That’s a broad title that can lead in so many directions.

The world today looks like we’re heading towards another two super-power situation.  Consider economic and political influence, voting on the UN security council, acquisition of oil, the space race, and even the medal count at the coming Olympics … there are a lot of themes that demonstrate the power of China, even relative to the US, and perhaps that’s one of several reasons why China is attracting plenty of foreign investment.

Before I get into a rant that leans in a fairly anti-US bias, I first want to preface this with the fact that I honestly believe that Zakaria’s comments on “the rise of the others” versus the decline of the US seems spot on.  The creativity and innovation of the US, and of course the developed world, will slowly have to compete with those from the emerging world.  But it will be some time coming in my opinion.  Since I focus on China in this post, I’ll give one example care of my cousin Grace who’s doing her grad work in that region.  So on her blog (runs in the family), she has a post showing this visual instruction for spectators to the upcoming Olympic games:

I should be like Jeff Matthews of famed “I Am Not Making This Up”. So Grace gives props to the BBC for sourcing this and here’s the accompanying text for the genius graphic:

Beijing Olympic chiefs are introducing an official cheer for patriotic spectators to spur on Team China at the Games, Chinese media reports.

The authoritative, four-part Olympic cheer, accompanied by detailed instructions, will be promoted on TV, in schools and with a poster campaign.

It involves clapping twice, giving the thumbs-up, clapping twice more and then punching the air with both arms.

The cheer is accompanied by chants of “Olympics”, “Let’s go” and “China”.

The Beijing Olympic Organising Committee has hired 30 cheering squads who will show spectators how it is done at Games stadia, reports Xinhua state media.

Say wha?  First, China is so NOT totalitarian since they won’t even have the masses practice before hand with drills.  Why not go full North Korean and have 25,000 people do that fully orchestrated “all in unison” song and dance that’s likely choreographed by the same person who gets 25,000 soldiers to march in unison each lifting their foot to the exact same height.  Scary in that “Brave New World” kind of way and all joking aside we can only hope some type of reform similar to what we’ve seen in China happens one day for North Korea.  Sadly there’s little to no chance they’ll do it on their own and given what’s happened to them over time (even before the Korean War) it will be a real challenge for them to move towards a world of partnership as opposed to isolated self-reliance.

But clearly, going back to the China graphic above, China still has a bit of North Korea old school in it and is still about hardcore conformity … it’s only a relative few who are taking hold of the new world and taking advantage of opportunities that result in tangible benefits for themselves.  It’s the creative/innovative class of the younger generation in the emerging world that will be the ones to watch.  Take a look at elite grad schools and note the demographics compared to ten and twenty years ago and you’ll get an idea of the growth of this new group.  Books are written about the billions in China and India and the demographic weight they impose is undeniable.  But it’s the future Gates, Jobs, Page/Brin to watch out for.

If the US is to really lose its place as the economic power, the rest of the world will have to compete in a manner where people try to copy their software, gadgets, and certain lifestyle attributes.  We’re nowhere close to a world where automakers try to copy the latest vehicles out of India.  They’re probably copying German not US auto designs but it’s still about the domination of the West.  How long will it be until China is designing the latest “iPhone of 2007″ Jesus Phone with the US leeching on with a fake?  I’m thinking not in my lifetime.  Maybe not.  Perhaps the blockbuster will be some YouTube, FaceBook, high intensity website that catches on fire like no other before it.

Well, long journeys begin with one step and clearly China is on an ambitious to its road to dominance.  They may not be the significant innovators until much later but in so many ways, they will be influential.  Of course, the trick for investors will be dealing with the bumps along the way and in today’s world the reality is that it’s all about a rather indirect manner to gain exposure into China.  For now, the easiest path is indirect investment via a closed end fund, mutual fund, ETF or hedge fund.

But I can’t help recalling one of many (MANY!) presentations on China I’ve attended in the past year where this gentleman (honestly, I can’t remember his name) was concerned about investing in the iShares FTSE/Xinhua China 25 Index ETF (FXI) since the underlying firms were controlled by a few people.  I’m paraphrasing but his point was clear and simple:  the Politburo controls virtually all the companies in this ETF.
Before the commentary, here’s a 1-year chart:

That’s about an 85% climb to nirvana over a two and a half month period last autumn.  Unfortunately, that’s about a 40% ulcer for the period thereafter that has dragged on for what must feel like years for anyone long FXI.  No wonder ProShares is having the time of their life with FXP and many of their other inverse ETFs.

So back to the Politburo which I still recall was the term used in the speech.  I’m no political scientist so I have no idea if the term applies for China as it did with the old USSR.  For now, I’ll assume that the situation described may still be true but given the latest helping hand from the Fed/Treasury Department/White House, you have to wonder.  The writers at Barron’s definitely have in this article with the sub-title “Socialism takes hold in US finance.  Get over it.”

We all know what’s happening and after Bear Stearns, this looks like chapter 2 of what could be a long story revolving around US policymakers adding band aid after band aid on a body that needs to bleed and perhaps follow up with a transfusion.  I thought I was decent in the art of metaphor but Randall Forsyth sets thing out clearly:

Even so, the descent down the slippery slope of socialization of the financial system is gathering speed.

“Capitalism without failure is like religion without sin,” Allan Meltzer, the distinguished economic theorist and historian once wrote.

Yet, like it or not, we don’t want to deal with such harsh verities, either in religion or the marketplace. Traditional churches are losing out to TV evangelists who promise material rewards now rather than later.

Forsyth concludes that we’ll see the pendulum swing back to increased regulation which shouldn’t be a surprise especially if the Democrats take over.

But the irony will be the trends taking place in both China and the US.   I seem to observe that they’re moving in opposite directions.  China is wanting to move into a dominant two-power global paradigm with the US as a capitalist powerhouse.  The US is on the defensive trying not to lose ground (influence).

It’s always funny when the US government comment on how bad the Chinese do things.  In the past, comments on the manner in which certain areas are treated or marginalized are retorted with Chinese counterarguments as to the manner native Americans or various other visible minorities are discriminated against.  It’s the same as the nitpicking both sides have with the other related to votes on the UN security council.

But today’s scenario is a juicy one for China.  The US government has often criticized the Chinese over various economic policies (currency, trade, commodity deals with foreign despots) and keeping a too-firm-hand on the wheel.  It’s almost too easy to respond with Bear Stearns, Fannie and Freddie.  It’s down right silly when Wall Street takes their show on the road to ask SWFs “Can you spare a billion?” and I wonder if they’ve come knocking on China Investment Corp?  Oh, wait a second … Morgan Stanley.  It’s so hard to keep track these days of all the SWFs and commentary regarding their dealings with Wall Street I-banks and the sense now is that the second wave of deals should be starting soon.

I leave you with this final chart showing the two most popular ETFs for the US and China since October 5, 2004 (inception date of FXI):

Quick note on FXI:  Don’t be fooled.  Of any asset category, it’s the China ETFs that differ from each other the most so selection criteria is critical in this niche area.

I state earlier that these two nations seem to be moving in opposite directions.  One is on the offensive while the other is on the defensive.  It’s a tough call to simplify things to the point of “buy FXI and short SPY” but in the longer term, how many investors are thinking about this?  From the SWFs point of view, it looks like it’s buy their buddies in the emerging markets but also buy the US … or at least financials at fire sale prices and with preferrential treatment in terms of yields.  The diversification story may be boring but owning some of both countries would make a ton of sense … the only difference among investors based on volatility and personal beliefs is what proportions.

A couple of weeks ago I was invited by the guys at “The Market Traders” to join in on their weekly roundtable podcast as one of three guest panelists.  If you check out their site, you’ll see that they’re big on commodities.  Possibly a bit more of a speculative bent to their site with ads that make me think that it’s a place where stock pickers come to congregate.  However, I was surprised to find that I wasn’t the only one commenting on ETFs and my fellow panelists didn’t really spend a lot of time discussing specific stocks although a few ETFs were mentioned (not just by me).

We basically comment three times:  Once on energy, the second time on the US dollar and finally with thoughts on areas of the market that we like.  Some who have followed my writings and have become accustomed to the way I do things might be a bit surprised by my final comments.  I basically state in explicit terms how I don’t believe now is a time to think like a traditional asset allocator.  I don’t think now is the time to stick to the “60%-equity/40%-fixed income” strategic asset allocation model.  Frankly, to have a “buy-hold” mentality all of the time requires a stomach of immense fortitude.  (What you are hearing now are people from Vanguard and DFA squirming in their chairs.)  Does that mean I’m leaning towards market timing?  On the spectrum, I don’t think I’m at the far end which is market timing, but I’m certainly not at the buy-hold end.  I’d like to think that the “strategic asset allocation” process which I think is so important (cool with that Vanguard/DFA?) should, in this environment as well as others, be allowed to deviate in two ways:

1.  Allow for some tactical asset allocation.  That may mean allowing min/max constraints for asset classes to deviate even more from “home” or what may be defined as the policy allocation.  That may also mean allowing the asset allocation shifts (rebalancing, delaying implementation of cash equitization, etc.) to happen a little more frequently than normal.  This allowance for tactical decisions could actually mean several things but generally I’m saying that I believe some allowance for deviation from standard asset allocation protocols is warranted.

2.  Allow for exposure beyond the traditional asset mix.  This means to make sure that alternative investment exposures are in place.  Is it too late today for gold, oil, agriculture and other commodities that seem to be getting all the attention these days?  They’re volatile (and I believe, getting more volatile) but their diversification properties are undeniable.  Caveat:  I’m talking about exposure to the commodities via ETFs, ETNs or derivatives, not indirect exposure via equities (like gold producers).  I don’t think it’s too late to get into infrastructure and other inflation hedging asset classes and the only question is how much of these alternative asset classes is warranted as a buffer to the core of traditional asset classes (stocks/bonds/cash)?

Buy-hold philosophies for multi-asset class exposures made a lot of sense for anyone from the period of 1980 to now.  The only major hit was 2000-2002.  The big question I ask myself is whether we are still in this secular up market or did that end one year ago.  In other words, are we in a sideways or down market that has the potential to be anything as bad as the 2000-2002 bear market?  My sense is that for broad regional market exposures like the S&P 500 the answer is likely to be yes.  However, for various sectors and foreign exposures, I feel confident the answer will be no.  We’ve come out of an environment where nearly everything did well fueled by a world of cheap money.  That doesn’t mean that the pendulum will swing causing nearly everything to plummet.

A very important consideration is also the role of private equity and hedge funds given my comments above on the importance of alternative investments.  I can’t stress this enough:  As much as I am a fan of passive instruments, I’ve never said that one should completely disregard active management.  Is it hard to pick the successful managers ahead of time?  Yup.  Do they cost a lot.  More than ETFs and mutual funds but if you’re finding non-correlated returns, they should cost more.  The key question in today environment is what proportion of your portfolio do you want to allocate to market risk and how much to manager risk?

That one takes a bit of time to sink in once you really think about it.

Then you have to ask yourself, is it possible that regardless of which way I choose, it’s likely that the result will be very similar?  In other words, you put all your money in one of two possible portfolios:  All ETFs or all hedge funds … and the result is both go up or both go down!  Of course it’s possible that these portfolios go in opposite directions but that’s what we would expect and that’s why we assume the active-passive proportion decision is important.  But if they go the same way, then we’re likely to lose faith in what we were promised by someone.  The passive route promises very little.  The returns are what the markets provide.  It’s the active route that promises quite a bit more … sometime more than what was provided.  The real bummer is allocating significantly to private equity and hedge funds hoping that they will provide a buffer to the traditional core portfolio of more liquid positions but not reaching that result.  In other words over-promising and under-delivering.

Today’s deleveraged environment provides opportunities but an ever changing landscape for investors travelling the PE/HF path, some good and some bad. We hear of pension funds allocating more and more to many alternative asset classes and strategies.  I wonder if they are pleased or disappointed with their results.  Are the fees worth it?  Are managers providing alpha?  Is the illiquidity constraint more than they bargained for?  Were they too late in making asset mix shifts?  Have they improved their asset/liability situation?

Everyone is talking about credit problems (mortgage, auto, credit card) and the various tentacles of the US economy that are breaking down.  My sense is that it could be as dire as some are stating but the press is likely doing a decent job of sensationalizing the story.  But what about the pension landscape?  Low interest rates plus negative market returns of the past 12 months are bringing us back to the asset/liabiility mismatch situation we first saw during the market slide of 2000-2002.  Are these funds doing so well with their portfolio returns that the relatively low interest rate environment is not causing havoc to their books?  Is this yet another cause for concern for the US financial “infrastructure” landscape?  So many questions and I only wish I could provide simple yes or no answers.  Then asset allocation would be like ordering a pizza.

Despite the volatility we expect to find in international markets and especially in the so-called “developing and frontier markets” (I’m very much not liking those names anymore) there are so many reasons not to have anything but minimal exposure to the US whether it be equities, fixed income or dollars.  Fareed Zakaria’s commonly cited view that one must notice it’s not “the fall of the US” but “the rise of the rest” is important.  It’s important for investors because there’s a parallel to a shift in asset allocation that will surely happen … and it’s already started.  Just how much is an appropriate allocation to the emerging markets?  Defining what is or is not an emerging market or frontier market or even developed market would help in answering this.  But just as important, I believe that the simple move away from “home biased portfolios”, driven by an acknowledgment that intelligent/selective global diversification, is a necessary move in what is likely no longer a simple long-term up market.  Diversification may not be what it used to be, but along with compound interest, it’s one of the very few free lunches we investors have.

Put another way, imagine you are one of the sovereign wealth funds that the press and politicians seem to enjoy commenting on these days.  Recent allocations of these funds to western financial conglomerates (investment banks in need of capital and quickly) is a move to use some of their US dollars to buy relatively cheap assets that will provide some yield (surely negotiated to be better than what others are getting) as well as a buffer to their home grown commodity exposures.  I spend a lot of time thinking about what else is on their shopping list to diversify themselves away from existing commodity and US dollar related risks.  It’s the same exercise any investor should have with their portfolio and the positions held within it.

I’m surprised that it’s only now that we’re starting to hear the term “contagion” used more often in the financial press about the current predicament seen globally and especially in the US. Over the past couple of years, I’ve mentioned in passing to different people my concerns regarding the economic outlook of the US. The way I see it, the typical American consumer (”super consumer” may be more appropriate) who is feeling the noose tighten from their mortgage obligations could soon make decisions that would have an effect on other forms of credit. Car payments are one area. We’ve seen GM trim operations yet again and with good reason … why would any sane person by a Hummer? I doubt that the typical buyer of an H2 has child seats in the back row and strollers folded behind them. That large demographic of young families would likely buy a minivan, smaller crossover or wagon. I can see the benefits of a pickup truck for many buyers but there’s a large group of models from the domestic automakers that simply have to go given that their target market is so small. High gas prices is just the final reason to adapt and the rationale for GM to make such maneuvers now while the Japanese and Korean automakers seemed to figure this out at least 5 years earlier gives good reason for top management in Detroit to be given the boot. Perhaps management wanted to take action long ago but government incentives and strong union action simply delayed the inevitable.

The real credit concern I have for Main Street however is when mortgage and auto related obligations lead to greater use of credit cards as a safety net. Maybe it’s just me but “credit card” and “safety net” are opposites. About as far apart “opposite” as Stephen Hawking and Homer Simpson despite their link to quantum mechanics. Yet, what are their options? Bank loans will be clearly harder to come by. Methods of the past such as home equity loans are no longer available. We’re quickly in a different world. The pressures to consume will have to be restrained but I’m no sociologist and I only wonder if the real fear of “losing it all” will curb spending patterns. I foresee trouble with auto loans affecting the domestic auto industry as similar problems with credit cards would affect Walmart, restaurants, leisure/gaming/travel and so many components of the economy. Banks will try to stimulate spending just like homebuilders are now pushing “buy one house get one free” deals. At the end of the day, I think it will be market forces that hit the consumer with the final blow of reality. Unfortunately, I feel like mortgages are just the beginning. It could be the first of many domino trails that fall in sequence and all we can do is watch. It’s the growing social fear that should help in increasing the average savings rate even a little which I think is all we need … nothing too drastic. Or maybe I’m just keeping expectations in check.

As an aside, I should add that the consumerism of North America is clearly growing globally to other markets. It’s not just Dubai but major centres all over the emerging world be it East Asia, the Mideast, Latin America or Russia/Central Eastern Europe. We’re hearing constant reminders these days of rising food, fuel and housing prices globally and this includes the developing world. Yet there is simultaneous high growth in the sale of luxury goods. Hand made Swiss watches, Italian cars/motorcycles, designer handbags, cigars … the necessities of life I suppose. Or you’d think that by visiting these regions. There are some neighborhoods in large North American cities dominated by high end automobiles. However, I’m always surprised at how this pales in comparison to what I can only say are the new centres of influence around the world. Dubai was a bit of an eye opener but now I’m interested in seeing what Moscow is like. Of course, the spread between the “haves” and “have nots” is very significant in the developing world but it’s surprising just how wide the disparity is. But all things eventually swing back the other way. The typical middle class US consumer will learn to adapt just like the typical Japanese worker figured out that the concept of lifetime employment with one organization is over.

So what other areas of the credit space will hit the everyday consumer not just in the US but for the growing “big spender” global citizen? Like auto loans and credit cards, each of these other potential chain of dominos are all part of a growing credit contagion that would have far reaching implications to the capital markets. To what degree and for how long, no one can say now and the economists will have to build new models to figure this out. I wonder if the parallels to the depression era will continue and be a basic assumption in these models.

Since this is “The Beta Brief”, I’d like to link the above commentary to the industry of beta oriented instruments. Both the ETF and derivative markets will have to be less US centric and gain further access to international markets and especially the developing world. Perhaps we’ll see the same result of redundant product offerings. With all the unnecessary, overlapping exposures in the ETF space that are especially focused on the US equity markets I can only assume that many of these funds will close down or merge. At this point, the recent closures at Ameristock of five Treasury bond ETFs in addition to those from Claymore a few months earlier are a telling sign of the excess of product growth that has been a defining story in the relatively short ETF saga. Well, it’s actually about 15 years. But if the writings of Fareed Zakaria and Mohamed El-Erian give insight into the future significance of the US economically and politically, the real attention of investors … and ETF providers … should be internationally. In the US, there are just about enough ETFs available to establish any sort of international diversification by region/country, sector, market cap or theme with very few holes remaining. However, we certainly don’t have that full availability of products in other jurisdictions. It may never get to be as crowded elsewhere as it is in the US now. It’s just a matter of time before the ETF industry expands in a more robust way to other parts of the world.

The current volatile environment with strong up days like yesterday (June 5th) but with even more down days does not seem like the best of times for passive instruments except perhaps for levered long and inverse exposures … basically, derivative markets and ProShares ETFs (I know, there are other providers now with levered long and inverse ETFs aside from ProShares and Rydex). The past year has been the time for hedge funds. Like the bear market of 2000-2002, we should see many hedge funds, but certainly not the majority of them, perform well but many investors in them come away somewhat unsatisfied. My guess is the final result in this downturn will be even less palatable for the vast majority of investors in hedge funds. Of course, those that do find success will have it big. It’s black swans and higher moments to the extreme. But I wonder if the strength in the ETF market which took place since 2003 was the result of investor dissatisfaction with the performance of active managers during the preceding market declines. And if so, will there be the same result at the conclusion of this rocky period?

The chart above would provide a more useful picture if the vertical axis was logarithmic. However, we can see that the current market declines of the past 11 months or so are still relatively small in comparison to what occurred earlier this decade. The same is true for the DJIA and the Nasdaq as well as international markets.

Who knows what the maximum drawdown will be from the highs of July and October ‘07? I’m starting to think that we might be in a longer term sideways market where the S&P bounces somewhere between 1,200 and 1,600 for a few years with continued high volatility … again, hedge fund heaven. If we have anything close to this scenario in our highly synchronized global market - well, actually anything other than a strong bull market like we saw from early ‘03 to mid ‘07 - then this should be a great time for active management as opposed to passive. In this scenario, passive management will be seen as something for old “has beens” and we’ll hear the same arguments against indexing as we heard in 2002. However, I think that the ETF industry has become, and will continue to be, less about buy-hold and a Vanguard-like philosophy but rather about the use of passive instruments within active strategies. Deb Fuhr (formerly of Morgan Stanley … anyone heard where she’s headed?) recently came out with a report noting that hedge funds are the 2nd biggest users of ETFs after financial advisors. Clearly, the active trading of ETFs, like it’s been in the derivative markets, will be hot and I see a growing list of managers of all types employing the use of ETFs in addition to single securities. I’m surprised how many managers I find today who use ETFs only within highly active mandates.

Funny enough, I hear these managers asking for more product related to foreign exposures and more niche offerings. It’s exactly where the industry has been headed in the past couple of years. We can see evidence of this with the continued success of ProShares and their move to foreign markets. Their levered long and short exposure funds are catered to the active investor. For those of you who are wanting some similar instruments that access certain commodity markets, ProShares manages ETFs for Horizons BetaPro here in Toronto providing long and short exposures to gold, oil, natural gas and agricultural grains. [Note: This isn’t a recommendation in any way. Just pointing it out to you.]

Like the Asian contagion of ten years ago, this is a time of serious crisis providing opportunity for the most active of active managers to shine. The long-term oriented investor will have to conduct a serious gut check to determine how their asset mix pie will deviate, if at all, should they consider the next five years or so to be anything but an up market similar to the past five years ending this past December. Another term making the rounds in the financial press recently is “depression”. Since I don’t see the US economy or the world as a whole going down to that degree (one of the reasons for my view of a sideways market over the next few years) the only form of depression I find applicable today is that related to mental health given the fear and then realization that the “American Dream” for many might be delayed and unfortunately for many more in the middle class, quite unattainable. This sad situation applies globally due to the spread of this credit and liquidity crisis beyond the US. However, the real key problem is the US. Fareed Zakaria’s article notes that the global shift we see today is less about the decline of the US and more about the rise of everyone else. His argument make sense given its lead in innovation, among other advantages, that come out of the robust economy that is the US juggernaut. But it will be the resiliency of the US consumer (along with their government and central bank to assist them) and their ability to adapt to this credit/liquidity crisis that will determine the course of things to come in the next few years.

For the most basic investor, the simple hedge might be increased allocations to international and especially emerging market exposures via decreased US exposures. That likely won’t be enough though and the importance of alternative investments, skill in picking successful active managers ahead of time and the ability to wrap this within an effective risk protocol might be what’s required. It’s a tough world.

Just got back from yet another conference and no surprise it covered the current hot topic: commodities.

Speaking of hot, this event was in Dubai. I’ve experienced some hot and humid conditions in my life in places like Manila, Seoul, Singapore and Hong Kong. But this was by far the hottest climate I’ve ever experienced. It was a dry, baking heat. When outdoors, finding shade helped and certainly the buildings had great air conditioning. But, for example, I had my cousin who lives in the city take me around the gold (souk) market. Getting out of the car into the sun was incredible. It felt just like a dry sauna. And they say it’s just the beginning of the hot season! Luckily, the hotels, office buildings and shopping centres are all so luxurious that climate does not have to be a concern. With most taxis I rode in being a Lexus, you get a sense of what this city is about. Never mind the Burj Al Arab hotel, indoor skiing and other obvious signs of excess.

A quick comment on the souk. It’s all about gold there. Prices are quoted daily and there are people buying. I wish I was in Dubai six months ago and a year ago to get a handle on the number of people transacting. A good sign was at the retail section of the Dubai airport (departure section). They had a gold merchant right at the centre when you pass through the last security checkpoint (I think my carry on luggage was scanned only twice which is hopefully enough). Unlike the real souk market which was not empty but certainly not busy, this place was packed! And people were really buying. They didn’t look like momentum traders nor supermodels but everyday travelers. Maybe they know that gold is back to where it was near the beginning of the year:

Or more likely, maybe they new better than me than to take the heat and walk the outdoor souk.

From the moment you cruise into Dubai International or drive into downtown, you can’t help but notice the construction. It beats Las Vegas, Miami and other real estate bubble regions of the US. It kind of reminds me of Seoul when I first went there as a youngster in 1979. My bet is that Dubai will want to host an Olympics … but they’re held in August and if that’s still the hot season I just don’t know who could survive the marathons, triathlons and other outdoor events. Still, you can’t help but sense the feeling of ambition in Dubai. For some reason, a lot of the new buildings going up have the number of floors in the triple digits. Excess is a relative term when you’re in Dubai. The sense on the ground is that the construction boom is in full throttle but not anywhere close to the bubbly stage. But I can’t get my mind off the fact that a lot of the construction is done at night when the temperatures are simply cooler. It’s the endurance of the migrant workers who have the day shift that I find quite astonishing. Think of the pyramids in Egypt and the Yucatan, the Taj Mahal and other larger-than-life structures and the same can be said for the city of Dubai. The super-skyscraper “Burj Dubai” was front and centre from my hotel room window. I can’t remember and certainly could not even count the number of cranes working throughout the day and night when viewing the skyline. Part of the view is filled with very unique and certainly luxurious looking buildings, but among them were cranes working on competing structures. The success story that is the UAE is of course based on the decision of its leaders to diversify beyond oil. But the structures we see being built today, like the pyramids of the past are built from the labors of a massive force that are too often left forgotten. I think that in today’s world when we think about gold and oil, the supply/demand imbalances are often cited as being driven based on what’s happening in the emerging world. That’s certainly true, but the commodity that is labor is certainly a key factor as well and you can see that when driving by any construction site in Dubai. Of course, think of the factories in coastal China and the low cost IT worker in Bangalore and you quickly get the story of the emerging markets.

An important point to make on this is the importance of the success of the emerging markets in aggregate. It simply has to happen. Jeremy Siegel at Wharton wrote a paper in the September 2007 Financial Analysts Journal titled “Impact of an Aging Population on the Global Economy”. To summarize one of its key conclusions I begin with a simple fact: The western world is aging and it can’t eat its financial assets during its retirement stage. Much has been said of an equity market depression should the boomers sell their equity investments as a whole even if it’s spread out over several decades. Siegel’s paper articulates the fact that the growing middle class of the emerging world can be a very significant group that buys these financial assets. As individuals, they may not have much residual assets left for savings and investment, but in aggregate the numbers can and likely will be in their favor. This logic makes sense and our only hope is that the typical worker from the emerging markets does not go berserk with their discretionary spending and adopt a savings rate similar to many in the west. Furthermore, we have to hope that the western world does not adopt a protectionist stand. We see the beginning of potential trouble already. How do most Americans (never mind their government) feel about some sovereign wealth funds buying significant parts of major Wall Street financial conglomerates? What about if the same happens to media firms, utility companies and certain defence/high tech firms? Much of Western Europe isn’t happy with the rising growth of mosques versus churches across the continent. Will religious as well as racial discrimination hamper the transfer of wealth, and as important, capital investment? I think that the factors driven by demographics are so strong that any reasonable person or society will figure out what measures are required in order to survive. Unfortunately, the short-term horizon of politicians often conflict with this simple assumption.

Getting back to this commodities conference, the overall turnout was a bit of a disappointment but what was especially poor was the level of institutional investors in attendance. I couldn’t find one. Luckily I had meetings set up for me prior to traveling or this would have been a rather uneventful trip. One observation that I made was the fact that despite this being a commodities event in a growing part of the emerging markets, on day one of this conference all sessions except for one made some reference to indexing, passive investing or the use of ETFs. I did not attend day two and so I can only wonder if this fact remained true. Now I know that most of the discussion revolved around the active use of ETFs and/or derivatives but this still strengthens my case that the ETF story is not only strong but expanding globally. I think that the saturation we see today in the US will grow to many other regions. However, it’s still early. Today, there are no ETFs domiciled in Dubai. Great fanfare has been made about Dubai as the financial centre bridging the time gaps between the financial centres of Europe and East Asia. It will only be a matter of time before Dubai becomes a hub for derivatives and ETFs. From my travels, I see a parallel between ETFs (or financial services products in general) and airports. The US and Europe are full of busy yet aging airports. The emerging world is now making waves about their fancy new and relative large airports, albeit in much smaller numbers. I think the ETF industry will expand to these same regions with a few but relatively large (by asset levels) offerings in the not too distant future. Who knows what the expansion will be like thereafter. I don’t see a duplication of what has happened in the US but perhaps something fairly close in a few markets. We’ll see how the BGI’s, SSGA’s and other ETF providers do in entering these markets to compete with the local providers.

By the way, I’ve mentioned that the ETF industry within the region is still sparse. However, we’re not much better here in North America. The SPDR S&P Emerging Middle East & Africa ETF (GAF) is all we have now.

Not exactly the greatest diversifier but the high correlation story is one you’ve heard from me enough times I’m sure.

An interesting tone I sensed at this conference and confirmed at my meetings was some urgency in terms of dealing with the commodity complex. The need for active management was clear. Most would agree that a “buy-hold” mentality just doesn’t make sense for this highly volatile asset class. This would be true not just for a diversified (index-like) exposure but also positions in specific sub-indices (agriculture, metals, energy) or direct single commodity exposures. Despite the fact that so many commodity tracker funds have been launched in recent months and years, it looks like the need for them is very high indeed.

If you were to ask an investor what was their main reason for commodities exposure, you’d get a variety of answers. This may be true for any stock, hedge fund or asset class but I’m very interested in those given for commodities: inflation hedge, low correlation to other major asset classes, macroeconomic rationale given growth of emerging markets and relative dormancy in 1980’s and 90’s, demise of US dollar. These are all risk based rationale but for whatever reason, it seems like there’s a vast array of investors jumping on the Jim Rogers bandwagon. This includes the many ETFs, ETCs and ETNs that have hit the market over the past few years with exponential growth both in terms of numbers and assets. Should there be cause for concern that these new assets are helping fuel the fire? I think so as it will likely lead to greater volatility both up and down. Don’t get me wrong, even without all these new commodity tracker funds, I’m still in the camp that we’re in a long secular bull market albeit with the strong possibility of down markets (drops of 20% easily) with the possibly of not regaining new highs until at least six to twelve months if not longer. The question is whether the magnitude of drops and time to recovery are magnified due to ETFs and related instruments. I can’t help but think so.

And the main reason why I think this is so is just from considering who would be using these commodity trackers. The big user has to be the hedge funds which for me includes managed futures/CTAs. Don’t have anything against them. My first job in the industry was basically in this space although the focus was squarely on equity indices. Just like quant funds that were quite synchronous (unfortunately to the down side) in the late summer of 2007, I could see CTAs herding in and out of the broad commodities complex to capture the major up and down markets … I’m not saying they’ll all move in line to day-to-day volatility.

This excess momentum due to mass herding is what angers the emerging countries when they consider the foreign “speculators” (not “investors”) getting in and out of their market. That’s one of the prices of capitalism. The key, like we see in Dubai, is to find the long-term story. Dubai and other countries in the GCC region and beyond will not only survive but evolve into a longer term success story based on their ability to reap the rewards of this high oil price period (or “era” depending on how long this lasts). My hope is, just as South Korea copied the Japanese model through a well educated workforce and strongly industrialized infrastructure, the neighboring countries in the gulf and the broader MENA region can duplicate some of the success of Dubai. We can see some of this already in Bahrain and Qatar but there needs to be more.

Final thought on Dubai. I had dinner with a gentleman in the industry and asked what model Dubai used for its success to diversify beyond its core asset. My guess was Hong Kong but he said it was Singapore. Makes sense since Singapore is a bit more diversified in terms of having had greater labor requirements in the past (not so much today) from abroad to help build its infrastructure whether it be engineering, financial or otherwise. Singapore definitely has a more culturally diverse population than Hong Kong or any other Asian city I can think of. In this regard, I can’t help but think that the commodity that is often left unconsidered or, at best, overlooked is labor. Where will the migrant worker move to next? Where can one find skilled or at least partially skilled labor? I heard of the incredible housing and food inflation in the UAE and I wonder how that effects the laborer at the very bottom of the ladder. Probably not well but it’s certainly better than their prospects at home. Still, on one of my comfortable taxi rides, I saw a bus packed full of workers … something I’ve seen in countless other cities but I could see that conditions for them were not good. Not to pick on Dubai, but I wonder how fair their labor laws are for immigrant workers. This question is easily applicable to other booming economies that have significant immigrant populations and the debate in the US on this subject is an appropriate example even though their economy, nor its outlook in my opinion, could not be described as booming. This trip was certainly an eye opener for me. The chance to see and feel the luxury was nice but I’m glad I was able to observe a bit of the other side although from far away. Cliche as it it may be, I think it’s Pierre Trudeau who first said something to the effect that you really don’t appreciate the value of Canada until you’ve traveled the world. It’s certainly not meant to be an insult to Dubai - clearly one of the great success stories of the emerging world and especially within a volatile region - but I find it interesting that after this trip I realized just how great Canada is. Maybe it’s also the fact that we get roughly ten days at most of 40 degrees Celsius heat or worse a year.

I spent some time today with my wife and daughters at the park with warm sun and a cool breeze. Perfect weather.

I keep telling myself, and the occasional inquirer, that I’ll get back into serious blogging … or at least publish at a pace similar to when I started back in 2006. Clearly, you will have noticed that that ain’t happening. One of the things that has kept me busier in recent times has been conference speaking. Just earlier this May I was at Connex International’s Public & Private Wealth Group Forum, an institutionally focused event with both a pension track as well as an endowment/foundation track.

To no surprise, there was a lot of content revolving around the use of alternative investments of all sorts but especially hedge funds. I was most interested in discussions related to emerging markets as, to me at least, it seems like this is an area where in the longer term there would be a fair assumption for double digit returns unlike other broad asset classes and strategies. The downside of course is the volatility but for long-term oriented institutions, that shouldn’t be a problem given appropriate diversification and risk budgets. However, the overall sense I had from this and other events in recent months was that emerging market investing is still in the early “toe dipping” stage. Never a good time to get in like when it’s nearly too late! I think it’s far from too late … in fact I think it’s still relatively early. But it’s this herd mentality that I believe is hampering the performance of many institutions. Perhaps the people working at conservative institutional funds just aren’t compensated in a way that would allow them to deviate from what would be perceived as “industry norms”.

Of course, the same could be said of the herd mentality of all investors including retail individuals and their financial advisors. What once was about picking stocks has now moved well past chasing managers with mutual funds to chasing markets via ETFs. Is Kang bashing ETFs?!!! Well, yeah in a way but everyone knows that the gold market and other peaky, speculative (pick an adjective) market has likely had its volatility juiced up due to the level of increased participation of everyday investors thanks to ETFs. Whether it’s good or bad is not for me or anyone to say … in any market that sees more speculators come in versus long-term investors it’s common to find more instruments to feed the frenzy. Remember all the tech and Nasdaq funds in 2000?

The whole concept of alternative investments is a bit of a conundrum to me. At the one end, it’s a reality that has to happen given the limitations of traditional investments. Having a vanilla portfolio of stocks, bonds and cash can only get you so far. So called “couch potato” portfolios sound good but when the markets are going against you, the tendency will be to take action at the very worst time. I didn’t even say that the action would be right or wrong; I’m just saying that the timing will likely be off. If the decisions of what to sell, what to buy, what to hold, whatever, are also off … well, no one does well in college or at their job by being a couch potato.

Correlations among asset classes and strategies remain high. The search for low correlated alternatives will evolve in time but this search for the next new market will persist. The frontier markets of today will be the emerging markets and then developed markets of the near future. Technology, high educational standards internationally and the globalization of economies and capital markets will see this transformation process increase pace exponentially.

The low yield environment of today is another reason alternatives are hot. The traditional fixed income market just isn’t enough. And that includes inflation adjusted bonds where we’ve recently seen the TIPS market hit some interesting numbers (zero).

If we’ve now entered something similar to the beginning of the decade (negative returns with low interest rates), then we’re back to the deadliest of combinations for pension plans and their asset/liability mismatch predicament. With low interest rates, the present value of their liabilities increase so that, on paper … well let’s just say, GULP. Not good. The honest knee jerk reaction from some along with, of course, thoughtful debate and consideration by many others will be to increase allocations to all sorts of alternative investments. It would surprise me immensely if hedge funds and real estate did not get the biggest chucks of these new allocations. My hope is that these alternatives, no matter what they are, provide a true “risk reduction” function for portfolios as opposed to simply a “return enhancement” function. I believe the period of early 2003 to mid 2007 was the time for thinking about return enhancement.

With regard to thinking about risk, I now refer you to three videos that were made immediately after an appearance I made in Las Vegas earlier in April. I was speaking on global investing at the 5th Annual Las Vegas Financial Advisor Symposium thanks to the organizers at InterShow and an invitation from the panel moderator and fellow blogger, Tom Lydon. FYI: Equally cool and insightful blogger, Roger Nusbaum, was also a panelist with me on stage. It’s clear that moving from a US-centric portfolio to one that is more international (with a significant dash of emerging market exposure) is key to improving risk adjusted returns for long-term investors. The concern is implementation and keeping intelligent diversification a key directive. Anyway, the evolution of ETF industry to active management, emerging markets exposure and risk management are the main topics from the three videos. Clicking on the still shots below will lead you to InterShow’s site and the videos [Sorry for having to make you leave this site and come back for each video but there was no allowance for me to embed the videos on my site … traffic matters].

Evolution in ETF Industry:

Emerging Markets:

Risk Versus Return:

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Taking advantage of downside market action in international and emerging markets can now be implemented through new ETFs from ProShares. No comments on this from me as I’ve already said for a while that the market has needed this so here’s the press release:

ProShares Launches First Short International ETFs

BETHESDA, Md.–(BUSINESS WIRE)–ProShares, the fastest-growing ETF provider this year, announced today the launch of the first-ever short international ETFs, designed to go up when a foreign market goes down. ProShares, the nation’s only short and magnified-exposure ETFs, recently crossed $9 billion in assets under management.

The six new ProShares, each to be listed on the American Stock Exchange, are:

The Short and UltraShort MSCI EAFE ProShares launched today; the remaining four are slated for release in November. After these launches, the Short ProShares lineup—providing short exposure to a wide range of domestic and international markets, capitalization sizes and investment styles—will number 35.

These launches follow ProShares breaking though $9 billion in assets under management after a significant market drop on Friday October 19. Initially launched in June 2006, ProShares had the most successful first year of any ETF company in history.¹

“The dramatic acceptance of ProShares has been fueled by investors looking to go beyond the basics and expand the strategies they employ in their portfolios. Shorting strategies have been used by serious investors such as institutions and hedge funds for years,” said ProShares Chairman and CEO Michael Sapir. “By introducing short ETFs to the marketplace—first on domestic market indexes and now on international—we have opened up opportunities for more investors to use short strategies to manage risk or to seek to benefit from market declines.”

Short and UltraShort ProShares offer many advantages over shorting baskets of stocks, individual stocks or ETFs. Investors can achieve short exposure without opening a margin account—buying short exposure is as convenient and simple as purchasing an individual stock. In addition, investors can lose only the amount that they invest, whereas when they short stocks, stock baskets or ETFs, their losses are theoretically unlimited. Moreover, these ETFs can be employed in vehicles that do not permit margin accounts—IRAs for instance. And finally, these ETFs can easily be tracked throughout the day.

Investors seeking to hedge gains should understand that they may need to make adjustments to their holdings to maintain a specific level of short exposure over time. Also, the funds have fees, expense and tax consequences of their own. These short ETFs are structured to provide the inverse of the daily performance of the market indexes that they track; that is, if MSCI EAFE declines by 1% in a day, the Short MSCI EAFE ProShares should gain 1%; if the index goes up by 1% in a day, the ETF should lose an equal amount. The UltraShort ProShares are designed to deliver twice the inverse of daily performance; in the above instance, where MSCI EAFE declined by 1% in a day, the UltraShort MSCI EAFE ProShares should appreciate by 2% and if the benchmark rose by 1%, the ETF should decline by 2%.

Today, I had a last minute invitation to speak on Canada’s Business News Network … that’s not a description, that’s its actual name. The channel was formerly known as “Report on Business Television” so you’ll have to decide if their name change was an improvement or not. The six and a half minute clip will be available for viewing online here until sometime late Monday evening of next week (when you click on this link I’ve provided, a small window with a built-in media player should pop open). If this doesn’t work, then go here and scroll down to the 4:40pm “After Hours” program. Hopefully, I will be able to have the clip viewed directly here on this blog at some point.

The opening shot of me appears to be my poker face or I’m about to enter the octagon for combat or it’s the once-a-month event when I screw up WordPress and lose a big chunk of my blog posting. Either way, it’s my “death stare” and I can only imagine that I felt pretty lousy running from my car to the building entrance of the studio in what has to be Toronto’s heaviest rain storm so far this year.

Anyway, the discussion was on market volatility but unfortunately the focus was almost entirely on VIX. I say “unfortunately” only because VIX can be (well, it is) a dry subject due to its rather technical nature. Despite being on the channel several times before, you’ll note that the topic of VIX was not quite enough to get me really loosened up until just a tiny bit near the end.

Well, here are two charts which I discuss during the interview:

3 Year VIX Chart

17.5 Year VIX Chart

I was hoping to get into a discussion on emerging markets, gold and oil markets, and a broader geopolitical debate. But at the end of the day, VIX is a tool worth considering for the defensively oriented investor so there’s merit in its discussion. Along with outright shorting and inverse ETFs, there’s not much out there in terms of true diversifiers/stabilizers available in this high correlation world.

On the other hand, I have actually noticed lately that a lot of hedge funds (fund-of-funds, multi-strategy funds and even some single strategy funds) have had better than decent performance in 2007 YTD. Could it be a result of the VIX spike up since late February? I’m sure it’s more than that but this good performance comes after a fairly long period of so-so returns.

On a separate note, after my interview, I had dinner with one of the ProShares directors who was up here in conjunction with Horizon BetaPro’s launch of their new Canadian energy sector index levered and inverse ETFs. This follows up BetaPro’s launch last week of similar long and short exposure ETFs for the Canadian financial sector.

Based on this BetaPro press release from April, it’s safe to say that we’ll be seeing the gold sector ETFs sometime soon as well.

For review, this is BetaPro’s lineup as of today:

Horizons BetaPro S&P/TSX 60 Bull Plus ETF - HXU
Horizons BetaPro S&P/TSX 60 Bear Plus ETF - HXD
Horizons BetaPro S&P/TSX Capped Financials Bull Plus ETF - HFU
Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF - HFD
Horizons BetaPro S&P/TSX Capped Energy Bull Plus ETF - HEU
Horizons BetaPro S&P/TSX Capped Energy Bear Plus ETF - HED

The Canadian ETF marketplace has basically doubled in a very short time especially due to the recent product development efforts at both BetaPro and Claymore. Unlike in the US, we don’t have as robust - some may say saturated - ETF marketplace here in Canada. Frankly, we don’t have the broad acceptance of ETFs here like there exists in the US so there is some balance there. I would guess by looking at reports, such as those from Deb Fuhr at Morgan Stanley, that all other markets outside of the US also have a rather small but growing ETF industry and that is likely where we’ll see significant growth as the ProShares, PowerShares, WisdomTree and other smaller participants do the same as BGI, SSGA and Vanguard with their already established global expansions.

I won’t get into the discussions I had with the gentleman from ProShares except for the fact that I asked the question that I think many want to have answered: When do we get the international exposures?

I’ll just leave you with a “let’s wait and see”. Let me be blunt as usual … I’d kind of like to see them, specifically inverse exposures for EAFE and emerging markets available before the end of the summer. Certainly before the end of the year.

Oh, and one last thing to consider for those of you who want to get some inverse exposure to emerging markets. I don’t know if that’s the right call (bearish on emerging markets) but considering the strong run up in China, central/eastern Europe and basically all subgroups in the developing world, it’s worth making preparations. But what to do when there’s no inverse ETF and shorting EEM or VWO is the only reasonable alternative? I suggested to my dinner partner from ProShares that the BetaPro S&P/TSX 60 Bear Plus Fund might be a good choice especially considering the relatively high correlation between the Canadian equity market (TSX 60) and a broad emerging market ETF like EEM. I would only guess that the new inverse energy sector ETF from BetaPro would be an even better proxy for a short EEM strategy. There’s not enough historical ETF data but your friendly neighborhood Bloomberg terminal, Thomson Datastream or similar data source should provide you with data for the underlying index as the evidence you need.

It’s a tough, high correlation world. But perhaps there are ways like this to use high correlations to your advantage. The problem is correlations change in time. I’d much rather have the inverse ETF.

No, not that The Guess Who although now I can’t get the song American Woman out of my head. News from MarketWatch today of Vanguard about to fire another shot across the bow and as usual, it’s more of a shotgun approach than a rifle. It’s broad access to the international space with nothing new but the same old EAFE exposures we’ve had from ETFs like EFA. But unlike BGI’s offering with a 35bps MER, this new fund from Vanguard (VEA) will sit at 15bps.

Vanguard already allows investors cheap international exposures to Europe and the Far East (VGK and VPL respectively) both at 18bps but this new ETF will allow international exposure in one position. With the ETF world having focused in recent years on the narrowest of regions and sectors, we’re now seeing quite a few product launches for broader international exposures.

For example, SSGA now has three ETFs allowing for very broad international exposures:

• The SPDR S&P World ex-US ETF (GWL) covers most of world outside of the US market. The underlying index is the S&P/Citigroup BMI World Ex US Index. This ETF has roughly 670 holdings and has an MER of 35bps.
• The SPDR S&P International Small Cap ETF (GWX) does the same as CWI but limits holdings to small cap equities. The underlying index is the S&P/Citigroup World Ex US Range < 2 Billion USD Index. This ETF has roughly 500 holdings and has an MER of 60bps.
• The SPDR MSCI ACWIsm ex-US ETF (CWI) is very similar to CWI in most respects except the underlying index is the MSCI ACWIsm ex USA Index. This ETF has roughly 680 holdings and has an MER of 35bps.

These SSGA funds allow for some (although not much) exposure to emerging markets while EFA and Vanguard’s new offering do not. Focusing on the large cap exposures (GWL and CWI) from SSGA, in general, you’re getting greater diversification from these compared to the BGI and Vanguard offerings which both track the MSCI EAFE Index. According to the iShares website, this factsheet for EFA shows that the three top country exposures are the UK (23.11%), Japan (22.29%) and France (9.46%). A total of about 55% in these three countries. Based on the SSGA website, GWL and CWI have the same top three countries but with decreased weights. Both GWL and CWI have about 45% in these three countries. I don’t see that significant a divergence among these funds in terms of general country and sector allocations.

Of course, many investors will want to make their own decision on how to split the developed and developing world within their portfolio. SSGA has recently launched a broad emerging market ETF (GMM) as well as five regional emerging market ETFs but with all of them at a 60bps MER, they like EEM (75bps) are relatively expensive compared to Vanguard’s VWO at 30bps. I think it’s worthwhile to explore the SSGA site to dig into their new emerging market ETFs as it allows investors to implement asset mix decisions within the emerging markets space and I’ve discussed this area a few months back here. SSGA’s emerging market ETFs weren’t available until the middle of March 2007 so they weren’t a part of that February posting but as you can see from this chart, the four broad emerging market ETFs track closely with a few times when the month-to-month return difference is rather significant.

I should also note that Vanguard has a competitor to SSGA’s GWL and CWI in their Vanguard FTSE All-World ex-US ETF (VEU). According to Vanguard’s website, VEU holds about 1,500 stocks (overkill?) yet is quite similar in terms of asset mix to the international funds from SSGA. Again, I find the same top three country exposures for its underlying index as the UK (17.3%), Japan (15.7%) and France (8.6%). But SSGA’s funds are at 35bps and VEU is at 25bps. In general, it looks like Vanguard is the cheapest with the broadest international exposure. Was there ever any doubt?

VEU began trading earlier this year so this chart goes back as early as will allow analysis of it versus the other broad international ETFs I’ve mentioned above (Note: SSGA’s GWL was not available until April 20, 2007 so I’ve excluded it here just so that it won’t be a one month chart).

A tighter group but again some spread in time. I don’t want to comment too positively on the good performance of Vanguard in both charts above, but if international exposure is a long-term hold for you, then the effects of fees and the benefits of diversification should allow consideration for Vanguard’s VEU and VWO as core holdings.

Many may disagree, but on top of these two core holdings, I would overlay some active tilting using a VGK/VPL combination for the developed world as well as SSGA’s new emerging market ETFs for the developing world.

To continue what seems like a series on chopping up asset classes into various investable components such as commodities and emerging markets I want to dig a bit deeper into the emerging market space, but specifically into the often cited BRIC nations (Brazil, Russia, India, China).Let’s start with a basic returns table for comparing a BRIC index and its 4 components with the MSCI EM Index (all in USD):

click to enlarge

The monthly return data used for this table goes back starting at December 31, 2001 but the Brazil, Russia and China index data only goes back to a starting value as of April 30, 2002 thus no 5-year returns for them in the above.

Pretty darn spectacular in what has been a pretty darn spectacular global bull run over the past 4 years. As usual, I now break out the charts starting with a comparison of the BRICs versus the MSCI EM Index:

So $1,000 grows to roughly $4,250 with the BRICs versus roughly $3,250 with an ETF like EEM. Clearly, a significant difference. So, now we see why that is:

So instead of comparing the MSCI EM Index with BRIC, we see it against its component indices. Despite the expansive discussion and coverage of “Chindia”, we find it’s Russia and Brazil that are the strong performers. Obviously, Russia is a big commodities play but Brazil is also commodity heavy. According to the iShares site for their Brazilian ETF (EWZ) the fund is roughly 25% in metals/mining and 25% in oil & gas.

Still, BRIC ETFs like the Claymore/BNY Bric ETF (EEB) in the US and the Claymore BRIC ETF [CBQ: TSX] in Canada, both of which track the BONY BRIC Index above, are not equally weighted by country. Both have the following country breakdown:

Brazil 45.88%

China 35.79%

India 13.56%

Russia 4.77%

You can see in EEM’s fact sheet (.pdf) that it has a 9.39% weight in Russia also as of December 31, 2006, nearly double the allocation in the BRIC ETFs. Yet despite this, EEM still underperforms the BRIC ETFs. Clearly the 18 other country exposures beyond the BRIC countries in EEM have an aggregate drag on return in relative terms. But in the bigger picture, we see that the divergence in performance is only significant in the past two years, but especially in the past six months.

The top five sectors are energy at 26%, 20% telecomm services, 19% financials, 14% materials and 9% IT. So, overall about a 40% commodity exposure and some decent sector diversification beyond that. No surprise then that the BRIC ETF tracks countries like Canada and Australia fairly well.

By the way, with regard to all the charts and data above, a big thanks to Som Seif of Claymore Investments here in Toronto.

It’s important to note that the indices mentioned in the above tables and charts are all from Bank of New York who is not a big name in indexing but who nonetheless has its own family of ETFS called BLDRS (Baskets of Listed Depositary Receipts). More info can be found on their site. I often mention EEM and VWO for emerging markets exposure, but I have been wrong not to include the BLDRS Emerging Markets 50 ADR Index Fund (ADRE):

This chart shows a slight outperformance of ADRE over EEM and VWO over this one year period but the ADRE factsheet (.pdf) from the BLDRS website shows that its benchmark actually trails the MSCI EM Index over the longer term. ADRE’s sector breakdown shows the same top five sectors as mentioned above but with an overall more diversified sector mix with less exposure to commodities.

With an underlying index of only 50 positions as opposed to EEM’s 275 holdings and VWO’s 862 holdings, you would expect greater volatility from ADRE. I would have expected more volatility than what is shown in the above chart. With a surprisingly low MER of 0.30% similar to VWO (unfortunately, the BRIC ETFs are both exactly double the cost at 0.60%), ADRE is an interesting choice for those who are willing to accept an even slightly higher level of risk, and thus potentially return.

Thus, ADRE nicely fits in between the (relatively speaking) low volatility EEM/VWO and higher volatility BRIC ETF as shown in this chart that only goes back as far as the inception date of EEB back in mid September:

Further to my closing comments on my previous piece specific to hedging strategies for emerging markets, if you’re looking to use these ETFs for opportunistic shorting during the relatively brief but often severe periods of distress, you may want to do some analysis on how their price movements compare historically. After the recent run (look at all the charts above and in my previous piece … many show them currently at highs), these positions as potential shorts could be truly spectacular, obviously if you get the timing right. For those with a more sensitive stomach, defensive posturing may be limited to simply reducing or outright selling positions if you, for some reason, lose your long-term orientation.

Hey, I just noticed one of my charts from the previous post, specifically the last one showing IFN and FXI. IFN looks now to be way down, in fact about 33% below its highs from May 2006. That looks a lot different from the light blue line for the BONY India Total Return Index which looks to be in a straight line up since roughly June 2006 in the second chart from the top above. Chalk up another one for the index.

So again back to basics: Not only is it difficult to choose a winning manager in the emerging market space (perhaps in the long only equity space overall?), but you also have to be right on the call among the various EM regions. For many, including the professionals, that can be tough. I’m all for having the choice to tilt EM regions and even countries like the BRIC components, but for most investors, a broader EM pick (EEM/VWO/ADRE) and/or a BRIC ETF should be sufficient exposure. Figuring in MERs and the costs of trading too many positions for what should be a rather small part of your portfolio, unless you really want a high vol program, one or two holdings is all you’ll really need.

In the past, I’ve commented on how a Canadian investor should not consider emerging market investments, in general, as a diversifier to their total portfolio. If in fact they do have a home bias, as most investors do, the results during times of distress can be quite agonizing. Not only are the correlation in returns high between Canada (EWC) and the emerging markets, but they are the perfect anti-diversifiers:

The same is true for other resource heavy economies such as Australia (EWA):

And South Africa (EZA):

Interesting that in this last case we see that the South African ETF is actually more volatile than EEM but that isn’t surprising when you see that nearly 25% of the fund is in the metals and mining sector.

Based on the above, it’s fair to assume that this correlation risk can be applied to any investor with a relatively large exposure to the commodity complex, no matter where they are located. However, you don’t simply want to avoid the greater macro story coming out of the developing world, do you? We need to think about what other possible choices there are beyond broad EM exposures such as EEM and VWO.

Latin America

Let’s take a look at these ETFs for the Latin America region:

Again, I use the same 3-year timeframe as the charts above. Probably not surprisingly, we see that the broad Latin American ETF (ILF) zigs and zags in tandem with the Mexican ETF (EWW) and Brazilian ETF (EWZ). Suddenly, EEM looks conservative in comparison to these but follows the same upwards and downward oscillations. The correlations are to be carefully considered if you hold some (or all!) of these.

East Asia

Here we finally see some variation in price movement, in this case from the far east:

The Malaysian (EWM) and Taiwanese (EWT) ETFs seem to move closest together. China (FXI) and South Korea (EWY) show great appreciation but at different times. However, what we find again is the synchronized down movements not only in the summer of 2006 but in March and October of 2005. Scroll up to review all the other charts and you’ll see that when I say “synchronized”, it’s global in scope.

Central/Eastern Europe

What about this region? We don’t have an ETF for this region yet although Roger Nusbaum discussed a new index that could be easily tracked by an ETF … but c’mon, 15 stocks! Bogle will go bananas over this.

So, I dig into the closed end fund world to build this chart which has the Central Europe & Russia Fund (CEE), Morgan Stanley Eastern Europe Fund (RNE) and the Templeton Russia & East European Fund (TRF):

Same moments of downward movement as described above, and then some. No doubt investors in this region experienced a “Maalox moment” last summer.

So, we can see that within each region there’s quite a bit of correlation, but especially during times of significant market distress where, in fact, the correlation is not just high within that region but within what looks like all emerging markets. What about the BRICs?

Although we have news of Van Eck soon to launch a Russian ETF, the best I can do for charting Russia is ING Funds’ Russia Fund [LETRX]. Similarly with India, the iPath MSCI India Index Exchange Traded Notes (INP) from Barclays does not have a long track record like The India Fund (IFN) which I use in its place.

The chart only goes back 2 years because of the shorter record for FXI. However, the real problem with this chart is that we have a mix of indexing and active management. For example, someone else may have chosen another proxy for India, such as the Eaton Vance Greater India Fund [EMGIX] and the results would be significantly different from IFN as shown in this 12-month chart:

But I think the point is that if you have regional emerging market exposures as shown with the BRIC exposures from the 2nd chart up, you’re getting about as good an amount of diversification as you can get … still getting the upside boost of these regions’ returns but also with the coordinated downside which it seems you can’t escape without some serious timing abilities.

Whether you call it timing or active management, it seems as if it is required for the emerging market space. And I say this despite the fact that the SPIVA scorecards from Standard and Poor’s show that active managers in even this space have a difficult time beating their relevant benchmark. Nevertheless, you either rely on some timing or else you’ll have to accept some serious drawdowns like we saw last summer as part of the plan.

I specifically chose some funds above from the individual BRIC countries but of them, it’s nice to see that it’s the big newsmakers, China and India, that show somewhat reduced levels of correlated returns:

To me, it’s unfortunate that Brazil’s weighting is so large in BRIC ETFs (nearly half) with China, and especially India, with smaller allocations. Thus, I like the idea of country specific ETFs for China and India as well as the idea of a Chindia ETF. Some news here about an upcoming ETF for this combination.

For the future, emerging markets, but especially China and India, are the real stories. If I were consulting on a hedge fund mandate related to these regions (which I’m currently not), the problem I’d focus on would not be the long exposures but the ability to be opportunistic on the short side. Based on the charts above, the down periods can be short but painful. However, it’s important to note that these are not just emerging economic markets but emerging securities markets. Thus, the regulatory environment does not often allow for easy and opportunistic trading. You will often have a tough time shorting stocks in these new jurisdictions. A combination of stock selection on the long side (bottom up analysis) with shorting of ETFs (top down analysis)? Sounds pretty basic but this may be the real value of emerging market focused ETFs.