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Originally published Saturday, May 4, 2013 at 8:04 PM

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Are ETFs a good bet?

Michael Sapir, founder and chairman of ProShares, talks about the exchange-traded fund industry.

The Washington Post

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Michael Sapir, 54, is founder and chairman of Bethesda, Md.-based ProShares, the nearly $29 billion asset-management firm that he co-founded in 1997. The firm has become widely known for the creation of exchange-traded funds, known as ETFs. The ETFs constitute the vast majority, more than $24 billion, of assets the firm manages.

ProShares specializes in “alternative ETFs,” with more than 120 funds. The alternatives come in four varieties: hedge strategies, global fixed income, “geared” funds and ETFs tied to market volatility. Sapir’s company labored in the legal trenches for several years to help win approval by the Securities and Exchange Commission (SEC) for ETFs that move in the opposite direction of the market and ETFs that magnify the daily return of the market.

Sapir has made a name for himself in the mutual-fund field, first as a securities lawyer and then starting in 1993 as a principal in the Rockville, Md.-based Rydex family of mutual funds, which he left because of a disagreement over strategy. He founded ProShares in 1997 with two partners, first pitching his index mutual funds to financial advisers and professional investors. Nine years later, he created an arm of ProShares exclusively focused on ETFs.

Sapir used his securities-law experience to navigate the SEC and to bring novel investment products to the retail market.

Some of his innovations have been cutting-edge but also controversial. He has created many ETFs, including those that seek to mirror investments in hedge funds and private equity, which have been historically inaccessible to retail and private investors.

A native of Florida, Sapir holds bachelor’s and MBA degrees from the University of Miami and a law degree from Georgetown University.

Q: I know what a mutual fund is. What are exchange-traded funds?

A: In essence it is a mutual fund that trades on a stock exchange. So ETFs end up having greater liquidity during the hours of the day than a mutual fund that you generally can only come in and out of one time a day. You trade exchange-traded funds like a stock. Generally speaking, ETFs are passively managed or indexed.

Q: Yours was one of the first companies to make large-scale moves into ETFs. Why did you feel this was the right marketplace to move into?

A: We started thinking about exchange-traded funds in the late ’90s, way before most people had heard of them. We had already offered a family of mutual funds that were passively managed, and we thought delivering indexed strategies through exchange-traded funds had a number of potential advantages for some investors, over mutual funds.

Q: What’s the difference between owning a no-load mutual fund and an ETF?

A: In a no-load mutual fund, generally you are buying directly from the fund company. In an ETF, you are buying the fund over a stock exchange, just like you would buy a share of stock.

Q: Can I own an ETF in my IRA?

A: Absolutely. In fact, we see a good amount of flows from ETFs into retirement accounts.

Q: Why?

A: Exchange-traded funds present varied advantages to investors, including generally being lower-cost, transparent and providing access to a wide range of parts of the investment landscape. We think investors find that attractive for their retirement accounts, as well as for their general investment accounts.

Q: Are there any tax advantages to owning ETFs versus mutual funds or individual stocks?

A: Versus mutual funds, I think, historically, exchange-traded funds compare favorably. ETFs tend to be very tax-efficient. They tend not to make, generally speaking, the level of taxable distribution that actively managed mutual funds make.

Q: What are the dangers in owning ETFs?

A: Each ETF, like each investment, has its potential risk and rewards. ETFs are a delivery vehicle for a particular investment strategy, so it’s imperative that the investor or his financial adviser understands the exchange-traded-fund structure but also the particular investment strategy that it is seeking to deliver.

There is a wide spectrum of strategies that ETFs follow. Exchange-traded funds can go from a basic S&P 500 large-cap index strategy to emerging-market debt to various sectors like health care to commodities like gold or currency to very conservative investments like we introduced last year. For example, one thing that ETFs have done for investors is to democratize the access to different slices and parts of the economic landscape.

We introduced a covered-bond exchange-traded fund last year. The majority of U.S. investors, including professionals, had never heard of covered bonds. But these had been available outside the U.S. for nearly 300 years. This is the only fund where an exchange-traded or mutual fund invests essentially all its assets in corporate fixed income rated Triple A..

Q: How many ETF s should the average investor own to be properly diversified?

A: That’s a very good question. Many investors are giving up trying to pick the stock or the active manager who will outperform the index. Because study after study shows that active managers don’t beat passively managed portfolios, you see more portfolios composed of assets with building blocks of ETFs.

There’s no magic number of ETFs to achieve the appropriate level of diversification for all investors. That evaluation is a fact-and-circumstances analysis based on the objective of a particular investor, their risk profile and lots of other factors.

It would be surprising to see a well-diversified portfolio with less than four or five exchange-traded funds. One element that we see increasingly being a slice of a well-diversified portfolio is alternative investments. These are investments that are other than what is traditionally long-only equities and fixed income and cash.

More and more smart people look at investments and think by adding these alternative investments, investors can reduce the risk in a portfolio and smooth out the ride.

Q: Jack Bogle, the founder of Vanguard Group, says, “An ETF is like handing an arsonist a match.” What say you?

A: ProShares offers a wide range of exchange-traded funds and mutual funds. They range from more aggressive investments than maybe what (Bogle) is used to, that are used in a variety of ways to seek profit and to hedge portfolios, to much more conservative investments like the covered-bond ETF. We also offer a number of alternative products that are used more to reduce risk in a portfolio than they are to try to knock the lights out.

Q: ETFs have grown rapidly over the past 10 years. Do you foresee ETFs supplanting traditional mutual funds in the future?

A: (Long pause.) Time will tell. But what I will say is, in terms of a vehicle to deliver passive or index strategy, I think the handwriting is on the wall. Exchange-traded funds have virtually won that contest.

I think the harder question is whether exchange-traded funds that offer an actively managed strategy are going to be able to deliver that sort of strategy and to compete mano a mano with mutual funds. So far, few ETFs that are actively managed have been successful.

Q: Some have criticized the ETF industry of proliferation — too many products and too many similar products. How do you counter that criticism?

A: Like in many areas, whether it’s cars or groceries, the more selection that a consumer has, generally speaking, the better off they are. In terms of exchange-traded funds, the more ETFs out there, the more tailored portfolios can be to suit the needs of a particular investor.

But it’s always important that an investor understand what a particular ETF is designed to accomplish. In the ETF marketplace, like any marketplace, the products investors don’t find useful tend not to gather assets and tend not to be successful and don’t survive in the long run. Those that tend to be successful tend to gather assets and tend to be around when investors need them.

Q: What risks face the ETF industry?

A: The number-one challenge is investor education. ETFs differ in important aspects from mutual funds. If you don’t feel like you understand what you are investing in after doing your homework, don’t invest in it. Or hire a financial professional to help you.

Q: Since the financial crisis, many average investors remain hesitant to take on risk. What is your message to them?

A: That’s a serious concern of ours. We may lose a whole generation or two of investors who effectively, like the Great Depression kids, just want to put their money under a mattress. That would be a shame. Over the long run, it’s our belief that investors who continue to be in the market and well-diversified portfolios that include alternatives will end up better off than someone who simply puts money in a mattress.

Q: What do you invest in?

A: I’m a true believer in passive and index investing. And I think I’m like most investors these days, which is I’m OK with a fair level of return as long as the volatility, in other words the ups and downs in the portfolio, are reasonable.

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