Sometime in early June 2006, I took up an offer by David Jackson at Seeking Alpha to write down some of my ideas on the use of ETFs and publish them on his site. Truly, it was easy to think of topics and start typing away as my life at that time involved managing portfolios consisting predominately of indexed instruments (and a bit of DFA funds but they don’t want to be called index funds). At times, I stepped away from discussions on just ETFs and entered the areas of hedge funds, alpha-beta separation, general risk management as applied to the process of portfolio construction and even some forecasts/outlooks although I never felt very good about going in that last direction.
So it’s now about two and a half years later. If you’ve followed my writing, you can see I’ve gone from as many as two to three blogs a week to basically once a month on average … if that. Part of the decline is likely the same as other bloggers … I just ran out of gas. I certainly don’t consider myself to be like other bloggers who write daily (or sometimes hourly) based on what’s happening around them in the world. There’s nothing wrong with that … in fact, it is the more successful blogging model … but it was just never how I intended to blog. Initially, I’d pick up on a news story and expand on it with my opinions and connected the dots with the world of beta oriented instruments. Now the world is far more complicated for many reasons which can take up so much time/effort so let’s just agree to accept that. In addition, the world of beta instruments (ETFs and their related siblings of ETNs, ETCs, etc. as well as the wide array of derivative contracts) has expanded in a way no one would have predicted ten years ago.
Now near the end of 2008, after at least a year of strong market declines, we should be seeing what I’ve called “the next wave”. As with the market declines of 2000-2002, we should see a new wave of exchange traded products. Everyone can see the massive outflows from mutual funds and other traditional products. Hedge funds are seeing the same. But we also find significant new monies going into ETFs. Whether it be a focus on costs, the realization of tax benefits, the frustration with active managers … all of the above … the result is this new wave. After the rebound in 2003 we saw the arrival of PowerShares, ProShares, Van Eck and several other providers who now manage billions of dollars in assets. This third wave will introduce many new entrants some sticking to the basics of indexing and other moving towards more actively managed mandates. Theirs is all a case study in timing. This wave of new arrivals hasn’t really started yet but had these new entrants come to market with their products 12 months ago, they’d now likely be dead; or like many smaller ETF providers today, barely breathing. But it’s not just a case study in terms of timing the overall market direction and attempting to launch ETFs at the beginning of a major uptrend. It’s about timing the tastes and values of investors.
Will actively managed ETFs gain favor of investors who are running for the exits (from mutual funds and hedge funds)? Or with an eventual rising equity market, will it just be a matter of time before risk aversion turns to risk acceptance and thus realize flows back into actively managed funds?
My sense is that it will take a very long time before actively managed ETFs get any sort of momentum. I would be very surprised if aggregate assets under management within US domiciled actively managed ETFs totals a quarter billion by the end of 2010 (two years from now). If it’s in that vicinity or more at that time, I’d further speculate that the more successful products will be “ETFs of ETFs” marketed by the biggies … like iShares. Unfortunately, I believe it will be the smaller independent providers with their own EoE that likely provide something special … meaning, an underlying portfolio of ETFs consisting of those from a wide variety of providers and no constraint in terms of who can or can’t be included. Somehow, I would think that a large “brand name” provider would only use their own ETFs as underlying constituents in their EoE. Can’t blame them really.
I am also a student of timing. My first job in the industry was with a company that actually had the word “Timing” in its name. Working in a conservative country like Canada (never mind legalized marijuana use for now) for what was essentially a hedge fund – and a proponent of market timing on top of that – makes me a student of timing in many different ways. I don’t know if there even was a hedge fund industry in Canada back in the mid 90’s but I remember how hard it was to be a market timer when the markets were only going in one direction. Fast forward over ten years and for precisely the entire calendar years of 2007 and 2008 I have not managed money. Instead, I have done some consulting which I really enjoyed, on top of the occasional blogging and conference speaking … loved that too. In highsight, not a bad career move as I’ve sidestepped the scariest and most volatile market activity that anyone can remember.
Lucky more than anything else. Actually, being away from the market as a professional participant looks even better when you look at this chart:
Some smartass might call me a chicken for bailing out during this challenging time. I’m up for a challenge, but I’m not stupid. If I know there’s a freight train about to run me down, I’ll get off the track. I’ve been bearish on the US market since early 2006 (way too early a call) but I never thought it would be like this: Maybe one investment bank gone but not three. The world now looking to do a photocopy of Japan’s ZIRP. Problems with the auto sector yes, but not nationalization. This last one really has me thinking … China is ever so slowly transitioning from socialism to a market economy with something that looks more like “trial and error” than anything from an economic policy textbook. Can’t bad mouth them for trying their own thing with the Russian model and past help from the IMF/World Bank not looking like safer bets. But with recent attempts from the US government to resuscitate the banking, insurance and auto industries, is the US moving in the other direction and possibly looking a lot more like the Chinese model? Maybe it’s too early to say this and so it’s a bit of an exaggeration since the US is clearly not moving from a market economy to socialism. However, if this is the beginning of a trend of China and the US merging to some form of “controlled capitalism model”, who would have thought? What a world.
Frankly, this past year should have been the time for hedge funds to shine but no one thought about the fact that panic can go to extremes … especially after such a long period of time with no panic. Just look again at that VIX chart. Was there anyone speculating for a VIX at 80? I’d like to talk to that person. As you can see, we entered a whole new world in the 4th quarter of 2008.
Despite this, I think what’s happening to the hedge fund industry is not all bad. The closing of some funds (including recently exposed frauds) is necessary just as it is for the closure of some ETFs this year. The hedge fund industry will have to evolve somewhat as both regulators and investors demand greater transparency and liquidity. To many, this will be more than “evolving” but a massive transformation. Will the active manager lose their information edge due to added constraints? Possibly and that’s sad. But I think there are markets where the information edge is still significant. Emerging markets, for example, will always be just that … emerging. The Poland of today could be the Germany of tomorrow just like the Vietnam of today might be the future South Korea. As emerging markets of today move up to developed status, like Korea recently, new countries will plug into the modern global financial complex, and investors will slowly enter these markets and seek information. Hedge funds should hopefully be the early entrants if the regulatory world allows them access. I generally don’t think it’s the more traditional investor (mutual fund, etc.) that will have the inkling or ability to make it happen.
Overall I believe there is a strong future for both ETFs and hedge funds and I’m keenly interested in how these two worlds interact. Furthermore, my interest is intensified when I intersect these areas with the emerging markets. Any reader of this blog should know that I have little interest in the active versus passive debate. Rather, my interest is in seeing how active strategies and passive instruments can work together, not just for the heck of it but because it makes sense. I honestly believe that emerging markets are the realm for active investors. The volatililty inherent in these markets turn a long-term oriented buy-hold investor into a short-term trader at the worst possible time. A hedge fund-like mentality is more likely needed for investors’ non-core positions which may or may not include emerging markets. I say “may not” for those who consider emerging markets to be an essential part of their core portfolio. Debate this point if you wish but let’s face it: with the needs on the liability side of the equation and interest rates where they are, there’s a lot of pressure for investors to get anything in at least the low double digits for returns. Although it comes with volatility, I can’t think of many other places like emerging markets where the long term potential for double digit returns exists. But it’s just that damn volatility. It requires supervision and at times tactical rebalancing.
This leads me to my final point on timing. I’m getting back in. Not in a portfolio context but professionally. IndexUniverse.com put a comment in one of their latest “ETF Watch” articles under the subheading “EGA Makes First Filings” about this new venture which we hope will be considered THE emerging market ETF provider and research firm. There’s a link at the end of the commentary to the registration statement filed with the SEC. Those in the industry will note I’m working with Bob Holderith (formerly of ProShares) on this and if you know what ProShares ETFs are about, you’ll understand the common thinking Bob and I have. We view ETFs as tools for any type of portfolio manager whether it’s the hedge fund or the couch potato at home. Although emerging markets may not be perceived as appropriate for everyone, investors realize the challenges that come with gaining exposure to these markets. We believe that the inherent benefits of ETFs (liquidity, transparency, ability to short, etc.) are just what are needed in emerging markets investing. They are not a solution on their own nor are they only for the ultimate buy-hold investor or day trader. They are just a piece in a bigger puzzle. Our lineup happens to focus on providing sector based exposure … a first to the market which is key. Because of where we are in the regulatory process, I am limited in what I can say about these new products. This blog post is not meant to be a form of product solicitation but to outline my transition away from blogging (at least for now) and back into the investment management industry.
I hope my timing’s good.
Thanks to those who have followed my work here at Beta Brief. I’ll still be writing and you’ll find most of it online on our company’s future website and possibly on one of the now many ETF related websites. I wrote a piece recently for Institutional Investors’ annual Guide to ETFs and Index Innovations and I plan on having a series of articles with my friends at IndexUniverse.com to keep me plugged in. So I’ll be busy, but not too busy to reply so note my future business email address: rkang [at] egshares [dot] com.
Best to you all in this challenging environment.