In 2017, the appeal of exchange-traded funds seems so obvious that their rapid growth and increasingly dominant role on Wall Street appears almost inevitable.
But according to Lee Kranefuss, a central figure in the industry’s early days, investors only began to embrace ETFs after an event with no direct connection to funds: the 2001 collapse of one-time energy giant Enron Corp.
Kranefuss is the co-chairman at 55 Capital Partners, a firm that develops portfolios using ETFs. He was also a founder of iShares, the family of ETFs, currently operated by BlackRock Inc.
that has an industry market share of 36.9%. (Vanguard, in second place, has 18.5%.)
The following interview has been lightly edited for clarity and length:
MarketWatch: Was there a point when you realized ETFs weren’t going to be a niche product?
Kranefuss: Probably around 2002 or 2003. We launched iShares in March of 2000, just when the internet bubble burst. While we had a strong belief that people would realize the value of ETFs, it was very challenging when we initially tried to explain them to people in the institutional market.
The biggest problem was awareness, but I’ll say this: Every time there’s been a problem in the market, that’s been helpful for ETF acceptance. The dot-com bubble showed that a lot of what people used to say about active management turned out to not be true. Managers used to say, “I can get you out of the way of a falling market,” and that’s just not what happens. Friends of mine, back in 1998 or 1999, were telling me, “It’s different this time, the world has changed, internet companies are going to take over the world and run forever.” Of course, they then got that shock.
An even bigger turning point has to do with the LQD (the iShares iBoxx $ Investment Grade Corporate Bond ETF
the market’s biggest corporate-bond fund). In addition to the massive correction in the Nasdaq, we saw the collapse in Enron, which had AAA-rated bonds. Suddenly it was as though the AAA rating didn’t mean what it used to. Because a lot of active managers had owned those bonds, we suddenly saw more acceptance of what we had been saying. An active fund didn’t sound as good after so many managers had been piled into tech stocks or Enron bonds.
MarketWatch: So, LQD provided an easy way to get diverse exposure?
Kranefuss: That’s right. LQD offered something much cheaper and simpler (than owning individual ones). I like to say that the hardest trade someone has with an ETF is their first trade. Once they got concrete examples of what they could do, rather than just abstract explanations, they got interested.
MarketWatch: Are you surprised by how big the industry has gotten?
Kranefuss: Yes and no. I can remember doing interviews in 2003 and being asked if ETFs would significantly displace mutual funds. This was at a time when ETFs were like 2% of the market. We were growing at a reasonable clip, but it was going to be a while before we reached even 10% of the market. Still, people could tell. Ultimately, I think it would’ve been impossible to stop that fundamental shift.
What still surprises me is how broad it has become. There are over 2,000 funds now because a lot of people saw a fund company—or even a single fund—take off, and then they tried to pile in. It just isn’t that expensive to launch an ETF, though it is hard to make one successful.
MarketWatch: Is it concerning when you see the number of funds that are closing?
Kranefuss: Yes. I don’t worry much about something systemic—the flash crash, for example—I worry about something going wrong with a small provider who is under-resourced. I don’t want that to happen and have people say, “This is an ETF problem.” The number of closings just leads to confusion and disappointment.
The whole idea of ETFs was that they were modular building blocks, and that you could use them to build a low-cost portfolio with desirable characteristics. That turned back into people chasing returns, only they’re doing it by picking ETFs instead of stocks.
Thematic ETFs trouble me, because they go back to the idea of, “Got a hunch? Buy a bunch.”
I view the ETF universe as something like [Apple Inc.’s
] iTunes—there’s infinite shelf space, and there’s something democratizing about that. The NYSE could have 100 million things listed. At the same time, the barrier to entry is so low that it encourages things that are very speculative. That’s what the issue is.