John Roberts Of Barclays Global Investors

You're right that the sustained bull market clearly contributed to the growth of mutual funds and drove the growth in exchange traded funds (ETFs), but there's another reason they're drawing money in. From an investing perspective ETFs are new, and it's easier for a new financial product to attract new money coming into the market, as opposed to getting people to move from one investment vehicle to another. So I would say the growth of mutual funds and ETFs ran parallel; as more money has come into the market, a portion of it has gone to ETFs.

We're starting to see an increase in the number of ETFs being offered. Do you think the new money is responsible for this growth? I think it's partly responsible. In addition to the new money coming in, I also think some investors who previously had used other investment vehicles are now moving money into ETFs. More of it is probably from individual equities as opposed to mutual funds, but I think there is a clear movement toward ETFs as an investment vehicle.

So you think that people who generally invest in individual stocks are moving into ETFs, as opposed to people who generally invest in mutual funds? At the moment, two sources of funds are driving the growth of ETFs. One is the new money coming into the equity markets in general, and the other is the group of investors transferring funds from equities to ETFs. I don't think there has been a lot of outright movement from index mutual funds to ETFs.

What are some of the advantages that ETFs like iShares might have for investors over individual stocks? One advantage of iShares for most investors, especially beginning and intermediate investors, is diversification. Until now, investors only had a limited set of investment vehicles to choose from. Index mutual funds tend to be based on the broader market indices. If an investor had an opinion about, say, the energy sector, the consumer durables sector, or the technology sector, there weren't many investment opportunities to express that investment opinion. The investor's only option was to buy a couple of stocks and hope his or her prediction was correct.

But if you have a sector with 200 stocks in it and you have a $50,000 portfolio, you can't afford to buy more than three or four different stocks. So you might wind up in the right sector, but you would be grossly underdiversified. It's easy to get into that situation. I know people who were right about the sector, but wrong about the stocks they picked in that sector.

As an example, suppose you wanted to invest in small-cap stocks or Japanese stocks or US technology stocks, but you weren't familiar with the individual companies within the sectors. By investing in an ETF, you can make a diversified investment, with a small amount of money, in the market segment in which you want to invest. And that's the beauty of iShares. We offer different types of ETFs, giving investors the opportunity to invest in various sectors. They have more alternatives than they ever had before ETFs came on the market.

When individuals invest in iShares, what are they actually buying? Are they buying the underlying shares? This is how the creation process works. Typically, the large institutional investors or broker-dealers can either purchase a basket of stocks that matches the composition of one of our funds, or buy the stocks themselves and create a portfolio that matches the composition of the fund. Then they transfer those stocks to the iShares Trust, which holds the shares of the individual stocks and issues iShares in exchange.

As an iShare investor, you actually own shares of a trust that is holding shares of all the different stocks. For instance, if you own shares in the iShares Dow Jones Technology fund that holds stocks such as Microsoft, Intel, Cisco, and AOL, the large institution can -- and you can also, if you go out and buy 50,000 shares of these things -- take your 50,000 shares, deposit the shares into the trust, and in exchange, receive a portfolio of all the stocks. So you could actually get all the stocks if you wanted to, but the transfer only takes place in very large blocks of stock.

Does keeping it at 50,000 shares or more make it possible to give people reasonable lots in return? Yes, but as a practical matter, the whole creation and redemption process, which is what we call it, isn't something an individual investor would ever do. But the large institutions would, and because of that, it acts as a natural economic policing mechanism to keep prices in line.

Suppose an iShare in which the stocks in the portfolio are worth $100 suddenly starts selling at a discount. Suppose for whatever reason, you could buy the iShare for $99. Here's what a large institution could do -- and if the price were to ever get out of line, they would do this. They would buy that iShare with $100 worth of stock for $99. Then they would redeem that iShare in 50,000-share blocks to the trust. So basically, they would deposit shares they paid $99 for and get back $100 worth of stock from the trust. This arbitrage mechanism provides comfort to individual investors. It assures them that the price at which their share is going to trade throughout the trading day will track the value of the stocks in the fund very closely. That comfort level is very important.

What are the main differences between index mutual funds and ETFs? I would say there are two key differences. The first is the enormous breadth of the indices. If you look at the iShares product line, you will see that iShares are available for several different types of indices. You're probably not going to find such a broad family of index mutual funds to invest in elsewhere, and even if you can come up with a list of all of them, you're certainly not going to be able to access them from a single source.

What's the other difference? The other difference is the ability to buy and sell ETFs at any time during the trading day. With a traditional index mutual fund, you can only buy and sell at the end-of-day net asset value. With an iShare or any other ETF, you can buy it at 9:00 in the morning or 2:00 in the afternoon. You can sell them at any time during the day. You're selling your shares in the fund, just like you would sell shares of Ibm or General Motors.

Trading in funds can involve higher expenses and capital-gains tax issues. Do those same problems follow iShares investors? There are two kinds of trading that can generate capital-gains taxes. One has no impact on iShares investors and the other has some impact. Suppose you and I were both investors in an actively managed mutual fund or an index mutual fund, but I decided to leave the fund. What I would do is, at the close of business, I would redeem my shares at the net asset value and get cash in exchange. The fund raises the money to give me cash by selling shares. But since I'm no longer in the fund, they can't charge me for selling those shares.

Who has to pay the commission and the transaction expenses incurred by people who leave the fund? The investors who stay in the fund. That's you. So you are incurring expenses that get charged against the performance of your fund, not as a result of any action you took, but as a result of an action that somebody else took.

By contrast, in an ETF, if you and I both hold iShares in the fund and I decide to sell mine, that action would have no impact on you. This is because I sold back my iShares to the specialist?, and there was no fund activity triggered by my decision to close my fund position. This is an important difference. It's really a question of who pays the expenses for someone else's investment decision. My attitude is, it's fair for me to pay the expenses for what I decide to do. It's not fair for the fund to ask me to pay the expenses for what you decide to do. That's an important, fundamental difference.

Capital-gains distributions arise because of trading within the portfolio. Whether a fund manager is buying, selling, or index rebalancing, this trading creates capital-gains distributions that the fund shareholders will receive notice about and have to pay. In an index mutual fund, the only trading is typically when the index rebalances and stocks are added or removed from the fund. The stock turnover in the fund is extraordinarily low. There's very little trading activity, and therefore, capital-gains distributions are low. In this regard, index mutual funds and ETFs are similar. They're both different from actively managed mutual funds, where the stock turnover is typically much higher and there is the distinct possibility of large capital-gains distributions to the investor.

There was one other investment product I wanted to compare iShares to. Are there striking differences between iShares and closed-end funds? ETFs, and iShares, are open-end funds. A closed-end fund's supply is fixed, so the price discovery mechanism for them is based on supply and demand. Typically, but not always, that will cause them to trade at a discount to the theoretical value of the stocks within the fund.

An iShare can be created and redeemed at any time. In a traditional closed-end fund, if there were not enough supply at a given price -- the fair value of the fund -- the prices would rise. The person buying into the fund would have to buy in at a price higher than fair value. In an open-end fund like an iShare, the specialist or any other institutional investor could simply buy or, if they already hold the stocks, deposit the stocks into the trust, receive iShares in exchange, and sell them to the investor. So the open-end nature of increases and decreases in supply means that you're going to have efficient price tracking to the index, whereas with a closed-end fund it can go wherever it wants, based on how badly the sellers want to sell or how badly the buyers want to buy.

iShares are fairly new on the market. How easy is it currently for people to move in and out of those shares? Is liquidity something that someone who is considering iShares should be concerned about? Liquidity is something everybody should care about for any investment they make. But the way you think about liquidity with an iShare or any other ETF is a little different than with a traditional stock. A stock is like a closed-end fund. There's only so much of it out there. If you see a stock that is trading 20,000 shares a day, you would say, gee, that's not much. In a case like that, you should be concerned about buying too much of that stock, because you don't want your transaction to be 10% of the trading volume on the day you decide to sell it. You really want an active, two-sided market to assure yourself that your desire to buy or sell isn't going to move the market against you.

With ETFs, you have more flexibility. Suppose you're looking at an ETF with an average trading volume of 20,000 shares per day. If you bring up a quote, you will see the specialists' bid and offer to be anywhere from 25,000 to 50,000 shares or more. This suggests that trades will be honored, even if they are higher than the average daily volume.

Suppose you want to buy 50,000 shares of an ETF. The specialist can get the individual shares in the open market. They will short the shares. They'll borrow and sell the shares to you. I'm oversimplifying the creation process, but in effect they'll take the money that you are going to pay them, buy the shares, deposit them in the trust, and then create the shares and close out the short position that was initiated when they sold the fund to you.

As long as there is a liquid market for the shares that underlie a particular index, there will be a very deep and liquid market in the ETF based on that index. In a theoretical sense, millions of shares that make up an index based on an ETF could be trading every day. It's only in the extreme case that an ETF wouldn't trade at all. But because the stocks that make up an ETF are trading all the time and there are liquid markets available in these stocks, a specialist or an institutional investor can efficiently buy those stocks to create more ETFs. On the other hand, if you want to sell, you have the comfort of knowing that whomever you are selling to can break up the ETF and get the shares they want. So this creation and redemption process makes the relationship between volume and liquidity for ETFs fundamentally different than a closed-end fund or individual stock.

We're also seeing -- and this is to some degree unexpected -- some money managers and institutional investors actively trading iShares. This can be good news for the individual investor. For one, it validates the concept that those who are paid to make investment decisions and do the due diligence to ensure they're making the best decision are satisfied with ETFs as investment vehicles. The other thing is, the developing institutional market for these funds gives the retail investor a lot more comfort, knowing there's going to be liquidity in these markets.

Do you have any sense of the profile of the average iShare investor at this point? Well, we think iShare investors make up an interesting mix. The mix is between people who do business through discount brokerage firms and those who do business through full-service brokerage firms -- receiving advice from brokers. If we were to see, and please understand that we have not seen, overwhelming volume going through either discount brokerage firms or full-service firms, that would have all sorts of implications for how we market the product.

Interestingly, the split in volume for iShares is about 50/50 between investors who use discount brokers and those who use full-service brokers. That tells me that individual investors making their own investment decisions, who often have smaller portfolios than people who have accounts with brokers, are interested in the product, as well as people who work through the full-service brokerage firms. It's a very diverse group.

The setup for iShares relies on institutional investors for things such as the arbitrage mechanism. How are institutional investors starting to look at iShares these days? You seem to be indicating that a lot of institutional investors have a fairly favorable opinion. Exactly. If you're an institutional money manager or a portfolio manager, you have your own version of the dilemma that I described earlier for individual investors, about being able to track a particular index with reasonably small amounts of cash. Typically, a portfolio manager needs to have ready access to a certain amount of cash to manage creations and redemptions. The problem is that with that last couple of million dollars, it is difficult to replicate your full portfolio and not cause tracking errors with what would otherwise be the cash component of your holdings.

Suppose you're a mutual fund manager for an actively managed technology mutual fund. What are you going to do with your cash? You're taking a chance if you just buy a couple of technology companies, because tech companies are typically volatile. Instead, you could buy, for instance, the iShares Dow Jones Technology Index fund. It might not replicate your portfolio, but it would be close. International portfolio managers, active managers, and hedge funds managers are all using iShares. These are institutional money managers who are investing their money not as an arbitrage, the way I described earlier, but actually buying and holding iShares to help improve the performance of their portfolios.

How sound are iShares as a long-term investment for individual investors? I'm thinking of an iShare-IRA type of thing. Is that a feasible strategy for someone using iShares? For an individ-ual investor, investing in iShares is a tremendous strategy. First of all, by creating a combination of different iShares, it gives the individual investor, who may not be working with vast sums of money, the ability to create some kind of an asset allocation portfolio. They can invest a certain percentage of their capital in large caps and some in small caps.

The other reason it's such a good idea is the pricing. The management fees of our iShares are typically much lower than either actively managed or index mutual funds. Over a surprisingly short period, the lower management fees can generate an enormous amount of incremental cash in the portfolio.

As a comparison, the management fee of the Vanguard S&P 500 fund is 18 basis points, whereas the iShares S&P 500 fund is 9.45 points. Suppose you invest $100,000 in the iShares S&P 500 fund. Over 20 years, a long-term investor will pay about $12,600 in management fees. Once you buy the iShare and hold it in your Ira, you pay 9 basis points. If you opt for the Vanguard S&P 500 fund instead, over 20 years, you would pay $23,800 in management fees. The difference in fee structure between the Vanguard Trust, which is by all accounts a very cost-efficient index mutual fund, and the S&P 500 iShare, which tracks exactly the same index, is $11,000. It's real money. The power of compound interest and the savings on the lower fees of an iShare clearly benefit the buy-and-hold investor.

I also wonder about some of the other monies that come along, like dividends on the underlying stocks of an iShare. What happens to them? Are they deposited? How are they accounted for? You've touched on one iShares advantage that investors sometimes don't understand. Let me take a quick detour, then I'll come back and answer your question directly. One of the advantages of iShares is that they're all 1940 Act funds. [Editor's note: The Investment Company Act of 1940 required closed-end investment companies, open-end mutual funds, and unit investment trusts to adopt standards for reporting requirements to investors as well as standards for allocating funds across investments.] They all have exactly the same structure, and if you understand how one iShare works, you understand all of them.

Some things that fall under the umbrella of ETFs are not 1940 Act funds in all cases. A SPDR is actually a unit investment trust (UIT). The HOLDRs, which stands for holding company depositary receipts, which is another kind of exchange traded funds, are an entirely different structure. In each one of those different structures, there are subtle differences, such as the treatment of dividends. Unit investment trusts cannot reinvest dividends in the fund over the course of a quarter. They have to be held as cash and paid out as dividends at the end of the quarter.

The 1940 Act fund structure of all our iShares allows immediate reinvestment of dividends as they're paid throughout the quarter. These dividends are continually reinvested. As long as the market is going up, that dividend reinvestment will benefit the investor. This is a long-term difference. It's not something that's going to make anybody richer or poorer within a given quarter.

At the end of a quarter, iShares and SPDRs investors receive dividends. But with your brokerage firm, you can arrange to have a dividend reinvestment program and simply indicate that the dividends be reinvested in the fund. So your dividends, which are really the dividends paid by the individual companies in the fund, will be paid to the fund and reinvested throughout the quarter. At the end of the quarter, they'll be paid out as dividends to you as a shareholder, but you can again have your firm automatically reinvest them into the fund, so you get the full compound effect of the dividends from the moment the individual companies pay them.

Is there a difference in the tax impact between this approach and that of UITs such as the SPDRs? Do those dividends come out as cash? Well, they're going to come out as cash either way. I'm not a tax expert, but I believe dividends are treated as taxable income when they're paid out. So when you reinvest the dividends, there's a little bit of trailing tax liability. The Spdr and the iShare are identical in that respect. Either way it's taxed, but then it can be reinvested.

To digress a little, how do iShares as a package avoid disproportionate representation within sectors? iShares were designed to be flexible, cost-efficient tools for building a well-constructed portfolio -- one that is diversified, risk-managed, and covers the investing styles, market sectors, industries, and regions that are appropriate for you. iShares can also complement a core portfolio if an investor wants to add international exposure.

When you get into sector investing, you are looking for fairly specific exposure. The Dow Jones sector funds are based on a slice of the Dow Jones Total Market Index. And that index has a large number of stocks in it. It's designed to reach 95% of the capitalization of US equity markets, starting at the top with the largest company. They study each company and assign it to an individual sector. For example, if microchip companies dominate the technology sector, then microchip companies would in fact be assigned to the sector.

That's logical. I guess an important advantage of the Dow Jones Total Market Index, and the sectors that are its components, is that when you reach 95% of the total market capitalization, you're reaching very deeply. For example, hypothetically speaking, if microchip production tended to be capital-intensive and the companies were very large but software companies had an entirely different cost structure, making them smaller, there would be more of them. The capital structure of different industries within a particular sector might tend to skew that sector's industry exposure more in something like a select Spdr than it would in the Dow Jones sector, because there are more companies in there. But when you get into sector investing, you're looking for fairly specific exposure.

One of the resources we provide is the iShares website, www.ishares.com. There's a place on our home page called Fund Components. You can click there and see the names of all the stocks of our funds. If you want to take a look at the stocks in a particular fund to get a sense of the exposure you're getting within individual industries, you can.

How much help does iShares.com offer its investors? Does it contain sample portfolios or glossaries? You mentioned shorting stocks, for example. Is there information on iShares.com about that? I know there is information on shorting. We try to make the iShares website a resource for investors so they can learn what iShares are, the objectives and components of each iShares fund, and how investors can use them. The purpose is to make the information readily available for people who want to learn more. The Internet is a remarkable tool in terms of democratization of information. For people who want to take the time to find out, there's an extraordinary amount of information in our website, including information on individual funds, individual indexes, the structure of iShares in general, and how they can be used as part of an investment program.

Are there any investors or investment goals that you think might be more difficult to satisfy through iShares? There are a lot of ways to put together an overall investment goal and its subcomponents. A lot of people and investment advisors talk about a core and satellite investment program. The core is a broadly diversified and indexed kind of tool added to your portfolio. In a core and satellite concept, you take, say, 70% of your money and put it in an asset allocation-based, broadly diversified set of investments, for which iShares are perfect. Then you take the other 30% and try to pick some winners. We all want to find the next Amazon.com.

In that 30% where you're looking for stars and want to find the stock that's really going to take off, though, an iShare wouldn't be the way to go. With the diversification that iShares give you, you wind up with an average performance for the sector that you're in, as opposed to the performance of the best stock in that sector -- if you were lucky enough to pick it. In a sense, that's the downside of diversification, which is otherwise enormously beneficial in terms of an overall investment program. If you're trying to hit a home run with a single pick, an iShare is probably not going to be your home run.

Just picking an individual stock might be a better approach. That's right. If you're looking for something to go up five times over the next 12 months, you shouldn't be looking for an iShare. But if you're looking for diversification, iShares are the way to go.

Thanks for talking to us, John.