The following is an exact transcript from my interview with Jeffrey Feldman, the founder and chairman of X-Shares Group, LLC. Jeff is an innovator in the ETF arena and his products are noteworthy. Below you can read an educated opinion about where exchange-traded funds stand in the investment arena along with information about the HealthShares product line. You also might learn something about the healthcare industry and the underlying problems which helped create the demand for these funds. As you’ll see, X-shares plans to continue innovating on their unique indexing strategies and launch more ETF platforms in the coming months. Enjoy!
Can you give our readers a broad overview of what it is you do?
We’re a sponsor of exchange-traded funds. We’ve created a platform which we call X-shares in which X is meant to be a blank in which we can, in license, from anybody, build indexes on which we can create ETFs. We have created a turnkey relationship with a specialist from Goldman Sachs, an index calculation agent from Standard & Poors, and custody and clearing agents from the Bank of New York. We can pretty much offer a turnkey operation. At the same time, we’re also developing our own intellectual property, and creating a suite of indexes based upon that (and ETFs based on those). Our flagship product is Healthshares and later this year we’ll be launching other products that are not related to healthcare but have a similar theme in that they divide a larger market into narrow verticals.
Before launching into specifics, let’s get some background information. I field a lot of questions about saturation within the ETF marketplace. Can you talk about what stage we’re in, in terms of the role of ETFs in investing right now?
If you go back to 1960, everybody had a “passbook.” We were a nation of savers and only 4 million people owned stocks–80% of which owned the “nifty fifty.” It stayed that way (very few people owning stocks) until the middle 70’s with the first energy crisis, followed by stagflation, and high interest rates. The money market fund came out in 1973, and for the first time since the depression, people moved money out of savings accounts and into money market funds. It stayed that way until about 1980 when interest rates started to go benign again. People then went back to passbooks, but the mutual fund industry had been born, ERISA passed in 1974, and it came about, in earnest, in the late 70’s, baby boomers were coming of age and said, “I don’t need a passbook, I can invest in the market.”
In 1980 we had 20 million shareholders, Dow 1,000. By 2000 we had 100 million shareholders, Dow 12,000. What’s an investor? An investor is somebody who wants to buy low and sell high. All the liquidity coming in during the twenty years between 1980 and 2000 allowed a series of people to buy low, sell high, buy low, sell high, and make money. In 2000, the question becomes buy low and sell to who? We all own stocks. And so we have to evolve again. The market has been sideways for the past 7 years. The nation of savers became a nation of investors. Now, since we all own stocks, the nation of investors has to become a nation of owners. We have to own investments that benefit us whether or not we can ever sell them back at a higher price. In order for that to work, since we’re all at different ages and income levels, we need to create sharp, narrow tools that allow us to own, exactly what we want to, to avoid single stock risk but still have a narrow focus and achieve our investment objectives. For example, if I’m buying long-term care insurance, and I’m paying for it for 25 years, I should have access to an ETF which owns stocks that include nursing home and assisted living stocks, which are likely to appreciate in value over the next 25 years to equitize some of our costs. So, my belief is that the nation of “savers” had at its disposal the passbook, the nation of investors had the mutual fund, and the nation of owners will have the exchange-traded fund. I believe it’s fundamentally the most important development in financial markets in history.
So, we’re far from saturation? You’re saying we may just be young in terms of the role ETFs will play in the future?
It hasn’t started yet because people don’t understand its role. This is before people really get it. Ultimately, it will become the dominant tool.
In terms of fund flows, will we see money heading out of mutual funds and into exchange-traded funds?
Gradually at first. Then, there will be a tipping point at which funds will move explosively. When direct contribution plans can invest in exchange-traded funds, that will mark an important point, and at some point, mutual fund families will say “ya know what, rather than having other people cannibalize us, lets cannibalize ourselves and create ETFs which clone our mutual funds.”
As for the structure of X-shares, I’ve read on the website that you guys are a registered investment advisor which services the ETF market. It indicates you partner with institutions, index providers, etc. to bring new ETF products to the market using your administrative platform. Can you explain to my readers what exactly that means?
We have an exemptive order to issue ETFs. We are an investment advisor. We create fund families, either based upon our intellectual property or somebody else’s. Those fund families are mutual. The family itself owns the ETF and we advise the ETF in terms of creating the rule sets and going about the operational issues that are necessary. ETFs are not managed, they’re based upon an index, but we oversee the ongoing existence of the ETF.
Are the same people who are purchasing an S&P 500 fund also buying Healthshares? Or would these be used more as speculative tools for the healthcare sector? Or perhaps speculative tools in general?
Healthcare is a 2 trillion dollar industry growing at 9% a year.* 45 million people have no healthcare insurance and employers are cutting back on the coverage they offer. At the same time, the pharmaceutical companies are selling us the same treatments for symptoms that they’ve sold us year after year. This in the face of the greatest innovation in history.
If I say the word diagnosis to you–in a medical context, you get a picture of a doctor in a white coat standing next to a table with a patient. The doctor is feeling around explaining symptoms and giving a diagnosis. He then prescribes a drug to deal with the symptoms. But, this shouldn’t be what diagnosis means. Diagnosis, right now, means taking a drop of healthy person’s blood, finding protein’s in that person’s blood that are forming, and looking at their genomic makeup to determine if with these proteins and that gene map, you may develop a malady. We can start to deal with that right now. But then in terms of dealing with it, the doctor turns to the industry and finds drugs that treat symptoms rather than underlying disease. That’s what pharmaceutical companies do. But, pharmacogenomic companies build customized medical tools to deal with the underlying cause of disease. That’s ultimately how we’re going to solve healthcare problems–by having people not get sick in the first place. In our industry, the financial industry, we drive most of the money to the pharmaceutical industry–which has a market cap of over one and a half trillion dollars. If you look at the majority of mutual funds and even ETFs, they’re cap-weighted, which means the majority of money is treating the symptoms and not the problem. This makes the system more expensive and less effective. We should be dealing with this problem through innovation and we’ve currently got it all wrong.
So, people can look at these shares however they want, depending on how much they care about the healthcare industry. What I’m hearing, at least in the political arena, is that outside of terrorism, healthcare is the next biggest concern.
You mentioned a flaw in the market-cap system. Can you explain the Healthshares approach to building a portfolio of stocks and the way it weights stocks.
We weight stocks equally. We’ve looked at the massive 360 biotech companies and thought about how to organize them to get exposure to innovation and mitigation of risk. We came up with the idea of organizing the industry by therapeutic area. So, we group together the cancer companies, all the infectious disease companies, all the auto-immune companies. Some of them are going to be successful at the expensive of others, but because the underlying demand is growing, you only need a few successes to make the industry work.
How many stocks?
Equally weighted, 22-25 stocks in each vertical area.
Do you have a rules methodology?
It’s all rules-based, including the number of products in each therapeutic area, the amount of revenue it derives, the amount of money it has in research and development, and the number of research and development products it has.
How frequently do you guys organize the portfolios?
You’ve commented before that healthcare might not be fairly weighted in major indexes such as the S&P 500. Where do you think healthcare weightings are headed in the next few years?
Well, currently it’s weighted somewhere between 16 and 20%. 75% of that is going to the big names. If you look at the major indexes, you’ll notice that more than 50% of the money is going to the ten largest companies. The average investor just isn’t getting adequate exposure to these smaller companies.
From an operational standpoint, people are always talking about the efficiency of an ETF, the tax benefits, and the low expenses. Can you talk a little bit about how that applies to your shares?
Our expense load is 75 basis points. We have very little turnover because we keep companies in our portfolios as long as they qualify so we don’t have much in the way of tax issues. ETFs are inherently tax efficient because of the like-kind exchange. We think we run them efficiently. Our costs are slightly higher than other ETF providers because we have niche products that are often a bit harder to build than other ETFs because our securities are slightly harder to locate and our administrative cost which go out to our mentors tend to be high as well.
People like to talk about liquidity issues with ETFs. I tend to think the liquidity question really deals with the liquidity of the underlying equity holdings, rather than that of the ETF. Can you clarify this for my readers?
I think exactly what you just said is correct. I think people don’t understand the liquidity issue and often may be scared to invest in our funds because of some of our currently low asset levels. That’s going to take care of itself over time, but most of the people who look at our funds go to their broker and then wait to buy because of low volume. I think we’re only getting 5 or 10% of the volume available to us because people like to look at a fund and see 20, 30, or 40 million dollars invested in an ETF before they buy it. And I’m fine with that–it may be a prudent thing to do.
About your other products… can you talk about what’s coming next?
The next product that we will launch at the end of May is the TDax product: our joint venture with TD Ameritrade to create five lifecycle, target-date retirement funds. It will be the first ETF to do a lifecycle fund.
State shares will be portfolios of the fifty fastest growing companies in each of 22 states. We will then release portfolios from the smaller states, probably 40 companies for another 10 or 12 states that will debut a few months later. You will be able to buy the New York 50, the New Jersey 50, the California 50, etc.
Finally, if my readers are ordinary investors looking to investing in ETFs such as yours, how would they go about doing so?
You can buy an ETF through a registered investment advisor, through a financial advisor, or any brokerage firm, discount or otherwise.
Great. Thank you Jeff for speaking with me.
Premier Financial Advisors
14 E. 60th Street, #402
New York, NY 10022
*Kaiser Family Foundation: Comparing Projected Growth in Health Care Expenditures and the Economy. May 2006
Russell Bailyn is a registered representative offering securities through: First Allied Securities, Inc., a registered Broker/Dealer. Member: NASD/SIPC. Premier Financial Advisors, Inc. is a Registered Investment Advisor. First Allied Securities & Premier Financial Advisors are not affiliated entities.
Exchange-traded funds (ETFs) have liquidity risk and may have a tendency to trade below net asset value and my have investment objectives other than matching a particular market index.
Although exchange-traded funds are designed to provide investment results that generally correspond to the price and yield performance of their respective underlying indexes, the trusts may not be able to exactly replicate the performance of the indexes because of trust expenses and other factors.
Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost.
Exchange-traded funds are subject to risks similar to those of stocks. An investor should carefully consider investment objectives, risks, charges and expenses before investing. This information and more complete portfolio details can be obtained by contacting X-shares directly (800-925-2870).
Investing in an ETF that concentrates its holdings in a single sector strategy involves greater risk due to increased exposure during less than favorable market conditions within the industry.
Investing in mutual funds involves risk, including possible loss of principal. An investor should consider the investment objectives, risks, and charges and expenses before investing. A current prospectus can be obtained by calling X-shares (800-925-2870). Please read the prospectus carefully before investing.