I received the latest press release form Van Eck Global. Earlier this year, they entered into the ETF market with their first offering – a gold producer ETF (ticker: GDX). As of September 30, 2006 it has over $250 million in assets and averages over 500,000 shares traded per day. It’s even option eligible. We maintain gold exposure through XGD, an iShare ETF domiciled in Canada giving exposure to stocks in the TSX Gold Subindex. Basically, this would be Canada’s counterpart to GDX. This is complemented with GLD. We’re holding no more than 5% in these gold related positions right now and don’t plan on touching these.Some news on two new ETFs from Van Eck Global from today’s press release:

Today, we are launching two new unique ETFs, one on Environmental Services and another on Steel shares. Both are based on indices developed and calculated by the American Stock Exchange.

Market Vectors Environmental Services ETF (ticker: EVX) is the only way we know of for investors to gain exposure through an ETF or mutual fund to the fast-growing environmental services industry. This ETF seeks to track, before fees and expenses, the performance and yield of the Amex Environmental Services Index [AXENV].

Market Vectors Steel ETF (ticker: SLX) gives investors a unique and important way to focus on steel, an industry that is fundamental to consumer durables, capital spending and construction and one undergoing significant change. SLX is the only ETF or mutual fund that we know of that investors can use to gain exposure to the steel industry. This ETF seeks to track, before fees and expenses, the performance and yield of the Amex Steel Index [STEEL].

More information on Van Eck and their “Market Vector” family of ETFs can be found at on their website.

With regard to EVX, I think about how it might play along with our clients’ positions in PBW (PowerShares WilderHill Alternative Energy ETF) which I have discussed in the past here and here. PBW casts a fairly wide net. It has utility companies that are relatively clean in terms of using hydroelectric power versus the burning of fossil fuels as one example. It also has significant “high tech” type exposure with companies in the clean energy industry. In fact, according to the PowerShares website, IT has the largest sector weight in PBW with 37.26%. For anyone interested in doing some “comparison shopping”, here’s the list of constituents in the Amex Environmental Services Index [AXENV) picked right off the AMEX website:

Amex Environmental Services Index [AXENV]

“Constituents as of September 29, 2006″

Ticker Component Name Shares

(ARS) Aleris International Inc. ” 112,920 ”

(AW) Allied Waste Industries Inc. ” 523,358 ”

(CCC) Calgon Carbon Corp. ” 801,254 ”

(CLHB) Clean Harbors Inc. ” 133,699 ”

(CVA) Covanta Holding Corp. ” 271,936 ”

(CWST) Casella Waste Systems Inc. ” 312,291 ”

(DAR) Darling International Inc. ” 1,411,638 ”

(ECOL) American Ecology Corp. ” 298,630 ”

(FTEK) Fuel-Tech N.V. ” 237,863 ”

(LAYN) Layne Christensen Co. ” 196,169 ”

(MTLM) Metal Management Inc. ” 212,749 ”

(NLC) Nalco Holding Co. ” 304,219 ”

(NR) Newpark Resources Inc. ” 1,069,342 ”

(RSG) Republic Services Inc. ” 433,275 ”

(RTK) Rentech Inc. ” 1,205,275 ”

(SGR) Shaw Group Inc. ” 234,497 ”

(SRCL) Stericycle Inc. ” 83,439 ”

(SYGR) Synagro Technologies Inc. ” 842,800 ”

(SZE) SUEZ France ” 383,091 ”

(TTEK) Tetra Tech Inc. ” 330,558 ”

(VE) Veolia Environnement ” 286,354 ”

(WCN) Waste Connections Inc. ” 149,905 ”

(WMI) Waste Management Inc. ” 475,926 ”

(WSII) Waste Services Inc. ” 370,612 “

Just below this list on the same page, AMEX gives daily price data going back to March 30, 2001 for all you backtesters.

For those of you more interested in the Steel ETF, here’s the low down on the Amex Steel Index (STEEL) from the same source:

Amex Steel Index [STEEL]

“Constituents as of September 29, 2006″

Ticker Component Name Shares

(AKS) AK Steel Holding Corp. ” 176,054,206 ”

(ATI) Allegheny Technologies Inc. ” 161,006,988 ”

(CAS) A.M. Castle & Co. ” 26,503,386 ”

(CGA) Corus Group PLC ” 797,929,419 ”

(CHAP) Chaparral Steel Co. ” 74,220,357 ”

(CLF) Cleveland-Cliffs Inc. ” 67,012,665 ”

(CMC) Commercial Metals Co. ” 193,332,833 ”

(CRS) Carpenter Technology Corp. ” 40,811,599 ”

(FSTR) L.B. Foster Co. ” 16,795,555 ”

(GGB) Gerdau S.A. ” 690,673,048 ”

(GNA) Gerdau AmeriSteel Corp. ” 488,139,610 ”

(IPS) IPSCO Inc. ” 75,477,624 ”

(LSS) Lone Star Technologies Inc. ” 49,212,576 ”

(MSB) Mesabi Trust ” 20,986,446 ”

(MT) Mittal Steel Co. N.V. ” 580,505,687 ”

(MTL) Mechel AOA ” 221,952,459 ”

(MTLM) Metal Management Inc. ” 43,028,612 ”

(NSS) NS Group Inc. ” 36,217,615 ”

(NUE) NuCor Corp. ” 258,252,205 ”

(NX) Quanex Corp. ” 59,128,351 ”

(OS) Oregon Steel Mills Inc. ” 57,282,440 ”

(PKX) POSCO ” 264,141,742 ”

(RIO) Companhia Vale do Rio Doce ” 1,905,989,847 ”

(ROCK) Gibraltar Industries Inc. ” 47,643,391 ”

(RS) Reliance Steel & Aluminum Co. ” 120,668,864 ”

(RTP) Rio Tinto PLC ” 213,201,208 ”

(RYI) Ryerson Inc. ” 42,017,680 ”

(SCHN) Schnitzer Steel Industries Inc. ” 49,162,989 ”

(SID) Companhia Siderurgica Nacional ” 416,449,219 ”

(SIM) Grupo Simec S.A. de C.V. ” 224,588,561 ”

(STLD) Steel Dynamics Inc. ” 80,868,198 ”

(STTX) Steel Technologies Inc. ” 20,871,276 ”

(TKR) Timken Co. ” 150,337,812 ”

(TX) TERNIUM S.A. ” 320,673,531 ”

(USAP) Universal Stainless & Alloy Products Inc. ” 10,298,075 ”

(WOR) Worthington Industries Inc. ” 141,868,054 ”

(WPSC) Wheeling-Pittsburgh Corp. ” 23,529,773 ”

(X) United States Steel Corp. ” 199,724,908 ”

(ZEUS) Olympic Steel Inc. ” 16,680,385 “

I see the Steel ETF as a potential building block for an infrastructure sub-portfolio. Thus far, I have focused on closed end funds from Macquarie (MIC, MFD, MGU, etc.) all traded on the NYSE. Stock selection makes sense here as well with positions such as CEMEX (CX) and Caterpillar (CAT). It’s amazing how this commodity plays into so many other asset classes. Another case aside from infrastructure would be alternative energy. I’ve heard from wind farm developers that one of their biggest costs is the price of steel. Another correlation play tying the commodity complex with alternative energy.

If you’re looking for the link that leads you to the above data, here it is.

Some further interesting notes about the composition of the two underlying indices from AMEX. This is from an October 3rd press release from AMEX found on PRNewsire:

The Amex Steel Index is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the production of steel products or mining and processing of iron ore. The Amex Environmental Services Index is a modified equal-dollar-weighted index comprised of publicly traded companies that are engaged primarily in consumer waste disposal, removal and storage of industrial by-products and the management of associated resources.

If you read closely you’ll see that the Steel Index is market cap weighted. The Environmental Services index is equal dollar weighted. I would very much be interested to hear what Rob Arnott would have to say about this. He’s the first person I heard discussing the benefits of non-market cap weighted exposure with first the concept of equal weighting and then the concept of fundamental indexation.

From the same press release, the next paragraph states:

The Amex Steel Index includes common stocks or American Depositary Receipts (ADRs) of selected companies with market capitalizations greater than $100 million that have an average daily volume of at least $1 million over the past three months. The Amex Environmental Services Index includes common stocks or ADRs of selected companies with market capitalizations greater than $100 million, three-month trading price greater than $3.00, and three-month daily average traded value greater than $1 million.

It’s fairly clear that there are not a lot of steel companies that can be put into the Amex Steel Index. However, the environmental services is certainly an area for decent long term growth. I would expect to see hundreds if not thousands of potential stocks that could be in this index now and in the not too distant future. Keeping a $3.00 minimum average price makes sense if not simply to keep the cost of running this ETF reasonable.

I love these new ETFs breaking into new asset classes. Keep ‘em coming.

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?

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?