, so whether it is an IRA or your 401k or 403b, those kinds of things.

Peter J. Wallison:  I see.  Okay, thanks.

T. Neil Bathon:  All right.  So let us take a quick look at some of the individual structures on the mutual fund side of things.  Just pretty straight forward, this is the asset growth of long-term mutual funds.  So we do not have the money markets here.  This includes ETFs.  We tend to view ETFs as a mutual fund more than probably most of the other research firms or others in the industry do.  The gross sales; you can see the growth sales.  I also just want to give you a sense – it is a little more telling.  Net sales, we are taking into account the redemptions.  I think that is a little clearer sense of the health of the industry.  And you can see last year in 2005 was a very, very good year, top 4 of all time.

 So the industry has bounced back from the low that it experienced early in the 2000 and we are off to a great start this year.  I think another 40 billion.  The number I have for ’06 is just for the first two months, but I think another 40 billion came in March in net new money, so it is off to a stellar start, a record-setting pace actually.  The categories that are selling well - and I’ll update this one because we do have more credit information so the new slides will be online - but basic, I think we have a lot of performance chasing going on.  Five of these categories are international and obviously, the returns of those funds have been just outstanding. 

So as much as we would like to think that we have evolved away from kind of chasing the hot dot, I think it is still pretty apparent.  As asset allocation models are being put in place -- and they certainly allocate more and more to international -- but I do not think that accounts for all the sales here.  Some of the other categories, we have two separate categories.  Precious metals and natural resources, which again are performance chasers I believe. 

And then the number five, which I’ll talk about a little more, moderate allocation is a function of the asset allocation funds that have gained popularity of late.  And to that point, let me jump ahead.  Just a second.  Asset allocation funds, this gives you a sense of all the funds that make up the categories, whether it is target risk or target date.  Target date; 2020 is the maturity date where target risk is the conservative, aggressive, moderate type of portfolios.  In the middle of the balance funds and then at the green at the bottom is your tactical allocation fund.  There is not a lot of activity, whether a new product development or sales or marketing support around the tactical allocation at this time, although they have been with us for a while. 

The life-cycle funds, which I just mentioned, a subset of the overall asset allocation pool, they have dominated the sales scene over the last couple of years.  About a third of all sales last year and the year before went into these life-cycle funds, which are basically prepackaged desk allocation portfolios.  A lot of them were funds of funds and we expect going forward this product type to capture about 25 percent of retail mutual fund sales over the next several years.  All right. 

On a separately managed account front, just a couple of slides give you a sense of our growth rates.  We have moved our projections down a little bit because we got caught up in some of the forward feeling maybe of three years ago, but they are still scheduled to or projected to grow a little more than twice as fast as the mutual fund industry.  And the number of accounts have actually exceeded our growth projection, so they are bringing on new accounts that are very high and steady paced.  And they have worked their way down into the market place where they were thought originally to be much more of a higher net worth client-type portfolio.  The separate accounts are now, Kereeyan [phonetic], for example, has a $25,000 or $50,000 separate account portfolio hecan get.

Peter J. Wallison:  Can you turn on your mic?  Yes, Steve?

Steven M. H. Wallman:  I have a question on the previous slide.  You thought that this is going to continue at pace.  Why do you think that has occurred?

T. Neil Bathon:  Two reasons.  One is that more and more, they are becoming the default option in 401k programs and they are being added to 01k programs in mass.  I think there are lot of forces behind that, not the least of which is a sense of concern by the plan sponsors about whether or not they have offered the right mix of options.  And also, which maybe is not such a great underlying motivation, but retail brokers and advisors for their smaller accounts are using these products as kind of the default. 

So if you show up at the distributor with the various [indiscernible] levels, but if you have $25,000 to invest, reps are being conditioned to focus more on their higher net worth clients and their prospect being in their client service.  And if you are a smaller relationship, you are going to be automatically put into a life-cycle fund which might actually be better in the long run, but…

Peter J. Wallison:  Would you define life-cycle funds for us?

T. Neil Bathon:  Yes, the two varieties are… basically, it is an asset allocation portfolio geared to some lifestyle, whether you are an aggressive, moderate, or conservative investor based on the timeframe using three, four, or five questions you will be asked by a rep or online will help kind of decide your risk profile and to help guide you to one of these varying risk-level portfolio.  The target date ones are really popular in 401k programs and they have a fixed maturity and the portfolio will evolve over time as you get closer to the maturity date, so more fixed income will work its way into portfolio, for example.

Peter J. Wallison:  So this is an actual fund which people invest in and has a changing characteristic based on life-cycle considerations, is that it?  How old you are getting?

T. Neil Bathon:  Yes.

Male Voice:  And what age you just start at as well, correct?

T. Neil Bathon:  Yes.

Robert E. Litan:  But it does not liquidate -- [audio skips] like I had a 2015 time…

[cross-talking]…

Robert E. Litan:  Huh?

Peter J. Wallison:  Yes.

Robert E. Litan:  They just stay in… when they get to 2015 or 2020, they sort of just stay where they are.

T. Neil Bathon:  They are self-evolving.

Robert E. Litan:  They are self-evolving, right.

T. Neil Bathon:  The interesting thing is some of the research shows that people own multiple of each, which kind of defeats the purpose a little bit, but we have seen people to have the risk based ones as well as the maturity based ones all mixed together, so there is a need for a little more education on this.  Okay. 

So separately managed accounts, in terms of where the sales are coming in, it does not look like it has much performance-chasing as we see on the mutual fund side.  It is kind of a core, large-cap growth value, all-cap, mid-cap, international, or the categories that are bringing in the bulk of the assets and the accounts.  So because the separately managed accounts are distributed a little more formally as part of a consultative experience for the client, I think it tends to wind up with the a little more effort on risk profiling and asset allocation is almost automatically the end-result of it. 

So I think the spread of portfolio weightings for the separate accounts tends to be less retail-driven if you will or emotionally-driven than maybe just the straight mutual funds side of the business. 

MDPs.  Between the life-cycle funds and MDPs, the MDPs are simply prepackaged separate accounts and not simply, but that is what we should go with.  So it is basically a mix of separate accounts that has been pre-established by the investment manager and the rep or the adviser has no real way of intervening on the portfolio. 

So you can see the growth rates that we have seen and project for it, these prepackaged separate accounts.  And the reason I draw them out, I think between these prepackaged separate accounts and life-cycle funds that are obviously prepackaged, I will use that to suggest that reps are getting more and more comfortable turning over their responsibility for manager selection to someone else, whether it is an outside firm or is it their own home office.  And I think that is a part of the evolution of the rep to realize that, really, the value they add is in advising guidance, not underlying portfolio construction. 

On exchange rate side of things, this is our sense of the growth that we have experienced as well as projection for growth going forward.  We are probably at the more conservative end here and we tend, at least at this point in time, to view ETFs as it relates to the retail side of business where half of the assets are currently thought to be on the institutional side.  But on the retail side, our sense is that they are extracting a fair amount of money from the indexes.  Obviously, all ETFs currently are index-based and I’ll just show you.  It did not make it into your slide.  Oh, but in terms of the use of ETFs going forward, we had a survey recently with the FPA (Financial Planning Association), and you could see 72 percent of the roughly 2,500 advisors indicated they are going to increase their use of ETFs going forward.  The 28 percent thought they would keep it the same.  No one indicated they were going to not use or use ETF less in the future than they are now.

Steven M. H. Wallman:  Neil, if you back up on that prior screen, going out four years from now, you get almost 900 billion in assets.  Are those all fixed income?

T. Neil Bathon:  Oh, I did not do the split so much, but I know it is…

Steven M. H. Wallman:  Or, excuse me, index.

Robert E. Litan:  Yes, that is index.  Yes.

T. Neil Bathon:  Yes, we are not anticipating… yes, it is all equity and all index.  I have not yet… so if active ETFs came to fruition, which of course they will, then that would layer on top of this.  This is really just focusing on index side of things.

Steven M. H. Wallman:  Thanks.

T. Neil Bathon:  So this is a slide that did not make it into your packets and I used this to kind of support the notion that some of what we see in the ETF front in terms of its growth is really a function of ETFs being a preferred vehicle for accessing/indexing, and I suspect if ETFs were not available, all of the money is going into them now would have found its way back into Vanguard’s Index 500.  So I tend to view it as not as being as much enamored with the underlying structure as it is with the growing appreciation for index, but I think you will hear different views on that. 

On the variable annuity side, I only have a few slides because it is really not a very pretty picture.  In a broad sense, the asset growth looks like it is mirroring the mutual funds side of the business, but I think the more important side here is the sales trend.  The gross sales are not unattractive at roughly 120 billion last year, but the net sales at about nine certainly indicate that variable annuities continue just recycling existing clients and are not bringing really any new money into their business, and these 10-35 exchanges that are about 70 percent of their sales are just really bad, so…

Peter J. Wallison:  Are these mostly by insurance companies?

T. Neil Bathon:  They all have… yes, all have an insurance sponsor.  I think variable annuities, unless they go through – well, you’ll see -- of a rather radical transformation of mindset in terms of how to position them and price them, I think they missed most of the retirement income wave that I think most of the firms anticipate they are going to participate in fully. 

So in summary, another major development in distributors is the growth of a unified management accounts, UMAs.  And basically what this is is the next generation of a wrap program where operational constraints in the past limited a brokerage firm’s ability to kind of cross-pollinate across different product structures.  So you would have separate wrap programs for an ETF, for mutual fund, or for separate account, and they did not interact with each other well or at all. 

What are coming on line now are programs that are not officially constrained by operations and now they can optimize across products structures.  So ETFs, separate accounts, mutual funds, hedge funds, close-end funds, individual securities, any other alternatives, private equity pools -- in theory -- although everyone is not there yet, you will be able to take into account all the different dynamic associated with these four different types of structures in order to present an optimum portfolio for the client.  It is obviously, in my mind, where the distributors had to evolve because anything short of this is kind of artificially constrained and suboptimal.  But the issue for those is that this is turning distributors into much more of a professional buyer and the components of success in the institutional world where you deal with professional buyers is quite of a difference. 

Certainly, performance is still very important but much more of so is the investment process.  There are not a lot of retail mutual fund companies that had to get into describing their investment process in any detail.  But if you are a separate account firm, that was kind of the core that you are selling much more of institutional approach.  So client service is quite a bit different.  You are not so much courting a rep in providing product information as you had in the past, image and reputation which is not… it is incredibly focused upon in the past.  I think it is going to be central to the decision-making going forward. 

And then just to wrap up -- so the things that the traditional mutual funds group could use to differentiate themselves with, they had product.  They came out with all kinds of crazy product, a lot of which fortunately has faded away - the option income funds, the North American Government Income Funds, there were all kinds of things that made some interesting sense from someone’s perspective but did not have any real merit. 

Performance.  There are too many firms that have good solid performers to really be a key differentiator.  Pricing structures are being more normalized, so you cannot get any edge by paying out brokers more. 

Promotion and packaging, I think you can get a little advantage there occasionally, but those things are easily replicated.  So I think the areas of focus going forward are investment process, corporate culture that flows through to your image and reputation, and your focus in terms of distributors in terms of how you match up with what their needs are and how you service them, but not so much just product information. 

And finally, so the outlook I have in summary across these areas is I do not expect mutual funds to slip much.  Across these categories I have covered, they have about a 64 percent share of the net sales, and I do not think that falls below 60 percent going out four or five years.  Variable annuities I already mentioned, they have serious issues.  ETFs, I think we are going to get to continue to benefit from the growth of UMAs where a wrap program sends everything today to a separate account. 

I think in these optimized, cross-structured portfolios, ETFs and the greater appreciation for indexing certainly carry the growth there.  And separately managed accounts, I think there has been bit of a focus on the sizzle of separate accounts and the allure.  But as people realize the customization and the tax efficiency components of those, I think their growth can be sustained as well.  All right.  So then, this is what I was referring to, the final slide just in terms of the mix of sales, net sales across product types.  All right.

Peter J. Wallison:  Well, thank you very much, Neil.  That was excellent.  We will now go to ETFs, and then we will go to SMAs, and then we will go to FOLIOfn.  So I want to introduce the two people who will be talking about ETFs which as you can see from Neil’s presentation, a quickly growing way, vehicle for collective investment.  Todd Broms and Gary Gastineau are both going to make the presentation, but that would not add to the total time that they will be taking, which will be about 15 to 20 minutes. 

Let me just introduce Todd first.  He, after school, he went to U.S. Steel where he was a loan officer in their real estate finance division.  Then he formed or was connected with the company.  He was the president of Nelson Broms, which is a merchant banking company between 1990 and 1997.  And finally, with a couple of intervening connections, he was also a CEO and board member of Eurotech, which is a technology development company.  He has over 30 years of experience in senior-level management, corporate finance, merchant banking, and advisory services, and he is now the co-founder and managing member of Managed ETFs, LLC.  His colleague in that business is Gary Gastineau. 

Gary is co-founder and managing member also of Managed ETFs, LLC.  He is a recognized expert on open-end exchange-traded funds.  He is managing director also of ETF Consultants, LLC, a firm that provides consultant services to the fund and index industries. Prior to joining ETF Consultants, he was a managing director for ETF product development at Nuveen Investments and preceding his 10-year at Nuveen, he directed a product development at the American Stock Exchange for approximately five years. 

Gentleman, decide between yourselves how you want to break up your time.  Gary, you are going to go first?  Go ahead.

Gary L. Gastineau:  Okay.  I want to thank Peter and Bob for the opportunity to be here and I think that this…

Peter J. Wallison:  Can you speak a little more into the mic…

Gary L. Gastineau:  I’m sorry.

Peter J. Wallison:  Or move the mic toward you.

Gary L. Gastineau:  The slide indicates that it is no secret that this has been an enormous growth in exchange-traded funds.  The slide shows mutual fund assets and ETF assets at their approximate levels at the end of 2005.  It took the mutual fund industry nearly 70 years to get $300 billion in assets, took the ETF industry less than 13 years.  Obviously, without the mutual fund industry showing the way, the recent growth in ETF assets would not have been possible.  Nonetheless, the dramatic growth in ETFs in a market space dominated by mutual funds suggests that investors recognize the benefits of ETFs.  Our objective today is to explain why the ETF structure is compelling for investors and for regulators. 

On this slide, we show the way investors enter and leave a conventional mutual fund.  The shareholders of the fund pay the transaction cost caused by investors entering and leaving the fund at net asset value.  Investors pay cash when they invest in a mutual fund.  They receive fund shares priced at net asset value and returned for their cash.  They receive cash when they redeem their mutual shares at net asset value.  All the transaction cost associated with investing incoming cash and portfolios securities when fund shares are redeemed are borne inside the mutual fund portfolio.  Just so there is no misunderstanding, what we mean by transaction cost, they include not only commissions but the bid-ask spread and the market impact of the transaction. 

During the rest of our presentation, we are going to be critical of the mutual fund industry investor entry and exit process.  Please do not interpret this as criticism of the mutual fund industry.  It is not.  Our position is simply that this entry and exit process is an artifact that the industry and its regulator need to change.  The exchange-traded fund structure is the most efficient and least painful way to change the way mutual funds accommodate entering and leaving investors. 

What the timers have exploited, the mutual fund investor entry and exit system to move in and out of the market by moving in and out of funds.  The timer essentially trades for free.  Unless the timer benefits from price momentum not fully reflected in the fund’s net asset value, trades initiated by a market timer or by an ordinary investor are equally costly to the shareholder of the fund.  The cost of the most innocently motivated mutual fund share transaction is borne by all the shareholders of the fund, not just by the investors entering and leaving the fund.  The Securities and Exchange Commission is in the middle of a major effort to change mutual fund sales and redemption practices.  This effort comes largely in response to the market timing and late trading scandals of 2003 and 2004. 

At the risk of oversimplifying their proposal, the SEC plans to require an irrevocable notice that an investor is planning to buy or redeem fund shares by 4:00 p.m. and most equity funds to impose a two percent redemption fee if an investor redeems shares within a week of purchase.  Everyone agrees that market timing hurts fund shareholders.  But market timers account for only a small part of the transaction cost associated with the flow of investments into and out of mutual funds.  Even if all mutual fund market timers are to be shut down, the fund industry and the SEC still need to address the transaction cost problem inherent in the structure of mutual funds.  This problem and the market timing problem can be solved simultaneously by the exchange-traded fund structure by extending that structure to improved index funds and to actively manage funds. 

The SEC redemption proposal would still permit free trading of mutual fund shares as long as the traders stayed in the fund for more than a week.  If a fund collects a redemption fee, a two percent fee should cover most of the cost to providing entry and exit liquidity to the trader.  If a redemption fee can be avoided by redeeming on or after the eighth day, the cost of the fund share trade would be a permanent drag on the fund’s performance record.  The cost will not disappear or dissipate as time passes. 

In this diagram, we illustrate how ETF shares are created and redeemed by in-kind exchanges of portfolio securities for fund shares.  Each exchange-traded fund pose a portfolio composition file, a creation-redemption basket each day.  In the case of today’s index ETFs, the basket essentially replicates the fund portfolio.  Market makers assemble the basket of securities and create ETF shares by exchanging the basket, a small cash balancing amount and a small administrative fee for shares in the fund. 

In contrast to the mutual fund example, ETF market makers pay the transaction cost of assembling the basket of stocks they deliver in a creation and the transaction costs of disposing of the basket of stocks they receive in a redemption.  The market makers pass these costs on to investors who buy and sell ETF shares in the secondary market so that all the transaction costs associated with increases and decreases in the size of the ETF portfolio are ultimately borne by shareholders who are entering or leaving the fund.  

Individual shareholders buy and sell ETF shares on the secondary market like they buy and sell stocks.  They do not trade directly with the fund.  Market makers create and redeem ETF shares in large blocks called creation units – 50,000 shares per creation unit in the case of the SPDRs, the oldest and the largest of the existing ETFs.  The value of a SPDR creation unit is about $6.5 million today. 

I want to stress that the important point in this illustration is that ongoing shareholders in an ETF are structurally protected from the cost of investor entry to and exit from the fund.  Last year, my partner in Managed ETFs, LLC, Todd J. Broms, and I, filed a request for an exemptive order from the SEC to permit our firm to offer actively-managed ETFs and improved index ETFs that will provide a full range of funds comparable in terms of investment objectives to the widely varied offerings of the mutual fund industry.  Because these funds will use the ETF structure and the ETF creation redemption process, the cost associated with increases and decreases in the number of fund shares outstanding will be borne by the investors entering and leaving the funds, not by the ongoing shareholders of the funds. 

There are enormous advantages to the structure, not only in terms of a more appropriate allocation of transaction costs, but in terms of virtually automatic regulation of fund share purchases and redemptions.  A small number of dealers create and redeem ETF shares in large, standardized blocks at net asset value.  There is an extraordinarily transparent record-keeping system for these large transactions.  The time at which an order arrives is carefully recorded.  For actively-managed and improved index funds, the order cutoff time will be earlier than the 4:00 p.m. cutoff time for today’s index funds.  There is a modest fund expense reduction with ETFs, but they are not a significant factor in the comparative economics of mutual funds and ETFs.  Management fees for actively-managed ETFs will be comparable to management fees for actively-managed mutual funds. 

There is, however, another feature of ETFs that is important to taxable shareholders, and that is that shareholders in a well-managed ETF will pay capital gains taxes only when they sell their fund shares.  Now, this slide indicates the range of economic advantages that ETFs have over conventional funds.  There is little agreement on how much the flow of money in and out of mutual funds costs fund shareholders.  The only formal study of the cost of flow to shareholders of a large number of mutual funds came to the conclusion that the cost of flow measured as a reduction in shareholder performance was about a 143 basis point or 1.4 percent per year. 

This study examined a sample of 166 equity and hybrid funds using data from 1985 through 1990.  The annual cost of flow of investors’ cash in and out of the average mutual fund might be less than 1.4 percent today.  It is certainly clear that the cost of accommodating investor flow varies greatly from one fund to another.  For example, a very large large-cap fund where shareholder flow is small relative to the total number of fund shares outstanding will have a much lower flow cost in a small-cap fund. 

Transaction costs and performance penalties are inherently higher in the small-cap segment of the market and in funds where investor flow in and out of the fund is greater.  If the ETF-type of shareholder protection from the cost of fund share trader entry and exit improved investor performance by one percent a year in the average equity fund, switching all mutual funds to the ETF structure would add $50 billion per year to the pre-tax performance experienced by U.S. stock mutual fund investors who do not trade their shares during the year.  I hope that is as impressive to Peter as the 1.9 trillion spread over five years was.  At any rate, each one-tenth to one percent cost of flow per year, costs U.S. stock fund investors $5 billion per year in lost performance.  Whatever the cost of flow is per dollar of fund assets, continuing growth in the fund industry makes it increasingly important that these costs be borne by entering and leaving fund shareholders, not by shareholders who do not trade. 

The market timing and late trading scandals of 2003 and 2004 led to the SEC’s current efforts to protect shareholders from the predations of market timers and late traders.  To our knowledge, no one has suggested that the costs associated with late trading and market timing could approach $50 billion a year.  In fact, the highest published estimate that we have seen for the cost of market timing and late trading was less than $5 billion per year.  The Commission’s own estimate of the cost of implementing the original version of its redemption fee proposal was over $1 billion per year for the first three years.  The cost estimate for the revised revision of the redemption fee proposal is substantially smaller, but the cost is still material relative to the cost of market timers imposed on other fund shareholders. 

The key feature of the ETF structure is the problems of market timing and late trading are solved for free by market forces when costs associated with entering and leaving the fund are transferred from the fund portfolio to the investors who enter and leave the fund.  We have presented a relatively simple explanation of exchange-traded funds.  We have not attempted to describe the approach we would take to delivering actively-managed and improved index funds through the exchange-traded funds structure.  To do that subject justice requires far more time than we have today, but a few comments on the effect a move to ETFs will have on some small investors seems appropriate.  We do not argue that every investor would be better off if the cost of accommodating flow into and out of funds is borne by entering and leaving shareholders.  Frequent traders and small traders may still prefer mutual funds. 

For the next few years, you will hear much more from us and from others - I think Sander will probably have some comments on this as well - about ways to make ETF shares more attractive to small lot traders.  The fact that small transactions have been subsidized by the fund industry and by other fund investors would make it difficult to serve small investors at the low cost they have come to expect.  Nonetheless, we believe that innovations in the ETF trading process will reduce transaction costs for investors buying and selling a few fund shares at a time.  Ultimately, we expect all but the very smallest periodic investment plan investor will be better off with ETFs than with today’s mutual funds. 

In closing, I would like to share something I found on the SEC’s website.  The SEC solicits comments from interested parties on most of its rule proposals.  I hope the people who have to read all these comments get paid extra for this work, but there are some occasional gems and this is one of them.  In going over the comments associated with the SEC redemption fee proposal, I found a remarkable comment from an investor.  What he says is, “Investors should pay the cost of transactions they cause.  If I invest a lump sum in a fund for 10 years, I should pay for twice only - the purchase and the sale.  If I buy and sell monthly, I should pay for lots of transactions. 

“So everyday that the fund has a change in total fund shares, figure out the cost of trading the stocks and bonds that must be bought or sold to match the change in fund shares.  Divide that cost under the new investors.  Do not make buy-and-hold investors pay for these transactions and do not subsidize them by penalizing these transactions, just have people pay for the cost they generate.”  This investor may not realize it, but he has asked the SEC for the cost structure of exchange-traded funds.  Thank you.

Peter J. Wallison:  Thank you very much, Gary.  One question; we hear a lot that the key to exchange-traded funds are tax advantages.  You have focused almost entirely on the cost of the internal transactions involved in the redemption process.  First of all, do you have a number on what that is?  What the actual costs of these things are to all funds?

Gary L. Gastineau:  Well, my best…

Peter J. Wallison:  Was that one percent?

Gary L. Gastineau:  …single point, yes, would be one percent, so $50 billion a year.

Peter J. Wallison:  Okay.  The other…

Gary L. Gastineau:  I can be off by a billion here and a billion there, but whatever Dirksen said of… [cross-talking]

Peter J. Wallison:  Yes.  It amounts to real of money essentially, right?

Gary L. Gastineau:  Yes.

Peter J. Wallison:  Now, what about the tax advantages?  How do tax advantages come in; why do you not seem to regard those as particularly significant to talk about?

Gary L. Gastineau:  Well, first of all, I do regard them as extremely significant.  The reason for focusing on shareholder protection is that regardless of your financial situation, regardless of how you feel about investing or regards to your politics, everybody is in favor of shareholder protection.

Peter J. Wallison:  Uh-huh.

Gary L. Gastineau:  A lot of people have funds that they hold in tax-deferred accounts, so they care or they should care about the impact that the entry and exit of fund shareholders has on their performance.

Peter J. Wallison:  Uh-huh.

Gary L. Gastineau:  Not everybody has funds in taxable accounts, so that is the reason for focusing on that.  I do think that for a whole host of reasons, the tax advantages here are enormous.  Now, well-managed ETF, there should never be a taxable capital gain distribution, okay?  That is the bottom line.  This number here is sort of the midpoint of a range that depends largely on what happens with your return, how your return increases year after year.  If the return is very substantial, the value of the tax deferral would be much greater.

Peter J. Wallison:  Uh-huh.

Gary L. Gastineau:  We have had a period where we are still in effect seeing the effects of the market break in 2000 to 2002.  There was an article in the Wall Street Journal, I think it was yesterday, about we are coming to the end of this period and as you look forward, the capital gains overhang in mutual funds is getting larger and larger, and you are going to see much greater capital gains distributions going forward.  So this is going to be a much more obvious point.

Peter J. Wallison:  Okay.  Quickly though, would you or maybe Sander wants to do this, either way is fine, but I just like to make sure the audience understands how the tax advantages come from the way that ETFs are structured and operate.

Gary L. Gastineau:  Well, I did not see anything like that in Sander’s thing so let me…

Peter J. Wallison:  Just quickly as you can.  Sure.

Gary L. Gastineau:  Okay, basically subchapter M of the Internal Revenue Code says that when a mutual fund realizes capital gains through the distribution of securities in-kind, in effect that does not give rise to a distributable distribution.

Peter J. Wallison:  Uh-huh.

Gary L. Gastineau:  Okay?  That is the way the statute reads more or less.  What it means is that the basis of those shares literally disappears for tax purposes, okay?  Now, that does not mean that the investor, when he sells his shares of the fund, which we would have appreciated, is not going to pay a capital gain tax.  He will, but it will be at a time of his choosing, at the time he liquidates his position in the fund.  The ETFs also have the ability to realize losses on the sale of the securities at a loss.  So it will be a very cold day in July when most of these ETFs have to make a capital gains distribution.

Peter J. Wallison:  But the ordinary mutual fund will capital gains distributions occur involuntarily?

Gary L. Gastineau:  Correct.

Peter J. Wallison:  How is that?

Gary L. Gastineau:  Well, the capital gain distributions occur involuntarily because there are relatively few opportunities for most mutual funds to do redemptions in-kind.  And as a consequence, they sell shares in the fund and those sales frequently give rise to taxable distribution.

Peter J. Wallison:  Okay, so it is the exchange of shares.

Gary L. Gastineau:  Exactly.

Peter J. Wallison:  It is the redemption shares in-kind…

Gary L. Gastineau:  Redemption shares is the key…

Peter J. Wallison:  …that makes the difference…

Gary L. Gastineau:  That is correct.

Peter J. Wallison:  …in the ETFs structure…

Gary L. Gastineau:  Correct.

Peter J. Wallison:  …in terms of taxes.

Gary L. Gastineau:  Right.

Todd J. Broms:  Also, Peter, the mutual fund tends to liquidate the highest tax basis when it sells portfolio shares to come up with the liquidity, and the exchange-traded fund will tend to redeem out its lowest tax basis, vast opposite positions.

Peter J. Wallison:  Uh-huh.

Robert E. Litan:  I got another just elementary question.  Maybe some people in the audience share this question.  And that is, one the relative advantages of mutual funds, is if I’m investing $200 every month, I just write a check to Vanguard for $200 and they give me fractional shares and I do not worry about it, all right?  In contrast, when I buy an ETF, because an ETF is like a stock, it pay to buy it in round lots like in units of a hundred.  And I’m not going to go out and buy 14.24 shares of ETF or frankly, even 13 shares of an ETF because the transaction costs are too high.  I would rather wait and accumulate $1,400 or $1,500 and buy 100 units at a time because it is cheaper to do that and is not that… because I think you were indirectly referring to that.  This is an impediment to reaching the small investor.  Am I right?

Gary L. Gastineau:  Right.  You are correct on that.  I think Sander is probably going to have a few comments to make on that

Robert E. Litan:  Okay.

Gary L. Gastineau:  But the basic bottom line, is that there is an awful lot is going on in the industry right now, which will permit the investors in ETFs to take small positions without undue cause and to permit certain accounts or most accounts to carry fractional positions.  In fact, in a lot of firms - and Steve may have some comments on this as well - you can handle fractional shares.

Robert E. Litan:  I was about to say, you can invest FOLIOfn $200 a month, too.

Gary L. Gastineau:  Right.

Robert E. Litan:  That is exactly like the mutual fund in that sense.  So it is very easy.

Gary L. Gastineau:  Yes, and that is one way you can buy ETFs, too.  He sells ETFs, too.

Robert E. Litan:  Well, that is right, except he has got them in folios and we do not have to worry if I send a check to Steve, $200, I do not worry about the transaction cost directly.  It is much easier.

Steven M. H. Wallman:  Do you want to spell the name of the name of the firm?  But that is right.  I mean, we allow people to buy fractional shares of any security ETFs included, and you can do it on a continuous basis like auto-buy so you can have $200 a month, and the cost is very, very small; a few bucks a month.  So we do allow that and I think that does solve a lot of the issues that you are just describing for ETFs and that technology will promulgate around.

Sander Gerber:  We also allow for … investment of small amounts through our managed accounts and then we will deploy it for you.  And we are also launching a collective trust product of ETFs, May 8th, and we will be able to accommodate small investor investment in the ETFs.

Peter J. Wallison:  Yes, exactly.  Okay, Sander, let me just introduce you and then you can go on with your presentation.  We would like to hear, actually, a lot more about the collective trust that you were talking about.  Sander Gerber has been involved in professional investment management for over fifteen years.  In 1991, he became a member of the American Stock Exchange, acting as a market-maker and providing markets in options contracts on various heavily-traded equity securities.  In 1997, he formed Gerber Asset Management, a proprietary investment vehicle and in January 2006, Gerber Capital Management Group was converted to a hedge fund structure, taking the name Hudson Bay Capital, LP.  Sander is also the founder of XTF Market Making, LLC, which is an AMEX broker/dealer that operates as a specialized market-making operation on the floor of the American Stock Exchange with an expertise in ETFs.  Sander?

Sander Gerber:  Thank you, Peter.  Thank you, Bob.  It is a pleasure being here with you.  It is also a great honor to be on a panel, a distinguished panel at the AEI.  I consider the American Enterprise Institute to be the leading think tank for development of policy that helps build America, so it is a great pleasure to be here on an industry panel in my industry. 

As Peter mentioned, I have been a professional investor for 15 years, and one thing always strikes me when I speak to people who are not in the investment business is how little they know about how to choose investments.  You have a list in your 401k and you pick a name that you recognize, or you see a fancy advertisement and you pick it.  But in a way, you cannot really blame people.  I’m a product of a public school education system here in America, in Michigan, and we had, growing up, we had physical education, we had nutritional education.  We even had sex education in sixth-grade.  I did not believe it.  But we do not have anything about investment education.  In fact, if you want to learn how to invest, generally the programs are or the place you learn are from the people who are trying to sell you investments, so that creates a lot of conflicts of interest. 

And as the famous philosopher, Yogi Berra said, “You have got to be very careful if you do not know where you are going, because you might not get there.”  And the truth is that investors really only need to care about one thing and one thing only, and that is after-tax returns.  It is particularly disappointing to me when I read the advertisements for mutual funds and I saw one this morning in the Wall Street Journal and it says, of the last one, three, five, ten years, this is our performance record. 

So that performance record - despite all the disclaimers and there are so many disclaimers, people do not even read them - that performance record is completely false.  And the reason why is because that performance record does not take into account taxes that are paid over time.  And as taxes are paid, you cannot reinvest those funds.  And so when you look at performance records over a 10-year period, and in particular when they compare it to an index, say, then compare it to the S&P 500 and they say, “Over 10 years we beat the S&P 500 by one percent,” it does not mean a thing because it is not talking on an after-tax basis. 

Studies have shown that the average tax discount to the cap gain distribution is 1.6 percent a year.  So it is very frustrating for me as a professional manager that the investors are not focused on one thing they should be, which is after-tax return.  So I started XTF with a mission to transform the way Americans invest by guiding them into low cost, tax-efficient portfolios of exchange-traded funds that best meet their long-term goals.  I started XTF Market Making in 2000.  We focused exclusively on ETFs and as I became better adept in the creation-redemption process that Gary was describing, I realized the significant advantages that this creation-redemption process has for investors.  And in ’05, I formed XTF Advisors and XTF Capital to open up the doors so that outside investors could reap the benefits of ETFs through a process of… with our help in terms of education. 

Now, in my presentation, I’m going to talk to you about separately-managed accounts, and I’m going to talk to you about ETFs.  I’m going to talk to you about separately managed accounts of ETFs.  SMAs are individual investment portfolios that are managed by professional investment advisors.  And what is key to this is that they are customizable.  They are tailored for the individual.  They have a specific investment objective, specific tax sensitivity, specific time horizon, specific risk tolerance - it is all customizable for the client.  Also, separately managed accounts are a transparent platform.  So typically, the ownership will be of individual securities and all fees are readily apparent.  There is nothing hidden.  There is control over realization of gains and losses to allow for potential tax advantages and you are not dependent upon the timing of other investors’ entry and exit into the portfolio as in a mutual fund. 

So in a mutual fund, as Gary described, when someone wants to redeem out of a mutual fund, the mutual fund has to sell securities to provide cash to give that investor.  When they sell the securities to get that cash to redeem out the investor, that is what triggers the capital gains.  With an ETF, because it is an in-kind creation redemption process, the investor, when he redeems, is not triggering cap gains.  In fact, when the market maker ultimately redeems out of the ETF, as Mr. Todd has mentioned, the lowest basis stock is pulled out.  With an SMA, because it is individually tailored for the customer, each time a stock is bought or sold, the manager can realize the gains or losses when they want to provide offsetting tax advantages for the investor. 

So a very important distinction between the SMA and mutual fund is the assets are pooled and commingled in a mutual fund whereas in the SMA, they are not pooled or commingled.  It is individual direct ownership.  In a mutual fund, if we go down to the tax efficiency point, the cost basis may include capital gains.  When you buy into a mutual fund, for instance, the Vanguard 500 mutual fund, as of the last report that I saw, 30 percent of its net asset value is unrealized capital gains.  When you buy into the Vanguard 500 fund, you are buying into 30 percent unrealized capital gains.  When you buy an SMA account, you are buying the securities and you are getting the cost basis when you buy in.  There are no embedded cap gains. 

Another important point is with an SMA, an investor can request exclusions.  So let’s say you work for Bristol-Myers and you want to have a diverse side portfolio, but you do not want drug companies.  You can request an exclusion from drug companies as part of your portfolio.  And as I mentioned before with a mutual fund, there are all kinds of fees and charges that are often hidden because it is an opaque structure, whereas with an SMA account, your fees and expenses are directly known. 

A very popular way as mentioned earlier by Neil to buy SMAs now is to wrap accounts, and it is estimated there will be $2 trillion in wrap accounts by 2010.  So it is very popular now to wrap mutual funds and to wrap SMAs to give you total diversification across all asset classes because one of the main determinants of portfolio performance after you take into account market timing and stock selection, a vast majority of, to determine portfolio performance is really asset allocation.  That is the key.  As David Swensen, a very noted Yale endowment investment officer states, “Asset-allocation decisions play a central role in determining investor results.  And regardless of the market’s zigs and zags, it really establishes the condition for long-run success.  Asset allocation is a key to successful investing.” 

Now, let us talk about the benefits of exchange-traded funds.  With ETFs, there is no survivor bias.  Survivor bias is one of those little tricks that is written about from time to time.  When a mutual fund wants to start a fund, they might often incubate 10 different mutual funds.  Now, out of those 10 which they incubate with internal funds, maybe two are successful.  So what they will do is discard the other eight, and the two that are successful will pick up the track record for inception.  So you are starting out with what looks like a great track record.  However, it is really just a process of selecting the good from the bad. 

An ETF is also very tax-efficient and as was mentioned, that the SPDR has only paid one cap-gain distribution in its lifetime; that was in 1996, 12 basis points, and State Street said they made a mistake when they did it.  The iShares products have distributed zero, domestic iShares have distributed zero cap gains over the last four years.  They have 100 ETFs trading.  ETFs are also very cost-efficient because of the various reasons that Gary mentioned in terms of the weight transactions are done entering and leaving. 

Also, because an ETF does not have the same overhead requirements that a mutual fund has - phone banks to answer, keeping track of who the investors are.  An ETF trade is like a stock, so it is much more cost-efficient.  An ETF is also transparent.  Similar to the SMA platform which is transparent, the ETF itself is transparent.  In fact, at XTF, everyday we dissect each and every ETF, and we look at the stockholdings to the share, and we look at the cash holdings to the half penny, and we monitor actually all the expenses that are taken out of the ETF whether it be for trading or for fund expenses, it is all totally transparent, so there is no ability to hide anything. 

And from a regulatory perspective, this is very important because it is very hard to regulate something that is opaque.  There has been a lot of press lately about payment for shelf space, where a mutual fund might pay to execute stock.  They might pay five cents a share to a major broker in exchange for that broker hosting or putting prominently that mutual fund on its shelf space.  And there are all kinds of issues and conflicts that arise when you are dealing with an opaque structure.  Fortunately, an ETF is transparent and fortunately, we monitor each and every ETF every single day, and we project what it should be like the next day to make sure that the ETF manager is doing exactly what they say they should be doing. 

So the transparency of ETFs provides a clarity of holdings that keep the portfolio components honest.  It ensures that the investor dollars are being put to use most efficiently.  It ensures that there is a minimal amount of slippage between the money going in to the fund and the money actually being deployed as the investment.  So it ensures that you always know exactly what makes up your portfolio and also it ensures that there is no embedded or hidden cost.

Peter J. Wallison:  Sander?

Sander Gerber:  Yes?

Peter J. Wallison:  Does the transparency come from the fact that it is indexed?  That these are…?

Sander Gerber:  No.

Peter J. Wallison:  …these are based on an index?  What is the reason for the transparency that is…

Sander Gerber:  Excuse me.  Gary mentioned it does.  In the current structure, the ETFs’ transparency, the ETFs are based on indexes, which I guess lends to transparency.  But basically everyday, the ETF custodian has to telegraph, has to send to the market exactly what the ETF is made up of.

Peter J. Wallison:  If it were managed, would the same thing be true?

Sander Gerber:  That is a question for Gary.

Gary L. Gastineau:  No, no.  It would not be true.

Sander Gerber:  Okay.

Peter J. Wallison:  Okay.

Robert E. Litan:  Because, otherwise, you will give away your…

Peter J. Wallison:  Correct.

Gary L. Gastineau:  Exactly, exactly. [cross-talking]  That is one of the problems that index ETFs and index funds have today.  I mean, I will hold respect for Neil’s viewpoint on indexing.  Indexing has a very serious problem today.  And that is that everybody knows what changes have been made in index portfolio, and there is a lot of…

Peter J. Wallison:  Front running?

Gary L. Gastineau:  …front running and trading against the changes in the index.  I saw this with Amazon.com, you saw with Google, and it is a very common thing.

Robert E. Litan:  When you say everybody knows there is widespread speculation about what is going to be added to the index…

Gary L. Gastineau:  Well…

Robert E. Litan:  You do not know for certain.

Gary L. Gastineau:  Okay.  There is a forward announcement.  There is a forward announcement.

Robert E. Litan:  Waying that the stocks are going to be considered to be…

Gary L. Gastineau:  No, that the stock is going to be added to the index.

Robert E. Litan:  Oh, it is like…

Gary L. Gastineau:  For example, on a Monday night after the close, S&P announced that Amazon was going to be added to S&P 500 after the following Friday’s close.

Robert E. Litan:  I see.

Gary L. Gastineau:  And the stock jumped about six or seven percent the following morning and a similar amount more by the close on Friday.  So the people who bought the stock to add to the index fund at the Friday close, which is when most people bought it, paid 12 or 13 percent more for it than it had cost before it was elevated to the S&P 500.

Peter J. Wallison:  Okay, sorry to interrupt.

Sander Gerber:  The Amazon case is true.  It is a bit of an extreme example.  There used to be a very strong, pronounced index arbitrage effect prior to ’02.  And since ’02, this arbitrage effect of the pre-announcement of the index additions and deletions has been basically arbitraged out.  It used to be that in addition to the S&P 500, would cause about a 10 percent increase in the stock market value from the date of announcement until addition, and now it is down to about two to three percent impact on a stock market price.  It was actually one of the strategies we used to deploy in our proprietary trading for a long time.  And unfortunately in ’02, that strategy did go away. 

Regarding the transparency ETFs, there are various ways to try to accomplish, and I think that is one of the things the SEC is struggling with is how to deal with transparency of ETFs in a managed account format, and there are different ways of providing character attribution.  There are also ideas in terms of providing delays of what the holdings of that ETF are and frankly, it has not been worked through.  I do look forward to be working through in that.  I wish managed ETFs all the success in getting that done. 

But right now, the hallmark of the ETF is its transparency.  And that transparency I think makes it very clear cut on what you have, and it makes it very easy to monitor that ETF is doing precisely what they are supposed to be doing.  And so from a public policy perspective, I think that is very important for American investors because it makes sure there is none of the shenanigans that have been exposed in recent years.  So ETFs, in a tactical model or as part of a managed account, ETFs are the asset classes.  There is no concern that the ETF is not tracking the asset class.  There is on mapping issues.  There are no style-drift issues because the ETF is the asset class and it is totally transparent, so it allows for an easy and very affordable way to manage exposure for the retail investor for a diversified portfolio. 

Like the Yale endowment, not exactly like the Yale endowment, but like Yale endowment, it allows you to get diversification across all asset classes very inexpensively.  An estimate that is composed of ETFs, unlike in SMA that is composed of a lot of stocks, reduces paper flows and confirms.  Every time in an SMA a stock is bought or sold, there is a confirm that is generated, and it leads to a lot of work for the accountants and for the administrators, and a number of people in the SMA industry have been switching from SMA of stocks to unified accounts of mutual funds to get rid of all this paperwork headache.  So SMAs comprised of ETFs reduce the administrative services, there are no 12B-1 fees, and there are none of the additional costs that are associated with mutual funds. 

There is also reduction in investment and management fees.  You are not selecting individual stocks, you are selecting asset classes, and you are over waiting or under waiting asset classes, not being a stock picker.  As studies have shown, stock picking does not really lead to out-performance.  There is a reduction of tax liabilities vis-à-vis mutual funds because ETFs do not pay cap gains distributions because the accounts can be managed individually, and it reduces trading cost because you are only dealing with a few securities that are trading.  An ETF can represent hundreds or thousands of stocks.  In one trade, you can literally buy or sell your exposure to hundreds of thousands of stocks. 

So at XTF, we recognize that we are in a changing market environment and we think that ETFs are a great way to capitalize on market fluctuations, but they have to be controlled ranges so you stay within your portfolio asset allocation to keep your asset allocation on the efficient frontier but with a tactical overlay.  We increase and we decrease the exposure cross asset categories based on our forward-looking view of the market place.  Our tax 70 portfolio has a target benchmark of 70 equity exposure and 30 fixed incomes.  But our tactical range, we go plus or minus 20 percent in a structure for the investor seeking growth of principle under a moderate risk profile.  Right now, we are diversified across U.S. large-cap, U.S. mid-cap, U.S. small-cap, international equities, U.S. Treasuries, real estate, and corporate bonds. 

So basically, the estimate platform if you plug ETFs into it, it gives you focus on after-tax returns which, as I mentioned in the beginning, really is the one thing the investors need to focus on.  And it is within a framework of total transparency; both the product is transparent and the platform is transparent.  So from a regulatory perspective, that really eases all of the problems and actually reduces the need for increased regulations because the transparency will self-police it. 

So I am very grateful for speaking with you and to entertain any questions or comments.

Peter J. Wallison:  Thank you very much, Sander.  Let me ask one kind of naive question, and that is you mentioned that stock picking does not lead to out-performance, and your studies have shown that again and again.  Why, in that case, do investors… let us just talk about SMAs and not the SMAs of ETFs, which are indexed.  Why is it that investors will pay someone to assemble an SMA for them made up of stocks?  What is going on in their heads here in your view?

Sender Gerber:  I think it comes back to education, that it makes more sense that you are going try to beat the market.  I think that it is just like why do people go to a casino even though they know that the house is going to win over the long haul, right?  Everyone knows that and yet…

Robert E. Litan:  Except for them.

Sender Gerber:  I think they even know it, frankly. But Vegas keeps growing every year.  I do not think that people as investors are always making the rational decision, which is unfortunate.  I think a lot of it is because they are educated by the distributors, as opposed to being educated in a neutral format.  There was actually work being done through the research settlement.  They were trying to set up a fund for investor education and the board dissolved itself.  They could not agree on how to best provide that education.  Wall Street has developed a machine and Wall Street wants to make money through this machine.  And I believe that the best way to service investors is through a framework of complete transparency where everything is on the table.  And I think that sometimes, SMAs of stocks might be good for a satellite holding.  But for a core holding, I believe that an SMA of ETFs will best accomplish their long term goals. 

Peter J. Wallison:  Thank you very much.  Steve Wallman is our final panel member and I’m delighted to welcome him to our platform.  Steve is the chief executive officer of FOLIOfn, which is a web-based brokerage and managed accounts platform firm.  He is also a founder of FOLIOfn’s wholly-owned subsidiary area, PROXY Governance.  PROXY Governance, incidentally, is a proxy research and voting agency firm providing services to mutual funds, pension funds, money managers, custodians, and other fiduciaries.  Prior to founding FOLIOfn, Steve was a commissioner of the U.S. Securities and Exchange Commission, and that was from 1994 to 1997.  I must say that both Bob Litan and I, on working on a number of our other projects, have taken advantage of Steve’s enormous ability to forward think and plan and see things in the future that most commissioners at the SEC do not usually do. 

So Steve, good to have you here, please proceed. 

Steven M. H. Wallman:  Thank you, and how much time do we have at this point?

Peter J. Wallison:  You have 15 to 20 minutes.

Steven M. H. Wallman:  Okay.  Part of the…

Peter J. Wallison:  Try to keep it 15 if you can.

Steven M. H. Wallman:  Fifteen?  Part of what I would go through, I think you have already heard so I’ll try to get through it rather quickly.  The concept of FOLIOS is somewhat different than what you’ve heard.  It is, in essence a platform; it is a service.  Keep that in mind as opposed to thinking of it as a product.  But it solves basically all the problems that you have heard so far in terms of the issues that mutual funds have, the issues that ETFs have, and the issues that traditional SMAs have. 

And so, I’ll go through this and give you a sense of how it basically answers all those questions.  Well, it has its own disadvantages as well.  In the beginning, if you think about it, there were sort of two different ways you could invest.  Mutual funds on the one hand, stocks on the other. 

With regard to mutual funds, it has the magic of diversification, very important, and it had professional portfolio management, which you can look at as either a managed account concept with managed funds, or passively indexed.  But, in essence, there is somebody who is basically taking care of it for you.  Stocks obviously have the advantages of control and flexibility, and there is a tax efficiency within individual securities that transcends anything in ETFs or mutual funds, which is not only do you have the ability to reduce the actual flow-through, if you will, of the capital gains distributions that mutual funds are famously known for as a problem, which something that ETFs can do to reduce that. 

But one of the other benefits of actually owning the individual underlying securities, of course, is you can actually harvest tax losses.  Because it is not only a question if you are looking at after-tax returns of deferring capital gains you might not otherwise want, but it is also a question if you are looking at the after-tax return, of being able to sell in November, for example, securities that went down in value and then buy them back in January or, yes, out of the market for those particular securities for the 31 days of December.  But you can be in the position where you have harvested the tax loss and deferred the capital gains completely. 

So owning the underlying securities themselves, being able to reach in, if you will, and harvest those tax losses, is a tremendous benefit you cannot either with ETFs or mutual funds or you do it, of course, if you have a whole portfolio of ETFs, which is fine as well.  You can sell the ETFs that were losers and then defer until you buy them back 31 days later.  If you are looking at the disadvantages of stocks though, and disadvantages of funds, they are pretty significant.  With regard to generally the way Wall Street has sold and brokerages generally sell security stocks, it is not easy to diversify. 

Almost all of brokerages, except for those who are now moving to a more fee-based platform, work on commission.  The idea is they want you to trade a lot, but nobody expects you to own 50 or 100 securities in your portfolio.  If you do that at a regular online brokerage, for example, you will be one of their best costumers.  People just generally do not do that.  So they are not diversified and they are putting too many of their eggs in one basket.  So you do not get the portfolio benefits as well. 

We have seen all the commercials where the guy decides that he was a tow truck driver guide but now, he got his desert island that he owns because he bought the right stock.  And that is the idea that we provide for people is how they should be good investors and to that degree, I agree a lot with others on the panel and I think it is a problem.  I think my colleagues in the online brokerage industry have done a disservice by basically transforming online brokerages into, in essence, an adult video game and making it something that is just simply fun to do but it is not a great way to invest.  And part of the problem is you do not get the advantage of diversification. 

We have already talked about the difficulty of selecting stocks, their high costs in terms of turn over.  You cannot do dollar base investing very easily as Bob pointed out.  People generally have to think about hundred share lots.  You cannot think about just investing a hundred dollars and say you got a lot of difficulties with traditional brokerage construct.

 Mutual funds, of course, are not necessarily the great savior either.  There is a complete lack of customization.  There are people who are very fond of saying, for example, that you ought to index.  Index has its advantages.  You have heard a little bit of that and there is probably some benefit to indexing.  But indexing also is, to some degree, one size fits all.  One of my good friends who was one of the founders and creators of the S&P 500 index fund concept used to say, “That is what everybody should be in.”  And you would say, “Well, is that including the 22-year-old and does that include the 72-year-old? 

And do you not think there ought to be some difference between them as to what they ought to be in?”  And the answer, of course is, yes, but you cannot easily customize in a mutual fund.  You, of course, have the bad tax advantages that we have already been talking about.  You have much higher fees than people think.  This is too sophisticated a crowd to do it but normally when I talk about some of these issues, you ask people, “What do you think the fees are in the mutual fund?” 

And first, you got half the room saying, “We do not think there are fees in the mutual fund,” which creates an interesting second question which is, “Do you think Fidelity is basically some kind of [indiscernible] institution or charity?”  That gives people some pause because they do not really think so, but they do not quite know how to answer the question because they do not know where the fees are; they have never seen the fees.  It is not in your statement, it is not in your confirm, it does not show up, so it must be free.  But you have these embedded fees in mutual funds that people just do not understand.  So you have that kind of problem and they are not inexpensive. 

Then you have the other issues, the style drift for the non-index funds.  And of course, you cannot use any of your corporate governance rights.  You cannot vote, for example, the underlying securities in the mutual funds or in ETF for that matter.  You are basically at a position where you delegated some of those corporate governance rights to the money managers as professionals managing the security if you care.  A lot of people do not care.  But for those who do, that is a disadvantage.  So the question then was how do you basically combine the advantages and get rid of the disadvantages? 

And what we came up with was we thought a different construct.  And I think I’m going backwards.  I’m going forward, and now I’m going backwards.  This seems to be going both directions.  The question is can you follow the slide fast enough?  Okay.  And so what we did is we created something called FOLIOS.  There is another way to get to the concept of FOLIOS, which is to do a little thought experiment, which was just think about the current understanding of modern portfolio theory. 

Thinking about the ideas of the notion of the diversification, think about the concepts of wanting to own a diversified portfolio as opposed to individual stocks.  Now add to it the ability to have the Internet and the ability to do a lot of computation and processing fast and very, very inexpensively, and now go back to 1910 or 1920.  Would you create a mutual fund?  I do not think so.  Why will you go to this whole effort of creating this packaged product that you have to wrap everything in if you could simply provide the people the underlying securities to begin with?  And if you can do that on a cost-effective basis, why would you not?  

Well, the answer was, of course, until a few years ago, you could not do it on a cost-effective basis, but today you can.  So what we did is we took basically the underlying concepts of portfolio theory, etcetera. Combine that with today’s technology and the intent was to create a superior vehicle for basically delivering core asset management.  We talked about 40-Act companies, mutual funds, ETFs, traditional SMAs, and now you, in essence, have folio type offerings.  It is just, in essence, another way to deliver if you really think about what the core delivery is here -- the underlying investment management.  And then investment management, of course, can be an index. 

To understand what FOLIOS are, FOLIOS are basically baskets of securities that can include any kind of security.  It can be a basket of ETFs.  It can be an SMA if you will, ETFs.  It can be hedge funds.  It can be a basket of mutual funds which is normally called a mutual fund wrap.  It can be a basket of individual securities.  And the interesting thing, because we talked about the sort of ultimate account a little bit at the beginning, what we have had for the last half decade has been, in essence, that because the FOLIO platform allows you to combine all of those.

 You can have FOLIOS of ETFs, mutual funds, and regular stocks all mixed in together.  And there is no distinction between them and among them and you can run them as one coherent core basket.  In addition, the FOLIO platform allows you to offer at an extraordinarily low price.  Again, because it is all technology based.  Confirm statements are all electronic; there is no paper.  It is entirely paperless in terms of the system.  If anybody wants paper, they print it out.  We do not have to send it, we do not have to mail it out, so it becomes a very, very efficient model and allows you, for example, Curian, somebody mentioned that they are offering SMAs as well as $25,000 to start runs in our technology.  And that is the kind of thing you can do with the platform that we built. 

One difficulty is it was very, very expensive to build it, and it took a number of years to get it built.  So this is not something you basically create in your sort of garage, as one example that we have been using to try to describe it.  Although it looks very simple to create this kind of technology to do this, it is much like a light bulb - it looks simple but try making one in your basement.  It is hard to do and it is the same kind of thing here where this looks real simple in terms of the result, but I can guarantee you it took an awful long time and a lot of money and a lot of people to actually build it, which is one of the issues and disadvantages of it.  But here are the things that you can do. 

You can buy an entire portfolio at once and you can trade it just like a mutual fund or trade it just like an ETF if you will.  So you could buy another 10,000 dollars of that portfolio, or you can sell 4,000 dollars of it, or half, or quarter of it, or whatever you want to basically transact in it.  But you can also reach in if you will and trade the individual securities.  Basically saying, “Okay, I have got my 25 securities or 50 or 100 securities in my portfolio.  I can buy another 10,000 dollars of that portfolio just as it is or I can go in and selectively take out some of the securities I put in different securities.”  So you can do exactly what you want as you wish in real time. 

It’s another advantage over mutual funds; you trade them like securities in terms of what is the underlying security in the folio and consequently, if want to go in or out multiple times a day, you can do that just like an ETF.  With regard to the power of this concept of the platform that allows you to combine a number of different things.  One of the clear issues still stymieing ETFs on the managed side is sort of the notion that the Commission is worried about transparency, which I think is an interesting question for them because they do not seem at all concerned about in the context of mutual funds since you can buy a mutual fund at two in the afternoon, have absolutely no idea what you are buying and they would not tell you what the price is until after the NAB is struck later on in the day after the close.  Whereas with an ETF, my god, if you do not know exactly what you are buying at that instant, there seem to be some issue. 

So I think the Commission is a little bit sort of schizophrenic on this point that perhaps it could think a little more deeply about.  But in any event with regards to FOLIOS, it solves that problem because FOLIOS are completely transparent.  You see exactly what you are going to buy at exactly the time you are going to buy in exactly the proportions that you have it in.  And we give you a quote in real time at that time so you know what you are going to be charged to actually acquire it. 

So you, in essence, have all those benefits rolled into one.  You can also, through this kind of technology, buy fractional shares, so you can buy tenth of the share of Google because that is needed in order to be able to drive the notion of buying 10,000 dollars of a FOLIO because a folio may have 100 securities in it, you got to be able to divide it up so you will be buying $100 of each of those securities. 

One other nice thing about a FOLIO is that you can rebalance it as you wish, not as an ETFs or mutual fund might be balanced.  So if, for example, you decide that the right way to be diversified is to be equal-weighted across your securities, which is theoretically the better way to do it than market cap-weighted or price cap-weighted.  In a FOLIO, you can actually go in if you want to click the button everyday and equal weight your portfolio back to equal weighting.  That seems a little bit obsessive but we have folks who certainly do that on a monthly basis and then get back to an equal-weighted portfolio on a monthly basis. 

Let me just give you a sense of what it looks… well, one other point that is perhaps worth making is that each FOLIO account is completely separate.  So your taxes are yours.  There is no mutuality, there is no fund, and there is no collective investment vehicle.  There is nothing that basically implicates your tax position with anyone else.  So if you want to harvest tax losses, go head.  That does not affect anybody else’s ability to harvest their tax losses or not as they see fit.  Also as mentioned, you can vote the specific securities underlying it, and one other thing that is worth probably pointing out in a FOLIO context like in SMA is that you actually have control over the specific tax lots as well. 

So in our system, for example, we provide eight different ways for inventory tax lot relief.  And people who want to do highest cost basis and others who might want to do lowest cost basis for other reasons because they actually have capital losses that they have got from previous years in and they actually want capital gains can select exactly which tax loss they want to relieve at any particular point and, therefore, get either a capital gain or a capital loss out of selling the same security. 

Let me just give you a screen shot so you get one’s sense of it.  We have, for example, and this is another sort of benefit of this kind of technology, we have what we call ready-to-go portfolios, and this is for people who want the equivalent of indexes or other kinds of passively-managed or quantitatively-managed portfolios.  We actually, with our one company, have a hundred of these, which is the equivalent number of portfolios if you will that Barkley’s, I think, has been able to muster altogether for its entire store of ETFs with all their power and might which is a little bit larger than ours.  So it gives you some sense of the efficiency with which you can create portfolios here. 

We also have the ability for… and there is another sort of complimentary platform, where an investment adviser or money manager can go on and create portfolios on their own, and then synchronize their accounts for those portfolios.  So if you think about it from that prospective, you get the same kind of equivalent feel as if it were a mutual fund or an ETF where you can have a professional money manager in 1838, or Rittenhouse, Delaware State Street or whoever, basically create portfolios, create models, and then have those models link to the various FOLIOS in anybody’s account, thousands of accounts, for example.  And when they make a change in their model, it ripples through all the accounts. 

So it is the equivalent of being able to do of having a mutual fund, if you will, in somebody’s account, except each account is separate and each account has its tax basis, and each person in each account can control for themselves whether or not they want exclusions or add something else to it or change the weights.  So it gives you a tremendous amount of flexibility to both do managed portfolios and passively-indexed portfolios for an extraordinarily low cost.  These are just examples of the kinds of things.  As mentioned, the point of this is to show that, for example, you can have a portfolio of ETFs, we love ETFs.  You can have a portfolio in mutual funds and you can mix them and have them ETFs FOLIO or funds and securities all in one big portfolio.  And you can create anything you want.  Lifestyle ones, for example, target risks ones, the same kind of things that Neil was mentioning earlier, etcetera, etcetera. 

This just gives you an example of what a FOLIO might look like, the transparency is obvious.  It shows you everything that is there and this gives you a sense of the fact that you can just buy a thousand dollars worth of it and the technology then ripples through, creates the fractional share amounts for each of those purchases and sells, and goes out and buys a fraction of the share if need be in order to give you the exact percentage weighting that you should have in your portfolio.  You can modify it and you can decide, for example, to trade each of the securities in the portfolio as individual stocks. 

And then, of course, we have other types of tools.  One concern, for example, has been how do you manage the taxes if you have all these tax lots?  Just thinking about somebody who has got a hundred stock portfolio and they are buying it just once a month over the course of 12 months, they are going to have 12 hundred tax lots.  Go out five years and you have 6,000 tax lots.  That is a lot of tax lots if they then want to sell that portfolio.  The system, of course, does it all automatically and that is one of beauties of technology. 

So a lot of the concerns that folks have had have now been resolved because of what technology can do.  You can have exclusions that can be automated like this, where you can just check a box and say “I do not want any alcohol in my portfolio.”   It will look through any portfolio that you are about to select and just take out the securities or alcohol securities.  Performance, of course, and everything else that you would normally expect can be provided. 

So, last point I guess is to say once again and something I care about because I just think it is good for investors to care about it is corporate governance rights and their ability actually to exercise their shareholder franchise.  This gives them the ability to do so because they actually own the underlying securities.  That I think is probably all I should do if you want to leave some time for questions because this goes on for three more hours.            

Peter J. Wallison:  Well, all right.  That kind of raises this question, that is to what extent is an adviser involved in the creation of these portfolios, or is this all done by the individual investor at his or her computer using your software? 

Steven M. H. Wallman:  You just hit this right slide.  And what you can see is that on this kind of platform, you can go the entire spectrum.  On the left hand side, you have the non