Let me start by saying that I received three calls today from the press. On the one hand, I’m happy that the blog is getting some attention and with further coverage in the mainstream press, I am very eager to see how my readership at “The Beta Brief” grows (fingers crossed). However, everybody wants to talk about the greater focus on “active management” in the ETF industry. Is it that surprising?! It’s neither bad or good. The industry is simply evolving based on its inner economic conditions, changes in the overall market environment and the resulting changes in the behavior of investors. There will be a continued push away from the classical passive form of index investing but, on the other hand, we will likely continue to see a very high proportion of ETF assets remain in the traditional, relatively lower cost funds like SPY, QQQ and the offerings from Vanguard.

With the recent downside market action and resulting spike up in VIX, I like many market participants am eager to see if this will be a relatively short “V” pattern with new highs being quickly re-established. Here’s a 10-year chart of the S&P 500:

As you can see, since early 2003, there has not been any serious drawdown and down markets were quickly erased with new highs in a matter of months. The growth versus inflation story both in the US and globally seems to have many investors feeling not too worried but not entirely care free. It’s the incredible resilience of the global markets to a continuous assault of significant events that has me wondering what does it really take to shock this bull market? Mideast turmoil and its effect on the energy markets hasn’t done it. An all out war (albeit short) in Lebanon in addition to conflict in Iraq and Afghanistan seems almost like a non-issue now. The UK subway bombing is an example of an even more “focused” event that shocked the market but in such a meaningless way in terms of severity and length. Closer to home in the US, despite a White House adminstration that seems destined to be the ultimate case study for grad school management programs (G.W. Bush was the first US president to have earned an MBA, right?) with a chain of foul ups too long to mention, the markets have shown a nearly straight line upwards. However, G.W. Bush assumed office in early 2001 when the S&P 500 was at around 1350. Just a simple observation, but if you include distributions (as opposed to just a price based calculation using the above chart), the US market has provided close to cash equivalent returns over the Bush presidency. Somehow I think if Gore won the election back in 2000, there wouldn’t have been too significant a difference in market performance although that’s certainly highly debatable. Well, I think there’d certainly be less laughs on the late night shows … I doubt Lieberman (or Edwards if Kerry won in 2004) would have done anything like shot someone in the face, but the Democrats are also damn good at screwing themselves with ease. The market was already on its way down and no matter who won the election back in 2000 nothing would have stopped the bear market. September 11th brought a quicker drop but spiked back up only to continue the downward trend until we hit bottom somewhere in the later half of 2002.

But now we’re at a completely different time. We’re near (S&P 500) or past (Dow 30) previous highs. And what interests me now is what remains highly resilient during the moments - even if they’re relatively short - when the market seems to release some steam. Hopefully, this kind of analysis not only finds good defensive performers in mini-corrections but in serious market declines as well. First, let’s take a shorter term look at the S&P 500:

We can see last summer’s market decline as well as the turmoil over the past month. In between is one of the smoothest bull markets I’ve seen. I think it’s too short to be considered a cyclical bull but at seven months, it was a fairly nice long run of about as straight a line as a market could have, and with a rate of ascent that makes it that much more incredible.

However, you plot some sectors over this chart and you see that there are areas that are even more incredible over the past year. With all the press related to commodities, one might guess that the oil & gas sector would have been a good place to put assets over the past year but all it’s brought is its usual high level of volatility:

At least it looks relatively uncorrelated to the S&P 500 so for asset allocators with an eye for diversification (not for Canadians, Russians and other oil producers of course) there looks like an argument to hold a certain portion of one’s portfolio here. What about gold & silver?

Pretty much the same story. Low correlation. With bigger drawdowns than in the oil & gas sector over this period, again the idea is to add some of this but not too much. It’s somewhat uncorrelated so it can dial down a portfolio’s overall volatility, but add too much commodities and watch your volatility skyrocket!

Obviously, something less gut wrenching is utilities:

No surprise, utilities are one of the classic defensive sectors. Compared to the broader market it often timeis has a lot less volatility and, in fact, over the recent year’s chart looks like a really well run hedge fund. I’m not joking. Look at the behavior of the Dow Jones Utilities Average over the months of May/June 2006 as well as over the past 5 weeks in the chart above. During these times of market stress, the DJUA was relatively flat or slightly upwards (last summer) or strongly up (recent weeks). Otherwise, during other times it looks kind of like the index but on a month-to-month basis you don’t see a high degree of correlation. Unfortunately, the comparison of DJUA with hedge funds only goes so far as you can see in this 10-year chart:

Unlike nearly all hedge fund indices (as bad as they are as benchmarks I use them as the only decent source for comparison), you can see that the DJUA did not protect investors from the bear market of 2000-2002 in any way better than the broader market S&P 500 Index.

Still, my point is that utilities is one of a few areas where it clearly has been going strong even in comparison to the S&P 500 during this bull market. And, of course, as a defensive play it seems to do relatively well even in times of distress. Recent commentary has suggested that the new infrastructure ETF from SSGA, the SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII) is actually a global utilities fund in disguise. For review, refer to my previous posts covering infrastructure here and here. Some of my comments from those posts seem to suggest that infrastructure, like many areas that have shown new product offerings in the ETF space, have shown too great a rise and that investors might be wise to show restraint and wait for better valuations and a lower point of entry. Price action over the past few months have proven me wrong overall as shown in the following chart which includes several infrastructure oriented ETFs and CEFs:

All of these funds involve Macquarie and although they have different mandates you can see that they generally move in tandem. For example, although the S&P 500 had a modest increase in the month of March, all infrastructure funds in the chart above had a strong month except for the first week. Perhaps I was correct earlier this year when I addressed concerns of the recent strength in infrastructure oriented funds. The sharp declines in late February in line with the overall market seem to agree with this. However, their incredible concerted rebound was frankly unexpected. I would have thought that any rise would be in line with the broad markets, not the sort of out performance shown in the chart above.
Therefore, and perhaps not surprisingly, infrastructure and utilities are quite similar in that they have demonstrated an ability to deliver favorable performance in the good times, but more importantly, when the broad markets are not as strong. And the immediate corollary to this for me is the attention given to fundamental indexation whether through PowerShares or WisdomTree. Like other alternative weighted index methodologies, the focus is on value over growth. No one would argue that utilities are a value play, but so too is infrastructure with the stable income generated from its business operations (airport, highway, port, water service, etc.).

Lastly, I have seen some very brief commentary on the transports. Here’s a 3-year chart comparing the Dow Jones Transportation Average to the S&P 500:

Over 1 year, the S&P beats the DJTA. Over 2, 3, 4 or 5 years, the DJTA wins. Regardless of commentary relating to transports as a leading indicator, I can’t see this an anything more than a high beta version of the broader market. And in today’s environment, for the defensive oriented investor, this or an ETF in this space is likely one to avoid. Look how it behaved last summer, over the past month and in other times of market declines. But perhaps technology or in the chart below, internet stocks, are an even better example of a purely cyclical play … the perfect opposite of the defensive sector play:

This example goes too far to the other extreme but it clearly makes the point to differentiate how far apart a defensive sector like utilities looks compared to a cyclical sector and versus the broader market. Some may think of transports as a possible defensive play but in times of market distress, if you felt nervous about the S&P, transports would make you manic! Speaking of transports, I’d like to write about freight derivatives at some point. I continually neglect the derivatives market as there’s just so much happening in the ETF space but it’s just so interesting to see the continued innovation in the derivatives markets (property derivatives, housing derivatives, economic derivatives, weather derivatives). Some more for the “to do” list.

Bottom line: For investors concerned about providing an adequate level of defense for their portfolios, some sector tilts may provide greater diversification benefits than geographically based asset allocation. Rather than allocating more towards EAFE or even emerging markets, investors may look to areas like utilities, infrastructure and other sectors that may have a better chance of sustaining past earnings levels or at least have minimal downside effects to general operations when the overall global economy softens. With concerns of greater correlations among asset classes and asset strategies, sector “bets” (yeah, it’s an active decision that may be right or wrong) are one of the more tried and true methods available to any level of investor. Clearly, some sectors are better than others for defensive maneuvering. If sector rotation is to be fully explored as a viable strategy, thank goodness for the recent delivery of sector oriented ETFs brought to the market by ETF manufacturers and especially the relatively younger providers who have brought some very interesting niche funds to the marketplace.

My February 22nd article appeared with an unfortunate title that may have suggested that WisdomTree was “Moving From ETF Evolution to ETF Pollution”. As mentioned in that article, I did find it surprising that WisdomTree would introduce a new lineup of ETFs based on a new fundamental factor (earnings) when all of their previous product development had focused investors’ attentions on the benefits of dividend-based indexation. My main inquiry was whether a portfolio construction process based on earnings as the determinant for weightings within an index would provide a significant divergence in performance versus one similarly based on dividends.Not a surprise, I soon had a call from WisdomTree . Many thanks to Luciano Siracusano, Director of Research for ETF firm WisdomTree Asset Management, for taking the time to give me some of the thinking behind WisdomTree’s new product line. Luciano is no stranger to the blogging environment and here are some of the main points I gathered from our phone conversation:

If the Russell 3000 represents the broad US equity market, an indexing strategy based on dividends will provide a subset of roughly 1500 stocks or 76% of the market. Based on this, if the remaining 1500 stocks represent the remaining 24%, you get an idea of the capitalization that is left out. Of course, investors in this strategy would be still be missing out on certain big names like Google (GOOG) but it’s fair to say that you have a fairly strong value and large cap bias.

A fundamental indexing methodology that uses earnings instead of dividends would have broader representation. Clearly, you have to have earnings before you can give out dividends. But, the difference is quite significant: Using the Russell 3000 as the overall market again, with an earnings based filter, you have access to roughly 2450 companies or 95% of the market.

The earnings based methodology provides a strategy and fund that appears to be a lot more like the traditional market cap weighted index fund. Sector weights are more similar, especially compared to the dividend based methodology. Overall returns for the earnings based funds should be highly correlated to market cap weighted funds.

Perhaps the idea from WisdomTree is to use dividend based indexation as a highly defensive measure and earnings based indexation as a pure replacement for traditional index exposures. In other words, if you have a broad US equity position like SPY, an investor could consider the WisdomTree LargeCap Dividend Fund (DLN) as a potential compliment (or outright defensive replacement) and the WisdomTree Earnings 500 Fund (EPS) as a potential substitute.

The evidence on non market cap weighted indexation (equal weighted such as Rydex’s RSP, or fundamental weighted from PowerShares/Research Affiliates and WisdomTree) seems to suggest an outperformance relative to market cap weighted indexation of at least 200bps per annum on average over the long term. Dimensional Fund Advisors is in the same boat as they also have de-linked from traditional indices … although they’ve been doing it for a very long time. DFA has shown incredible strength in their asset gathering despite focusing on the mutual fund structure and not joining the ETF bandwagon. Whether they do a “Vanguard” or not, the continued interest and product development in non market cap weighted index instruments will surely continue. It’s just one of many trends away from the origins of passive management, CAPM.

Like I said in my earlier piece, I’m not sure about the future success of WisdomTree’s new earnings based ETFs. The dividend based ETFs seems to make sense and a serious down market will surely prove their worth as a diversifier. If the earnings based funds are somewhere between the dividend based fund and the traditional index fund, I wonder if enough interest can be created based on something that seems “stuck in the middle”. Frankly, I see a lot more marketing for WisdomTree versus the FTSE-RAFI based ETFs coming out from PowerShares, so I would not be surprised to see them have success with their new products. Thinking for a second about the FTSE-RAFI fundamental index methodology which is based on four factors, I wonder if WisdomTree is considering the remaining two factors or, more broadly, any other fundamental factors for future product development?

It makes me think of the FTSE-RAFI funds like a BRIC fund. It could make sense to have separate funds for Brazil, Russia, India and China for global asset allocation decisions. But what about comparing the FTSE-RAFI based funds versus WisdomTree’s focus on dividends and now earnings? For now, I understand the reasoning behind WisdomTree’s launch of the earnings based funds to go along with their dividend based funds. I don’t see much use in bringing out further product lines focusing on other fundamental factors, the remaining two from Research Affiliates (the “RA” in the rather convoluted FTSE-RAFI acronym) being book value and sales. I’m sure there are a plentiful number of academic papers to suggest other factors (cash flow?) which may also outperform the market cap weighted index and provide other tangible portfolio benefits.

We’ll see. I am sure that the marketing minds at WisdomTree are many miles ahead of me. And I am now even more interested than I was a few days ago about the future success of WisdomTree’s recent efforts.

Further to recent articles by Tom Lydon we find continued interest in the exponential growth in ETF product development. The movement to more thinly defined sectors as well as alternative index weighting methods seems to be of great interest to many. Just yesterday I saw something from WisdomTree (WSDT.PK) about their upcoming earnings-weighted index ETFs.I wonder what’s the longer-term plan at WisdomTree? They’re certainly pushing the envelope with arguments against market cap weighted indexation in favor of fundamental weighted indices. But with their first wave (actually, multiple waves) of product offerings, the focus was on ETFs whose underlying portfolio is weighted based on each position’s cash dividend payout. The question I have now is why the shift to ETFs that track an underlying index whose focus is on another fundamental factor – in this case earnings? According to the press release (.pdf) these new offerings are very similar to WisdomTree’s existing “Domestic Dividend ETF” lineup. For example, the first ETF listed in the press release is the WisdomTree Total Earnings Fund (EXT) which has a 28bps MER. It seems to be the exact counterpart to WisdomTree’s Total Dividend Fund (DTD) which has the same MER. Little surprise to me, the backtested performance of the two underlying indices do not have significant deviations as shown on this chart on a page (.pdf) from WisdomTree site.

Despite what seems like a potentially redundant new set of ETFs due to what could be future performance within very close proximity to existing ETFs (is cannibalization a concern?), WisdomTree does give some suggestions for how an investor may decide to focus on one factor over another:

How Do I Decide Which Approach Is Right for Me?

All of the WisdomTree ETFs provide investors with an alternative to market cap-weighted ETFs, and all are designed to be used as core holdings within an investor’s portfolio. If you are seeking the potential for income-generating yields and relatively lower volatility, you may want to consider the Dividend Family. If you are seeking broad market exposure or exposure to traditional sector classifications through companies with an earnings track record, you may want to consider the Earnings Family.

I’ll be very interested to see the growth of assets in this new family of earnings based ETFs. Even more interesting, I’d be interested to know what market environment would cause any sort of significant deviation between WisdomTree’s dividend based ETFs versus their earnings based ETFs. I’m guessing not very many situations. If so, my feeling is that this provides more fuel to the existing discussions of there being too many ETFs. As Richard Ferri of Portfolio Solutions LLC puts it:

“What I am seeing is a rapid shift from ETF evolution to ETF pollution.”

As Keanu Reeves so eloquently said in The Matrix, “Whoa”. The above quote is from John Spence’s recent article “ETFs wade into a dead pool”, he puts out an argument that suggests a significant market decline could not only slow down ETF product development (he suggests consolidation and I’d buy that), but also close down some as well. I’d buy that too but to a lesser degree.

Let’s be honest. Fund manufacturers including ETF providers are just as bad market timers as any other investor. TD Asset Management up here in Toronto had to close their ETFs a few years back. They had a nice lineup of ETFs with broad market exposure to Canadian equity markets even with some value and growth biased ETFs and this was at a time when ETFs weren’t considered to be so “weed like”. Perhaps Canadian investors just didn’t have the will to accept the passive approach at that time to warrant product offerings beyond what Barclays had already been providing the market. But we also saw the same with a small US provider of bond ETFs. They didn’t last long either. Clearly, many of the new niche funds are providing investors access to markets which are hot and at or near their all time highs. Furthermore, the fact is that nearly all markets are at or near their highs. Beta is hot and thus ETFs are the flavor of the day. If we were in a 1970s-like environment we would surely see less interest in ETFs and more interest in hedge funds and defensive strategies. Perhaps even more likely the popular choice would be term deposits … I’m thinking an environment like the beginning of the 1980’s when no one talked about the stock market.

But we’re in 2007. After the risk taking environment of the late 90’s to the sudden risk aversion during and immediately after the bear market of 2000-2002 and the shift to “risk management” thereafter (Basel, Sarbanes Oxley, growth of hedge fund use, etc.) we find ourselves now again at a time of relatively high risk taking. That’s what a four and a half year bull market and VIX down to 10 does to the collective psyche of the global investing public. By the way, have you seen where VIX has been in the past week?! And don’t think that the Bank of Japan’s 25bps rate hike changes the carry trade situation.

It’s also little wonder that hedge funds are having a hard time finding stocks to short. Actually, it kind of sounds like value managers in the late 90’s saying they can’t find good stocks to buy. Shorting is a tough sport in today’s environment. The stock you might want to short could be the same one Carl Icahn is looking to take private, turn around and resell to the public market. It’s tough to be a hedge fund these days. They’re dying to finally get some decent performance fees. They need a bear market badly. Whether they actually do well in a future bear market is another story. Some will and some won’t. Maybe cash really is king. But until then, ETFs are king.

Unfortunately (or fortunately, depending on your view of monarchies), Kings get dethroned. Spence has a heading within his piece called “Shades of 1999”. He doesn’t mention this but it made me think if the ETF explosion could be compared to the dot-com bubble. Well in the one case you have money chasing various asset classes or sectors. In another case you have money chasing stories with no fundamentals to back them up. A broad generalization but enough for me to think that it’s not the same. Still, we’ll definitely see some ETFs disappear as Spence has given some examples similar to mine above. I don’t think it will be like all the tech mutual funds that closed up during the bear market. The King may get hurt, but I don’t think he’ll get dethroned.

What I don’t think people realize is that ETFs are not for the buy-hold investor. They can be; but the direction or trend of the industry is focused towards the more active investor who either prefers a slightly more tactical rather than strategic asset allocation framework or the investor who wants to do some sector rotation … or in fact a multitude of other active approaches including hedge fund like strategies.

Can’t it be possible that there is a level of “micro” efficiency within asset classes such that ETFs provide an ideal, or at least preferred, means for exposure whereas in the more broad “macro” world there can be a significant of overall global inefficiency such that some active management of positions (whether ETF or not) is required?

If so, then the active management of ETFs has some merit. The level of comfort, proficiency and experience as well as other factors will determine to what degree of activity one will allow for their own portfolio. Again, it’s good to have ETFs so as to allow investors that choice. If there is to be a concern, the concern should not be about instruments such as ETFs, but for the overall risk appetite in aggregate within the investing world and what repercussions that may have in a much broader sense if things turn for the worse.

First there was Rob Arnott and his firm, Research Affiliates, who now manage ETFs with a fundamental indexation strategy for PowerShares and Claymore. Then WisdomTree entered the market with their version of fundamental indexing although based on dividends while Arnott’s was a combination of dividends plus three other fundamental factors. Now comes news of an ETF behemoth entering the market. Here’s the press release from State Street Global Advisors.

Let’s see. Here are the main points that I get out of this press release:

· “FTSE GWA index is one of a new breed of indices that weight stocks based on fundamental financial data rather than their relative size in the market”: FTSE is diversifying its non-market cap weighted indexation business. It already has the FTSE-RAFI indices with Rob Arnott and his group. The new FTSE-GWA indices seem to be direct competition to the FTSE-RAFI and not to WisdomTree’s indices.

· “…historic studies suggest that the strategy can be expected to outperform traditional market capitalisation indices by approximately 2 percent per annum over the long-term with similar or lower levels of risk.”: This sounds a lot like what Research Affiliates says. In fact, in John Mauldin’s book, he has a chapter dedicated to a discussion with Rob and the “2 percent premium”.

· “Wealth-weighted indices, by definition, hold greater weightings in securities with below-average price to earnings (or price-to-book or price-to-cash flow) ratios and are therefore considered “value” biased.”. This is followed up a couple of paragraphs down by this: “the weighting of individual securities is based on fundamental financial data — in this case earnings, cash flow and book value — rather than a security’s price and number of shares (market capitalisation).”: So SSGA focuses on 3 factors: earnings, cash flow and book value as opposed to Research Affiliates and their 4 factors of book value, income, sales and dividends.

· “…expects the product will co-exist peacefully with market cap indices, providing an interesting investment alternative.”: I have agreed with the idea of using very low cost market cap weighted ETFs along with some use of fundamental weighted ETFs.

I’m not sure what to think of this. Barclays Global Investors and SSGA have been the big gorillas in this industry from the beginning. Although having some big names like the Spyders (SPY), SSGA has basically lost the battle in the retail oriented ETF business. However, with its stated US$1.5 trillion mentioned at the bottom of the press release, “losing” hardly seems like the appropriate term. Certainly, like BGI, SSGA has a very substantial institutional business. But diversifying into fundamental indexation? This leads me to believe that Research Affiliates and WisdomTree are still so small that they might just not have the logistics and resources to tap the global megapensions and endowments who would be interested in this new innovation - or at least SSGA sees a window of opportunity as they already have the ear of many in the institutional space (at least more so than Research Affiliates). But that’s the institutional side.

What happens if SSGA decides to build products (ETFs) based on their fundamental indexation methodology for the masses. This could be an unforeseen problem for both Research Affiliates and WisdomTree. In the ETF market, “first to market” matters (think GLD versus IAU), but if SSGA enters the ring, it really would be a case of two Davids versus a supersized Goliath. I still am a supporter of Rob Arnott and his group. Frankly, his 4-factors just makes more sense than the alternatives and the numbers back it up.

[However, to make full disclosure, I have zero of my client’s assets in any form of fundamental indexation products. All our non-market cap weighted exposure is in funds managed by Dimensional Fund Advisors as we’ve been with them since 2003.]

I see no rush for me to add or change positions related to this discussion as I plan to wait and see how this new area develops. This news from SSGA is certainly interesting and if SSGA were to enter this specialized market, I would only see a “lowest cost” approach as a way to entice investors to consider their offering.

I have a copy of Morningstar’s “ETFs 100” on my desk as it’s a decent source of info on US domiciled ETFs. It basically has a nice 1-page fact sheet for each ETF as of December 31, 2005. Each page has (thankfully) no assessment for the ETF in terms of number of stars although there is some commentary/opinions given in a few short paragraphs. Yesterday I came across this from the IndexUniverse.com website (sub. req.):

Is Simple Better?

Morningstar bestowed its highest possible mutual fund honor on the Rydex S&P Equal Weight ETF (RSP), awarding it five stars for the three years ending June 30, 2006. The Morningstar rankings are based on risk-adjusted performance, with funds measured against other funds in the same category – large cap growth funds against large cap growth funds, small cap value against small cap value, etc. RSP was evaluated in the “large blend” category, and apparently, it compared well.

Before we celebrate (and evaluate) RSP’s performance, however, let’s take a moment to pity the poor active fund managers in RSP’s category. Imagine their fate: They’ve been staying up late, pouring over company filings; they’ve logged 100,000 air miles shuttling to and from conferences and corporate headquarters; their hair is turning gray, there are bags under their eyes, and they haven’t seen the sun in weeks. Maybe they are doing well … maybe their performance is up, and they’re looking at three or even four stars … when along comes RSP, flouncing by with its simple equal-weighting methodology, and it earns five stars without breaking a sweat. It is the idiot savant of strong performance. If I were an active fund manager, it’d drive me crazy.

I mean, let’s be serious: The strategy winning these accolades could not be simpler – you hold all the stocks in the S&P 500 at equal (0.20 percent) weightings, and rebalance quarterly. That’s it. No comparative analyses or complicated quant-driven programming. Instead, it’s like a kid in a candy store: I’ll take one of those, and one of those, and one of those…

I don’t mean to criticize the fund. RSP has delivered 16.27 percent annualized returns to shareholders over the past three years, compared to just 11.22 percent for the traditional S&P 500. And there’s a good body of evidence that suggests that both mid/small tilts and regular rebalancings are associated with improved performance – both of which RSP provides in one fairly inexpensive packet.

But the utility of the rating – like the utility of all Morningstar ETF ratings – is suspect. We know that RSP’s portfolio sits on the very edge between mid- and large cap exposure (57 percent large cap vs. 43 percent mid-cap exposure, according to Morningstar). With that in mind, the rating tells us … what, exactly? That small/mid caps have outperformed large caps over the past few years? Well, yeah…

And if small/mid caps fall out of favor for a while???

I do think there is some utility in the Morningstar ratings for ETFs when applied to the fancy, quantitative strategies, of the kind introduced by PowerShares and its various followers. After all, those funds are trying specifically to “beat the market,” not to simply provide exposure to a given slice of the market. (Note: The PowerShares Dynamic Portfolio (PWC) – one of PowerShares’ flagship “enhanced index ETFs” - has also received a five star rating from Morningstar, and has outperformed RSP over the past three years.)

But for most ETFs, I’m not convinced. So, congrats to RSP – they have an interesting fund that incorporates some basic good ideas for shareholders, such as rebalancing on a regular basis, and they’ve delivered strong returns. But my advice? Don’’t let it go to your head.

So, we now have Morningstar providing ratings for ETFs. Intuitively, I wouldn’t think that those in the investing world would find much value in Morningstar ETF ratings. Certainly, for the truly passive ETF based on the traditional, market cap weighted indexation, what would be the point? I suppose it would be similar to the S&P SPIVA reports which determine how well active managers beat their relative index. In the case of the Morningstar report, instead of comparing active managers within a certain asset class or subclass, they’d be making the comparison to the more appropriate, after fees/costs equivalent, ETF.

More importantly, the writer discusses the value of ratings on enhanced index ETFs with specific mention of PowerShares’ ETFs based on their Intellidex methodology. I would agree that Morningstar has a case to provide ratings to the new batch of ETFs based on quasi-active management. In addition to the ETF mentioned, this would also include those from PowerShares (based on RAFI methodology) and WisdomTree. Although DFA is not in the ETF space, it would be interesting to see Morningstar’s commentary on the fundamental indexation based ETFs versus the Fama-French based mutual funds from DFA. However, I’d be quite doubtful if their examination would be anything close to the highly quantitative analysis I’ve seen (William Bernstein, Burton Malkiel) seen recently surrounding the introduction of fundamental indexation funds from PowerShares and WisdomTree.

For me, as someone whose company tilts more against the role of manager selection, I have never been a fan of Morningstar ratings. I will only expand briefly on this by saying that if an investor can use some form of inexpensive means to gain broad market exposure (index derivatives or ETFs), that should be the focus. Manager selection should be limited to areas where these products just don’t make sense for various logical or logistical reasons such as private equity, hedge funds, infrastructure, etc.

Despite this, I suppose there’s nothing wrong with someone out there who has built a name - some would say good, some would disagree - based on rating funds (OEF or otherwise). What I don’t understand is how an investor can consider the Morningstar rating system anything more than a rough guide. Certainly I hope it isn’t used even partially to build an investment process.

Last thought: There’s been a lot of commentary online about the fundamental indexation ETFs. There has also been some analysis and follow-up commentary comparing FI methodologies and results to the Fama-French models. There has not been much discussion comparing any of this to RSP. Similar results in terms of dialing down the large cap in favor of small cap. RSP also has a longer track record, albeit entirely in a strong bull market. Morningstar ratings aside, the concept of equal cap weighting is so simple, it’s silly. Other indexes also have ETFs with equal weights. Of course they have their downside of greater trading costs and the related performance drags such as taxation. I’d be interested to know if the performance of equal cap weighting is inferior to fundamental indexation (whoevers version you use) for, let’s say the broad US equity market. Also, if so, by roughly how much?

It’s interesting that a lot of innovation in the ETF space has come out of Canada. We’re like an incubator of ideas before the full rollout of products occurs in the US and globally. Below I discuss some new offerings to this market. They may prove to be clues of similar offerings that could soon appear in your jurisdiction.Up here in Canada, the ETF market is dominated by Barclays Global Investors. Recently BGI rebranded their ETF lineup from iUnits to iShares, similar to their ETF family in the US. DFA has had a presence here as well since 2003. TD Asset Management (a subsidiary of TD Bank) had a short attempt at the industry with a small family of ETFs. With a broad composite, as well as value and growth tilts on it, I thought these funds had a decent shot at building a following. It didn’t happen. My feeling is that the Canadian market is not that big, certainly not big enough to sustain too many ETFs. Still, as we’ve seen globally, ETF investing is gaining significant ground here.

Enter Claymore Investments (“Claymore”), a Canadian subsidiary of the Claymore Group out of Chicago. As I reported on June 20th, Claymore has teamed up with Rob Arnott’s Research Affiliates to bring fundamental indexation to Canada. Claymore now plans on launching 6 new ETFs in the following areas:

· Global Fundamental Indexation

· US Fundamental Indexation

· Japan Fundamental Indexation

· Oil Sands

· BRIC (Brazil Russia India China) and

· Dividend & Income

Like the Canadian Fundamental ETF, the new Claymore ETF FTSE RAFI products have a 65bps MER. The other 3 ETFs have a 60bps MER. Interestingly, Claymore has a 2nd class of ETF called “Advisor Class Units.” This tacks on 75bps as an annual service fee (in Canada, we call it a trailer fee) payable to the client’s advisor. A couple of thought on this fee structure. First, it allows Claymore’s offerings to have broader appeal, at least for those who are involved in selling financial products. Specific to Canada, I remember learning from DFA that their class of funds with similar trailer fees was a new company development tailored for the Canadian market. I believe that the Canadian marketplace is still behind the curve when product developers have to provide incentives to sell their products where such incentives are not required in other jurisdictions.

For global readers, I believe that the significance of the new fundamental weighted ETFs is further proof of the growth of non-market cap indexation. It’s too early to say whether or not fundamental indexation is a fad. Anything can happen, and like TD’s ETFs in Canada, any ETF without a large size of assets under management can quickly be shut down. However, I can only imagine that Rob Arnott as well as the guys from WisdomTree are making their rounds globally trying to spread their wares. The evidence is compelling: Moving away from cap weighted indexation, whether towards Arnott, Siegel or Fama/French, provides better risk-adjusted returns.

Now let’s focus on their last three ETFs. First, the oil sands. I don’t think this one is late to the market but my feeling is that every Canadian already has a position or ten in this sector. BGI Canada has an ETF that tracks the S&P/TSX Energy sub-sector (XEG), has a real track record of about five and a half years and with the usual oil sand majors well represented. Still, it’s true that there is no ETF specifically for the sector. The market will decide if one is needed.

Similarly, BGI has a dividend and income ETF even though it’s only about seven months old. It tracks the Dow Jones Canada Select Dividend Index. Although Claymore’s offering tracks a different underlying index (Mergent’s Canadian Dividend & Income Achievers Index), I’ll be eager to learn what are the overall yield targets and see how historical backtests compare in terms of volatility of returns. I would be surprised to see much difference between the two.

According to my contact at Claymore, this is the first BRIC ETF in the world. A lot of people have been waiting for this. Its planned launch is August 15th. It is based on the ADR’s that trade in the US, which limits liquidity concerns and local market issues. Also, the ADRs are only issued by companies that are regulated by the SEC. This is good in terms of dealing with companies that follow standardized accounting practices but clearly eliminates a lot of companies in these countries. Of interest only to Canadians is that the US$ currency from the ADRs will be hedged to eliminate the FX risk. Of interest to American and other investors is that a US domiciled version should be not too far behind.

The portfolio has roughly 70 holdings. Country breakdown is currently 50% Brazil, 30% China, 15% India, and 5% Russia. Since ETFs already exist for Brazil and China, I would be happier if larger allocations were given to India and Russia.

Industry Breakdown is:

Energy 29.33%

Telecommunication Services 16.28%

Financials 16.17%

Materials 14.91%

Information Technology 9.47%

Industrials 4.36%

Consumer Staples 4.15%

Utilities 3.35%

Consumer Discretionary 1.43%

Health Care 0.55%

My only concern with the BRIC ETF is the same I have with EEM. Another play on the commodity complex?! EEM’s chart looks a lot like that of an energy sector ETF. As time passes, I think I want to be dialing down, not up, on my overall commodity exposure. I’m still completely bullish on commodities, although maybe not like Jim Rogers, but I’m always thinking about how much of my portfolio is “commodity sensitive”, especially considering the flaw of “home bias” and thus how much our clients have in the Canadian market which is nearly 50% energy/materials. The dialing down of commodities may not be happening soon but I am simply cautious now of adding more.

What would really interest me is a product offering that combines the concept of BRIC investing with specific sectors that just make sense for these areas. For example, what about an infrastructure fund investing primarily in the BRIC countries? This would certainly be an actively managed fund so I”ll stop there.

As a professional manager, I’m happy to see the added fundamental weighted ETFs as potential core asset class positions. The BRIC ETF could be a nice add-on to the international equity lineup of EFA/EPP/EEM. However, with the still relatively young Canadian ETF industry, not in terms of years but in terms of assets and trading volumes, I will be somewhat cautious. With increased trading volumes I will become more comfortable in implementing these positions.

But what this industry really needs is greater acceptance of new entrants. This includes Claymore in Canada as well as WisdomTree, ProShares and Powershares in the US. Nothing against BGI, but maybe as an owner/operator of a small shop myself, I cheer for the small guy. BGI certainly has been an innovative provider in the past with new ETFs for more diverse asset classes but it’s the new small providers that have become the new innovators. Are they bringing too many products for the markets? Let the market decide. Some may become a BGI. Some may become a TD.

Let’s get ready to rumble. Non-market cap weighted indexation is starting to heat up even futher. DFA started it a long time ago. Rydex brought out RSP a little over 3 years ago.Rob Arnott has been talking about fundamental indexation for a few years now, and his firm Research Affiliates teamed up with index provider FTSE and manufacturer PowerShares to provide the first “fundamentally based” index ETF with The PowerShares FTSE™ RAFI US 1000 Portfolio (PRF).

With WisdomTree’s version of fundamental indexation based on the research of Professor Jeremy Siegel (focused on dividends, while Arnott’s version is based on four fundamental factors: book value, income, sales and dividends) launched just last month, PowerShares has countered with news of the registration with the SEC for ten new funds. Again they will be branded as PowerShares FTSE™ RAFI Portfolios but will cover nine sectors. One will cover small-mid caps. Here’s the list:

* FTSE RAFI Basic Materials Sector Portfolio
* FTSE RAFI Consumer Goods Sector Portfolio
* FTSE RAFI Consumer Services Sector Portfolio
* FTSE RAFI Energy Sector Portfolio
* FTSE RAFI Financials Sector Portfolio
* FTSE RAFI Health Care Sector Portfolio
* FTSE RAFI Industrials Sector Portfolio
* FTSE RAFI Telecommunications & Technology Sector
* FTSE RAFI US 1500 Small-Mid Portfolio
* FTSE RAFI Utilities Sector Portfolio

It will be very interesting to see the growth in assets in these funds versus those of WisdomTree. One thing that has always been an important truth in the ETF industry is that first to market matters. Consider GLD versus IAU. In this case however, there is more of a fundamental (sorry) difference between what WisdomTree and PowerShares are providing.

Side note: PowerShares is reportedly registering 31 new funds with the SEC, including those mentioned above. The vast majority of these new funds (all but 6) are sector funds. Question: Don’t we already have enough sector based ETFs? If they don’t have comparable MERs or cover new territory (geographic or otherwise), you really have to wonder. The one that really gets my interest is the Cleantech ETF. I’d like to add that to our PBW position.

There’s been alot of recent news about new offerings being introduced by WisdomTree and Powershares and some not so recently by the bigger shops. I have two comments:

1. Market cap weighted indices. Rob Arnott is often credited with the introduction of an alternative to market cap weighted indices – specifically, the idea of an equal weighted cap index. The data looked conclusive and made a lot of common sense. In many ways, the basic idea overlapped well with the Fama-French 3-factor model which considers size (small versus large stocks) and value (high book-to-market ratios versus low BTM ratios) in addition to just market risk [CAPM]. So when the Rydex S&P Equal Weighted ETF (RSP) came out in 2003, which in highsight was a perfect long-term entry point after the bear market of 2000-2002, it looked like a good core holding for US equity exposure.Thereafter, Arnott’s writing moved into the area of fundamental weighted indexing and with it, a combination of various fundamental measures which could determine the composition of an index in a slightly more complex manner. More recently, Arnott’s firm Research Affiliates has worked with various manufacturers to introduce the next stage of non-market cap weighted ETFs, specifically PowerShares FTSE™ RAFI US 1000 Portfolio (PRF) as well as ClaymorETFs FTSE™ RAFI Canadian Index Fund (CRQ on the TSX), both based on his concepts of fundamental indexing. However, just like any other method of building an “index”, fundamental indexing will perform better than other manners of indexing in certain, but not all, markets.

WisdomTree’s new ETFs tread fairly closely to these also using the term “fundamental weighted indexing” in their marketing material (.pdf). I give true credit for a practical alternative to market cap weighted indices to Dimensional Fund Advisors. I find it interesting that DFA, the real pioneers of “thinking outside the box” in the world of index investing and whose funds revolve around the Fama-French 3-factor model, have not entered the ETF space. Their US-domiciled funds have a much longer-term track record compared to most ETFs, and have a loyal, almost “cult-like” following which is now growing internationally into the UK, Australia, Canada and other jurisdictions.

However, the way in which they market their funds through selective advisors does not lend well to a transition into ETFs. Furthermore, with the recent entry of WisdomTree, there may not be enough space in such a specific ETF market, but there still are some differences between the philosophies and methodologies at the two firms.

To me, the simplicity of RSP (equal weighted indexing) is magnified compared to the newer offerings of recent weeks or even the 3-factor model+. Costs seem comparable, but what we are seeing here is the move towards something that looks less like a traditional index instrument and more like a quasi-active fund. Powershares seems to be pushing the envelope the most as WisdomTree’s offerings lean more towards a simple dividend oriented bias.

Will someone try to build a fund that tracks an index whose underlying constituents are actively managed, such as a hedge fund index? Whether the logistics works out or not, I’d rather not see that happen. I can only imagine the spread between the market price versus the underlying fund’s NAV in addition to the numerous other potential complexities. Overall, it certainly is interesting what’s happening and I’m always eager to see what new innovation in coming down the pipe.

2. Although I am happy to see innovation in the ETF space as explained above with alternatives to market cap weighted indices, I am not so happy with what is broadly coined as “alternative investments”. Obviously, we’ve seen new products brought forth in conjunction with the commodities boom of the past few years, and especially very recently (GLD), (SLV), (USO), (DBC).

My concern with these is similar to the countless Nasdaq linked index products which came out just prior to the top in 2000. The idea of investing in materials and energy makes sense as components in a broadly diversified global portfolio. I just can’t see them being major (> 10% in each) holdings in this kind of portfolio.

Speaking of this type of portfolio, what would be a good model to follow? I like to see what certain large institutions are doing. Up here in Canada, we have a few pension behemoths that are quite innovative. In the US, there are far more interesting ones to choose from, but I’ll focus on endowments such as those at Yale and Harvard.

Without going to deep into details, I propose a read of Yale’s latest annual report (.pdf). A key excerpt that shows how different they think in terms of asset allocation:

Today, target allocations call for less than 20 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real estate dominate the Endowment, representing more than 80 percent of the target portfolio.

Furthermore, they state that:

The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

Clearly, there are challenges to building an ETF, or other highly liquid instrument, for certain of these asset classes. So far, for investors interested in building a portfolio more aligned to institutions such as Yale, the energy complex and real estate are areas where they have been able to participate.

For real estate, REIT ETFs (RWR), (IYR), (ICF) are a start and Robert Shiller has been making the rounds promoting housing futures that began trading on the CME in late April. So, for the next stage of the growing ETF universe, what about an offering related to timber? Investment returns related (among other things) to the physiology of trees sounds like something that should be uncorrelated to the broad markets and may also provide decent yield. Another interesting area is infrastructure. So far, closed end funds (MIC), (MFD), (MGU) are the only viable choice for non-institutional investors.

Despite the interest from institutions in both these areas, I doubt there’s any significant interest from the ordinary investor that could lead to an ETF. But how many large cap value funds (whether domestic, international, or whatever) can you have out there?