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.

The EDHEC Business School in Nice, France and its EDHEC Risk and Asset Management Research Centre produce a lot of great material on their site with free access to all.  The research centre’s focus on asset management hits me the right way with writing grouped into areas such as “Indexes”, “Alternative Investments” and “Asset Allocation” to name a few.

Via an EDHEC-Risk email, I received a complimentary copy of Investment Management Review and found an interesting article on beta.  After receiving permission I now provide the text in its entirety.  No comments from me … just the content as it is.

Ok, just one comment.  Note Anson’s introduction of a continuum from classic beta to pure alpha.  Very similar to my alpha/beta spectrum but with well defined zones along the line.  I can spend a lot of time thinking about this and how it will apply to future product/service offerings in the changing investment industry.

BETA CONFUSION

 

Editor’s introduction

 

What does ‘beta’ stand for? The terms ‘alpha’ and ‘beta’, once the province of academics, quants and risk managers, are now familiar to every professional in fund management. Unfortunately, they do not mean the same thing to everybody and there is considerable looseness in the current jargon. ‘Beta’ as it was in the old-fashioned sense represented the bet one took against a market, a beta of more than and less than 1 meaning riskier or safer than the market respectively (see ‘What is beta?’ box).

 

 

A current widespread interpretation of beta is different. In the simplest sense, it is used as the proxy for matching the market risk and, in a wider sense, it is used to represent all sorts of risks which can be easily replicated, perhaps with a computer.

 

The two papers below highlight the different ways, the old and the new, in which the word ‘beta’ is interpreted. Markowitz’s conclusion in the first paper rests on the old idea of beta (see above box)

 

Anson’s paper for the most part implicitly refers to the newer idea.

 

As widely referred to now, beta is no longer a number as it used to be, defining leveraging or de-leveraging relative to the index. It is now a concept reflecting the matching of the market performance, as opposed to alpha, representing the excess return. Undoubtedly, many still adhere to the previously prevalent rigour, including academics and quants, but the newer use of beta conflicting with the old is now widespread throughout the industry and among commentators.

 

 

 

 

Markowitz back on the warpath

 

‘CAPM investors do not get paid for bearing risk: a linear relation does not imply payment for risk’, Harry M. Markowitz, The Journal of Portfolio Management, Winter 2008, p91

‘Markowitz attacks beta’, Investment Management Review, Winter 2005/06, p46

 

Prof. Harry Markowitz, the founder of modern portfolio theory, has returned to attacking the use of the capital asset pricing model (CAPM).

 

In the above paper, Markowitz focuses on the outperformance by a security over its benchmark going up and down proportionately with its beta. He attacks the fact that the proportionality between the excess return and beta is wrongly interpreted as investors being paid for bearing systematic risk.

 

He uses high-level mathematics in showing that this is not so, because two securities with two identical risk structures in terms of the way they are correlated with other securities in the market place can have different excess returns.

 

Different types of beta

 

‘The beta continuum: from classic beta to bulk beta’, Mark Anson, The Journal of Portfolio Management, Winter 2008, p53

 

Mark Anson provides some insights into the different ways the term ‘beta’ is referred to by investment practitioners, which as mentioned above is different from the sense in which it was formulated in the capital asset pricing model.

 

He starts by defining beta as the efficient capture of risk exposures tied to broad asset classes such as equity markets, bonds and commodities. Beta should be acquired cheaply, because active asset management is not necessary for exposure to an entire asset class. For instance, equity market exposure can be achieved by investing passively in an index. Beta represents passive management and alpha refers to active portfolio management. Along with many others, Anson refers to the excess return as alpha, though, as the box above shows, beta also can be a source of excess return in the old-fashioned meaning of the word.

 

Anson argues otherwise. But he does not revert to the old meaning of beta. He disputes the notion of a sharp demarcation between alpha and beta, and argues that in fact that there is a continuum from classic beta at one end to pure alpha at the other, with various types of beta in between.

 

In elaborating, he outlines the following different types of beta.

 

1. Classic beta – This is related to the ‘beta’ as referred to in past decades, though now corrupted to mean precisely matching the market. In the new parlance the word beta is equivalent to a beta of 1 under the older definition. It effectively means just matching the market, whether the market is the US stock market, the UK FTSE 100 or the global MSCI-EAFA. Standard index funds come under this category.    

 

2. Bespoke beta – This refers to the same as 1 above except that the index no longer represents the broad market but particular sectors or other asset classes. For instance, the banking sector or a basket of commodities.

 

3. Alternative beta – Anson describes this by example. The rationale is that there are systematic risk exposures which were previously not available to investors but which can be now accessed through ETFs. As an example, he cites a currency ETF linked to the price of the euro in terms of the dollar.

 

4. Fundamental beta – There is now a raging debate as to whether indices constructed by weighting the constituent stocks by market capitalisation are the best proxies for the market. A strongly supported school has sprung up which claims that fundamental indices, in which the constituents are weighted by fundamental factors such as revenue or dividends, are much better. Anson refers to matching these fundamental indices as fundamental beta.

 

5. Cheap beta – This refers to a situation where beta cannot be produced by investing in an index or ETF, but where beta is embedded in a complex basket of risks within one security. An example is a convertible bond. This has the following elements of risk embedded in it: interest rate risk, stock market risk, credit risk, and volatility risk. Players in convertible bonds are effectively getting indirect exposure to all these different betas. Interestingly, here Anson thinks of beta as numbers rather than as the concept of matching the market.

 

6. Active beta – Here Anson refers to long-short funds such as 130/30, where the overall exposure of the portfolio matches the market but additionally there is 30% additional long exposure in favour of stocks, counterbalanced by short exposures in unattractive stocks.

 

7. Bulk beta – This refers to traditional equity portfolio management of the standard type, where portfolios consist of a large element of beta, i.e. market exposure, as well as the ability to generate alpha through stock selection.  

 

Editor’s comments

 

This is not the first time that Markowitz has gone for the CAPM and the use of beta. In late 2005, he attacked the concept of beta and the CAPM as not relevant to the real world, though he did describe the CAPM as a thing of beauty. In particular, he criticised beta being used for risk-adjusted performance (see Investment Management Review, vol.1, issue 4, p46).

 

What is particularly fascinating is that, when Sharpe was awarded the Nobel Prize for Economics for his CAPM, in 1990, Markowitz received the same accolade alongside him for his seminal work in the early 1950s. Markowitz’s seminal research was not regarded as very practical at that time, given the lack of computer power. It was the simplification introduced through Sharpe’s model that allowed modern portfolio theory to take off. It is ironic that it is now Sharpe’s model that is more suspect, whereas Markowitz’s techniques of correlation have more widespread uses across other asset classes, because of advances in computing.

 

On a different note, having done his path-breaking work in the early 1950s, Harry Markowitz cannot exactly be described as young today. What this paper perhaps demonstrates is that his intellectual vigour remains intact, which must be encouraging to baby boomers who want to carry on being productive.

 

Anson has embarked on an unenviable task of trying to introduce order and clarity into the use of the word ‘beta’, which has been highly corrupted since its inception during the 1960s.

 

There are some logical deficiencies in Anson’s classification. His classic beta (1), bespoke beta (2) and fundamental beta (4) are all essentially the same type of beta, but with the market defined differently. There is no conceptual difference, whether one talks about the global Morgan Stanley index, the national S&P, the sector-based banking index, or the fundamental index. It is the same type of beta, with just the index being defined differently.

 

With his ‘alternative beta’ (3), calling a euro-versus-dollar currency bet a beta is stretching the applicability of the concept too far. It is open to even the poorest individual to go into a bank and buy a fistful of foreign currencies. Of course the spreads he has to pay might be different, but it is difficult to justify the use of the word ‘beta’ merely because there is an ETF alternative.

 

Overall, Anson plays a useful role in highlighting the looseness of the term. Previously, beta has been also defined as any process or investment that can be easily replicated.

 

There is possible reason why this looseness in the use of the word beta might have arisen. A beta of 1 is easy to understand and accept as matching the market index, whatever that is.

 

When, however, beta values significantly differ from 1, their validity and reliability have always been regarded with considerable scepticism by many investment practitioners, even those well versed in the theory. Equally it is difficult to explain the concept to many non-technically minded players. Many academics, including even Markowitz, as referred to above, have joined the band of disbelievers in beta in the CAPM sense.

 

Against this background, perhaps it is understandable why so much looseness surrounds the idea, and why many people when referring to beta merely think of beta having the value of 1 in terms of the theory.

 

This is not just an academic debate. It is now common for asset allocators to talk about splitting their fund into two separate portfolios of alphas and betas. Industry-wide uniformity in the use of the word ‘beta’ would be welcome, though perhaps not achievable. Anson has contributed strongly to this topic, the deficiencies of his classification notwithstanding.

 

It’s not just me and this blog that’s back in action but the markets:

Since the bottom in late ‘02/early ‘03, we have seen dips followed by relatively quick erasing of the drawdown. Something as fundamental as poor credit practices looks now to be rather minimal in terms of market effect although 1) we’ll see just how accommodative the monetary authorities remains for the rest of 2007 and 2) we’ll see how the remainder of the year turns out as we’re yet to get the full reporting (latest quarterly earnings from the financial sector, inflation numbers, hedge fund performance numbers).

You’ll note that the dips are getting deeper but the time to recovery seems to be constant. We have V shapes that are only being stretched vertically. I’m a bit surprised that VIX hasn’t dropped back below 15. No forecasts from me now. After hurricanes, subway bombings and credit crunches, this global market has shown resilience that makes me think we’re well into the area where behavioral finance takes over. Kind of has that late 90’s feel (I’ll comment again on this below).

I have not submitted a blog entry since June 21st, nearly three and a half months ago. Is it me, or has it been relatively quiet in ETF land? Not to say that there haven’t been new products launched, there have been … some good and some not so good. But my feeling is that the conveyor belt has not only eased up on its acceleration rate but may have actually decelerated. If this is not true, someone please let me know. But if I’m right, then let’s all give a collective sigh. This pause in product launches should give investors of all types the time to reconfigure their processes to determine their investable universe and even tighten up their actual potential short list.

But don’t be mistaken. This pause is temporary. Although I may have been silent online, I have been in contact with many in the industry. We are going to see more from the big 3 (BGI, SSGA, Vanguard) although I’m thinking that PowerShares should be included in this group soon. However, the more interesting developments will come from the new entrants … some of them you have already heard of and others you likely haven’t. Some will provide exposures “with a twist” to asset classes already covered. Some will provide exposure to new areas of the capital markets.

It is the arrival of many smaller new entrants into this space that will provide what some will call innovation or differentiation while others might simply call (in aggregate) crap. I mentioned before about the feeling of the 90’s. If the new ETFs coming out focus on new ideas … there’s way too many to list so I might go over them one-by-one in future postings … then wouldn’t this new chapter in the ETF story be similar to the dot-coms? It’s simply the transfer of capital to new ideas, some that will work and some that won’t. Most of these new entrants have the backing of VC firms. You have to make your way to them to understand why they think their story is unique (i.e. why they have skin in the game). It’s pretty much the same idea on the hedge fund side. Except the manager doesn’t usually have the backing of a VC firm although they may be involved in some way (distribution). But the hedge fund is also about an idea. Unlike the ETF that provides (hopefully) a new or significantly meaningful market exposure, the hedge fund’s idea is about some new actively managed opportunity. I personally don’t see that significant a comparison with the dot com craze. The anti-ETF crowd surely sees it differently.

In this tough environment where getting paid for risk premium is suspect, it’s no surprise that we continue to hear about the growth of both ETFs and hedge funds. Hat tip to AllAboutAlpha for the latest commentary on this subject from InvestmentNews. Having now passed the half trillion dollar mark, you just have to wonder if the real asset growth of ETFs will be in the tried/true SPY-type behemoths or will the smaller players and new entrants be able to gain significant market share.

An interesting development is the cross border (or in most cases cross-ocean) movement of firms and operations. For example, SPA who is based in Europe have recently set up operations in the US. For those interested in the fundamental indexing approach from the likes of WisdomTree and PowerShares (via Research Affiliates), you’ll want to check out SPA and their fundamentally driven ETFs which are advised by MarketGrader who are based out of the US. I’d like to see this type of development (international operations) continue and the trend lead to more fluid trading of instruments. A good start would be to have NYSE-Euronext allow for a full ETF menu for US and European domiciled funds to be easily traded on a convenient online platform. We must be already headed that way.

I’ll find out additional information on these little tidbits and more in a few weeks at the “World Series of Exchange Traded Funds -West” conference in Scottsdale Arizona. From what I can tell, this should have a similar feel and scale as IMN’s similar event in Miami back in March. However, it won’t be as big as the upcoming “Superbowl of Indexing” which is also in Scottsdale and has more of an institutional investor bent.

For those of you who know me or have communicated with me in the past few months, you’ll know that I focused my attention on finding a new role for myself. My consulting work from earlier this year was meant to be a transition for me as was the blogging. One of the potential avenues open to me is writing. I have been given suggestions by several people about starting up a paid newsletter focused on ETFs. I remain cautious on this as there are a lot of these types of newsletters and there will surely be many more. In New York, I have spoken with a group that is interested in institutional level research of course with an ETF focus. Think I-bank but with an adamant spotlight on independence. One individual suggested that I have a 3-tiered service: free blog; low fee newsletter and top shelf institutional service. I just don’t know if I see myself in the online media business as all I’ve focused on in the past 12 years or so is the management of portfolios. It would be nice to do both (hence the blog), but you can only spread yourself so thin.

So, I have been speaking with a small number regarding possibly joining their organization. Some small, some large. This is where I have focused myself over the past couple of months. The upcoming busy conference schedule over the next few months helps in the networking so we’ll see how it goes. Like Yasser Anwar and various other bloggers who have spent far more resources than I have on their site (with surely more impressive results such as number of visits … mine is certainly a bare bones blog), I have found that as much as I enjoy blogging, the opportunity to turn this into a business is possible but likely not my path. The 3-tiered online service is something I have been thinking about for a while and I now have some potential partners to work on this with. But deep inside, I feel like that that would be a nice place for me to be AFTER I decide to stop managing money.

Let’s face it: This has got to be one of the most interesting times ever to manage portfolios. It’s a low yield world where it’s also harder to find alpha. This has forced sophisticated investors to explore new asset classes and strategies. This kind of thinking is making many market participants attempt to emulate others who are ahead of the pack … have you noticed how so many people online and in the mainstream press are talking about Yale’s endowment? We could certainly be in a point right now where the next ten years will have negative annual average returns.

For me, despite my focus on ETFs on this blog, I’m interested in the broader asset allocation problem. Writing about this just isn’t as much fun to me as compared to actually managing the money. So for now, I’ll put up the occasional blog posting here but hopefully I’ll be notifying you soon about where my career path takes me.

David Hoffman at InvestmentNews.com has the scoop on the news of Rydex being up for sale. He has one story that mentions multiple suitors and then a quick follow up story that specifically mentions again Invesco but also mentions E*Trade Financial.

Invesco makes sense to me as they’ve already started down the path of acquisitions in the beta space with their purchase of PowerShares in 2006. One of the articles mentions that there’s some overlap between Rydex and PowerShares so this acquisition would be a bad move for Invesco. I don’t think so. Rydex focuses on levered and inverse exposures similar to ProShares, not PowerShares which is going after the niche sector ETF market as well as quasi-active strategy ETFs.

Rydex has yet to do what ProFunds has done by creating an ETF-centric organization (ProShares) to go along with its open-ended fund business. Why has Rydex been slow to follow? We know of filings with the SEC as I and many others have discussed the long list of ETFs that are in the pipeline from Rydex. PowerShares has had a fantastic track record of pushing products through the pipeline with very little friction. Maybe the people at Rydex will gain something on that end should this acquisition take place. Another good reason.

Furthermore, I wonder if scale will help both the PowerShares and Rydex families bring fees down. That could help in the Rydex battle against ProShares. PowerShares has multiple competitors in WisdomTree (for its fundamental weighted index ETFs) as well as Claymore and First Trust who both also have interesting niche sector funds as well as quasi-active strategy ETFs. A future pricing war between these firms would signify to me an important evolution in the industry. Saturation would also become a concern in my opinion but I have a feeling that we’re still pretty far away from that, believe it or not.

The tone of David’s last article seems to suggest that the purchase is basically a done deal. I don’t think it’s significant news in the bigger picture but I wonder what the next steps are? Who’s looking to scoop up Claymore or First Trust or Van Eck? There aren’t that many of these lower tier firms to choose from. When I say lower, I mean by assets compared to BGI, SSGA and Vanguard. But there will likely soon be many more new entrants in the ETF provider space. These new entrants will surely bring new ideas to the ETF marketplace as most of the traditional space (broad asset classes, sector exposures, levered/inverse) has been covered. We’ll likely see more target date programs and other “funds of ETFs”. Also expect to see more in the alternative investment space including more in private equity as well as hedge funds. With so much coverage of highs in the S&P 500 and other benchmarks, perhaps the timing of these alternative investments will be right.

Final thought: What if State Street Global Advisors got into the acquisition game? According to this story also from InvestmentNews, SSGA has revised its compensation formula for wholesalers in an effort to focus more on ETF sales efforts instead of mutual funds and SMAs. I don’t think BGI’s shaking over this. There’s a comment in the story about recent strong numbers due to new offerings like their new international real estate ETF. I’m thinking that you put some interesting products in front of the wholesalers and they’ll be quicker in pushing them out the door. Until recently, SSGA wholesalers must have been feeling like domestic auto dealers. Dealer management can somehow try to pay a bit more to sell whatever’s on the lot but if they’re driving an import or have one on their screensaver, you know it’s a losing battle. Maybe SSGA will continue their recent roll of introducing interesting new products (and it’s been good) so it would be unnecessary to even considering purchases. But it makes much more sense than BGI or Vanguard who I don’t see acquiring any of these smaller names at any point in the future.

In the vast majority of my posts, I comment on some sort of industry event whether market related or product related. At times, I might throw around some industry jargon without much thought as to who’s reading this on the other side of the wire. I have always assumed that anyone interested to peek into “The Beta Brief” knows what beta is all about. On more than one occasion, I have commented on the difference from what I believe to be “philosophical alpha” versus “statistical alpha”. There is no such dichotomy in beta. It’s just the market. Well, even that is being rethought and I’ll get to that at the end. But to simply define beta as “the market” may be considered as being too vague so I’ll try to take small steps in providing greater clarity on the field of portfolio theory and, more specifically, beta.

Warning: Once you start digging deeper into the following readings, you’ll quickly see that a basic understanding of algebra and statistics is required. If you’ve taken any sort of college level stats, you’re fine. One of the main things you’ll have to understand is regression analysis. Basically, by plotting one set of sample data (say, returns for a stock in a particular month) with another set (say, returns for an index in each corresponding month), you can plot the corresponding points on a Cartesian plane, the x versus y graphs that you likely spent a lot of time playing around with in high school. If there is any sort of pattern between the two groups (not necessarily proving causality) then this will be provided mathematically with a “best fit” straight line. From, high school algebra, we know that the formula for a straight line on the x-y graph is:

y = mx + b [Equation 1]

You may have also learned a variation of this which is:

y - y1 = m * (x - x1) [Equation 2]

which can be manipulated to solve for m as:

m = (y - y1) / (x - x1) [Equation 3]

In equations 2 and 3, the “number ones” should be subscript but I hope you get the point. The x1 and y1 are the x and y coordinates for a specific and unique sample used in the regression analysis. I recall first learning of slope (m) as rise over run, or in algebraic terms “delta y over delta x” which is mathematically shown in equation 3.

This is the most basic of introductions. The key is that it’s equation 1 that we’re trying to find based on a sample set of data. For our purposes, it will usually be returns data for a securities and index. But all you really have to know is that m (the slope) is your beta value using regression analysis. The intercept of the best fit line to the vertical (y) axis is your alpha value and is represented by the letter “b” in equation 1. The calculations involved in regression analysis are important to understand but thankfully, in today’s world, anyone with a spreadsheet program can calculate beta and alpha on their own. For example, MS Excel has a built in “Data Analysis” program and within it is a regression analysis program.

Now the theory. And it goes way (WAY!) beyond the above. Here’s a small list of free online sources of information related to portfolio theory and, where possible, specific discussions related to beta. If you know of more, please send them in as part of a comment to this posting. Thanks.

For the most novice investor who has never read anything on portfolio theory, these might be a good place to start as they’re rather short so they’re easy to digest in one short sitting:

These are all taken from the same source, RiskGlossary.com, which covers many terms in portfolio theory, but I have arranged these in order that I believe provides a logical sequence of order:

1. Portfolio Theory

2. Capital Asset Pricing Model (CAPM)

3. The Market Portfolio

From #2 above (on CAPM), it introduces the term “Systematic Risk” as:

Systematic risk is the risk of holding the market portfolio.

#3 above briefly discusses the term “Market Portfolio”. This then leads to …

4. Beta

According to this, beta “measures the systematic risk of a single instrument or an entire portfolio”.

The above material is written in as concise a manner as I believe is possible. For a more expansive and thorough explanation, consider this lecture which covers a large area of portfolio theory including a discussion on beta.

This lecture is part of an eight part introductory investment theory course at Yale’s School of Management. The entire set of course notes are available online here. You can thank me for forwarding this to you, but an infinitely bigger thank you needs to be offered to Professor William Goetzmann and the Yale School of Management for having this all available for free to the public online.

I was also able to find this useful treasure trove from the MIT website. For those so inclined to dig deep into various fields of academia, you can literally get lost in time with MIT’s OpenCourseWare website. Pertaining to this blog, you will find this set of lecture notes for a class simply called “Investments” worth reviewing.

Class #6 covers CAPM and discusses beta. For those so inclined (and with at least some college level math), it’s not a bad idea to go through lectures one through seven for a thorough review of portfolio theory. For those who are not so confident in their mathematical abilities, I’d focus on the notes from Yale carefully and do your best following up with those from MIT.

At the beginning of this post, I mentioned that “beta is the market”. The problem is that the traditional form of beta, based on CAPM, is being distorted by new developments in the indexing world. Such recent developments have brought forth terms such as exotic beta and alternative beta. I don’t want to dig too deep into this but I believe these terms still need time to get a general level of acceptance in terms of standardization. Not all individuals in the industry agree on their definitions. I have always seen exotic beta as the beta for any asset class that is considered to be beyond that of the stock or bond markets so this would include real estate beta and commodity beta. Alternative beta is any form of duplicable return process and truly straddles the line between pure beta and pure alpha. For example, are the new fundamental weighted indices used in WisdomTree and PowerShares’ ETFs truly beta or some alternative beta? Similarly, many hedge funds, in this case I am specifically questioning those that are mandated to a beta-neutral objective, have returns which are not entirey driven by alpha but also by traditional beta (CAPM) as well as alternative beta. I know, this new world of “funky” beta can be confusing so I will only now refer you to two other bloggers who have already ventured into explaining these areas … very well I believe. I will likely revisit this discussion as it’s an important one not only for The Beta Brief but for the ETF and hedge fund industries on an ongoing basis.

Here is one hedge fund participant and blogger’s attempt to define and analyze these betas.

This blog also gets into exotic beta.

Happy reading!

As this is my first posting on the SeekingAlpha blog network, I’d like to first thank David Jackson for the invitation to be a contributor. I’ve followed Seeking Alpha since its beginnings and have a lot of respect for those who provide the write-ups on a continuing and periodic basis. Hopefully, I can add some worthwhile input of value to readers.I’d like to give a bit of background on myself as a set-up for a variety of issues that I hope to get into greater detail in the near future. I started in the industry working in an investment firm whose primary business was tactically trading North American equity index futures. We’d be either 150% long, 100% short or cash.

The business expanded to include US equity long-short portfolios. In this case, we basically had to be fully invested so when we couldn’t fill in the gaps with stocks, we used ETFs (specifically SPY and QQQ). We were also briefly involved with principal protected notes with underlying fund-of-hedge funds. I learned most of what I know now of this industry during my six years at this firm.

After bouncing around for a few years thereafter, I co-founded the company I now run, Toronto-based Meridian Global Investors. Our focus is on broad global asset allocation (more strategic than tactical AA) with a strong bent towards alternative asset classes, although not necessarily hedge funds. Implementation for nearly all asset classes are through ETFs, derivatives, and certain passive oriented funds such as those provided by Dimensional Fund Advisors. However, we do have some stock and bond selection although in a very limited manner. Basically, if we can use an ETF or similar instrument, we would prefer that but we would never allow our investment process to be bound by rigid policies. We are primarily retail based now but are beginning the process to move business development efforts to the institutional side. Our process is highly risk measurement/management oriented to provide performance that best controls volatility.

So here’s what I hope to provide readers of Seeking Alpha:

· Thoughts on specific strategies using passive instruments.

· Thoughts on specific ETFs, closed end funds, index options and futures and index mutual funds

· Thoughts on the art and science of risk management, specifically what I believe to be the holy grail which a lot of institutions are trying to build for themselves – the risk budgeting system.

· Thoughts on the so called “new paradigm” in investment management which involves the separation of beta and alpha. The terms “portable alpha” and “alpha transport” (they’re synonymous) are viewed by some as a marketing ploy while many truly see this as the future of institutional money management. Will this new process improve problems with pension liabilities? Can (and should) the process be applied to the retail investor?

· Thoughts on the pension crisis and whether this new paradigm will offset: 1) the growing number of pensioners (who are dying later while often retiring earlier) and 2) the disproportionate ratio of paying working contributors to retired pensioners in most plans (numbers look bad, but the trends look worse).

· Thoughts on some of the more innovative institutional investors and the pros/cons of what they’re doing versus the more traditional institutions.

· As a mirror to the pension crisis, thoughts on retail investing and the battle between traditional actively managed mutual funds and ETFs/index mutual funds. Also of interest to me is the retailization of hedge funds especially through the use of structured products and specifically principal protected notes.

· Thoughts on broad global geopolitical and macroeconomic issues that we are looking at and how it has lead to specific position views.

There’s a lot of varied and interesting writing going on in Seeking Alpha, so I know that a lot of what interests me will have some broad overlap with other contributors. I only hope that my input creates some discussion (and even some debate which I think is healthy exercise for the brain of every investor). Lastly, I hope the readership finds a similar amount of interest to mine in these issues.

FYI: My firm is currently at a defensive stance. With an overweight position in cash for all of 2006 (allocation due to an underweight in bonds) plus put options on DJIA and TSX 60 (Canada) implemented near the end of April, we are about as defensive as we can be due to investment policy constraints. Broad equity index exposure is at roughly at its median weight but with higher exposure to international equities, especially east Asia/EM in lieu of low exposure to US equities. Alternatives are relatively high which includes commodities (fully in gold and energy as well as some alternative energy), infrastructure and some timber. We were right with the high cash, low bonds and put options but the equities (especially international/emerging markets) and alternatives have hurt us.