With Daniel P. Dolan of ALPS Distributors Inc.

Aug 27, 2007 @ 8:46 am

By David Hoffman

It seems not a week goes by without the introduction of a new exchange traded fund. At the end of June, there were 526 ETFs, up from 359 at the end of last year, according to the Investment Company Institute of Washington. But at a time when new products are being added to almost every ETF group, one group has remained the same since 1998: the Select Sector SPDRs. Of course, Select Sector SPDRs ó a group of nine ETFs that follow the different sectors of the Standard & Poorís 500 stock index ó are something of a special case. SPDRs were originally sponsored by Merrill Lynch & Co. Inc. of New York, which now has very little to do with the ETFs. Technically, Merrill is the index agent, which means that when there is a change in the S&P 500, it determines in which sector stocks belong. The ETFs themselves are managed by State Street Global Advisors of Boston, which also manages and sells its own ETFs, called SPDR ETFs. They are distributed by ALPS Distributors Inc. of Denver. It can be confusing, but despite that, the nine Select Sector SPDRs have amassed more than $20 billion in assets. Part of their success has to do with their appeal to financial advisers. ďThere are other sector ETFs. Yet with the exception of Rydex equal-weight ETFs [from Rydex Investments of Rockville, Md.] which are good to use when small-caps are in favor Ö Iím hard-pressed to see the advantage of using other sector ETFs,Ē said Marvin Appel, chief executive of Appel Asset Management Corp., a Great Neck, N.Y., firm with $50 million under management. Such comments are why the man responsible for selling Select Sector SPDRs, Daniel P. Dolan, 44, the Garden City, N.Y.-based director of wealth management strategies for ALPS Distributors, thinks that the ETF group has a bright future even though there are no plans to expand the lineup.

Q. Select Sector SPDR ETFs are unusual in that they donít have a sponsor who is very involved in the products. How did that come about?

A. We created Select Sector SPDRs when I worked at Merrill Lynch. At that time, we made a very smart decision to partner with State Street Global Advisors, who would manage the money. [The ETF group] would not have the Merrill Lynch Asset Management label all over it, because we thought we could create something the entire Street could trade and invest in. If it was something that was labeled ďMerrill Lynch,Ē others would be less likely to participate.

The idea was that at Merrill Lynch, they had a very smart chief investment strategist named Charles ďChuckĒ Clough. Chuck had a model portfolio that divided the S&P 500 into nine sectors. The idea was to take the S&P 500 and carve it along Chuck Cloughís model portfolio. Financial advisers loved what Chuck had to say, but they had a very difficult time implementing his strategy.

Q. What happened?

A. Since 2002, when Chuck departed Merrill Lynch, the need to have the Select Sector SPDRs aligned with Chuckís model disappeared. Merrill Lynch is technically still the index agent, but Merrill Lynch has agreed to agree with Standard & Poorís [of New York regarding index construction].

Q. So does that mean Select Sector SPDRs are an entity unto themselves?

A. Well, State Street Global Advisors manages the money. ALPS is the distributor. With that structure, there is a stand-alone independent board of directors that makes decisions regarding the running and the operation of Select Sector SPDRs. The board of directors Ö really have worked on bringing expenses down.

We just went down to [0.23 percentage] points of expenses.

Q. With The Vanguard Group Inc. of Malvern, Pa., and Barclays Global Investors of San Francisco also deciding recently to lower ETF expenses, it seems that ETF expenses as a whole might be coming down. Would you agree with that?

A. I would not agree with that. With Vanguard and Barclays, thereís a bit of a war going on, but in general, thereís been a creep-up in expenses.

The average expense ratio [measured in basis points] is now in the low 50s, as opposed to the low 40s two years ago. The newer products are really being targeted to individual investors, and they are being sold through armies of wholesalers like traditional mutual funds. Because of that, you have higher expenses.

Q. What do you think about some of the newer ETFs, specifically those that try to represent subsectors or individual industries?

A. I think the further you slice the market in the very fine segments, thereís fewer and fewer people that itís appropriate for. You do get into a higher risk spectrum for certain people, and itís just not as appropriate as the original ETFs may have been. So yeah, I think when you slice portions of the market very thinly Ö itís a little more risk than I think most people should take.

Q. Some critics have suggested that even sector ETFs such as yours are dangerous.

A. Some people will say ETFs are like a loaded gun. You can trade all day long and blow yourself up, but we havenít seen that.

If you look at the really good ETFs that have strong institutional interest and strong retail interest, yes, the institutional folks will trade these things. They go long, they go short, they move in and out of the markets throughout the day. Individual investors, retail investors, are not moving in and out.

If I buy 100 shares of [Energy Select Sector SPDR ETF] in my retirement account, itís sticking there.

Iím buying that because Iím of a view that energy prices will go higher. I donít have to be right about an individual name. Itís a smart move by investors to reduce risk rather than take on more risk.

Q. How do you see the ETF market developing over the next few years?

A. Youíll probably have another year or so of heavy product introductions. I think that will be followed by a period of consolidations.

I think when you look at the marketplace today, there are two or three ETFs from competing firms for every segment of the market, and you have to get really creative to find a portion that is not served by some ETF.

When you look at whatís going on in the ETF business today, the growth numbers are great Ö but below the surface, itís not as healthy as people think. You look at where the money is going, and itís the big guys that are getting the money. A lot of the new stuff is not seeing much.

Q. Could the Select Sector SPDRs be acquired by an asset manager looking to break into the ETF business?

A. Itís an independent product. I donít see that changing.

Q. What does that mean for the group?

A. Our approach has been to stick with the nine ETFs we have. We have a dedicated effort to talk about sector investing and why it makes sense. An awful lot of the industry is focused on size and style, and the sector conversation is left off the agenda.

We like to focus on that. It has worked well for us. We feel that in the segment that we are in, there is just so much more out there to do. As people figure out different applications for the products both institutionally and on the private-client side, our asset growth will continue to grow.

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