Roughly a year ago, I wrote a post discussing the concept of alpha (that rare and valuable thing) which becomes less rare and eventually commoditized into beta in time. Here’s a bit of what I said at that time:

Isn’t alpha supposed to be the returns from a strategy that is based on market inefficiencies? If so, then shouldn’t these market inefficiencies disappear as other players enter the field? This line of thinking is discussed in this paper available on SSRN:

By the way, this paper was written by market participants. At the time of its publishing, the authors worked for ABP Investments which, according to its website, is the 2nd largest pension fund in the world. This paper discusses how investment processes can be divided into two groups:

Traditional beta which they call “commoditized beta”. This is based on exposures to various markets and is the classic definition of market risk.

Traditional alpha which they call “non-commoditized beta”. This is based on other risk factors not associated with market exposure.

Basically, the writers of this paper sum up things well in four points (bottom of page 4) provided here ad verbatim:

1. Any investment process which today generates return by taking exposures, which are not well known, will become obsolete progressively, as the exposure premium reduces or the exposure is commoditized.

2. As exposures become commoditized, the space to generate additional alpha return (from the residual) decreases, and the space for beta return increases.

3. There is practically no alpha based exposure, which cannot be commoditized.

4. The investment problem which originated in finding exposures to generate alpha will gravitate towards becoming the process of analyzing when to take a specific commoditized beta exposure.

They go on to say that the alpha versus beta debate is irrelevant. “The eventual investment problem is therefore not to now generate exposure combinations, which would generate alpha, but to be able to time the betas of the existing exposures. We therefore believe that active management will devolve to an exposure based allocation process, where the objective is largely to allocate to different forms of beta, and where alpha does not actually exist. Portfolio diversification is then just the diversification obtained by applying the forecasting process to more than one beta.” This is basically a rewording of point #4 above.

A key point from the above I believe is this: ” … where the objective is largely to allocate to different forms of beta.”

Remember, this was written by some portfolio managers who were at ABP, one of the world’s largest pension plans. They’re trained and compensated to care about the long term horizon, not the short term. But it seems like what they’re saying is that not only should one NOT stick to only investing in the plain vanilla betas (broad market index exposures … let’s just call that the very large, broad, market-cap weighted ETF behemoths which generally come with low management fees) but in fact must allow for the niche exposures personified by the newer and more controversial ETFs that have higher fees. I’m assuming that these niche ETFs provide the required “different forms of beta” mentioned above. The writers say that alpha does not actually exist in these areas (this could be sector or regional exposures). They even go so far as to say that the investment problem should focus on the timing of the beta exposures.

Let me be clear: The moment you talk about timing beta exposures, you’re talking about actively managing your ETF holdings. I’m not sure if this is what the original ETF pioneers were thinking about roughly 15 years ago but I don’t believe that this paper I was referring to was written by two dummies. I have great respect for this philosophical exercise in thinking about alpha and beta.

Why do I bring this up today? Well today, I spoke at the Hedge Funds World Canada conference here in Toronto. I led a session in the afternoon focusing on matters related to beta within an alpha centric world (it’s a hedge fund conference in case the event’s title wasn’t clear). The session following mine focused on alpha but since the two greek letters are very much related in portfolio theory, there was some overlap.

Aside: Interestingly enough, I found the term “beta” used just as much (if not more) than “alpha” in this first day of this conference. There was a session on 130/30 programs. These mandates are engineered to remain extremely constrained so as to continually have beta of 1.0. Again, at a hedge fund conference. Beta 1.0!!! Isn’t that an index fund?! Well not necessarily but it kind of blurs the line between hedge funds and mutual funds. At the least, it certainly makes me think what Jones, Soros, Robertson and other “old school” hedgies would think about a mandate with a target beta of 1.0 being discussed at a hedge fund conference. 130/30 programs also called a variety of other names including “Active extension strategies” and are commonly discussed in many other events both related to hedge funds, ETFs and well just about any investment related conference these days. Think of it, currently anyway, as the rock star of the institutional investment community. Well, I don’t know about rock star … why am I picturing a bunch of pension actuaries dressed up in leather like Kiss for their office Halloween party? Note to self: Too much coffee at the conference today.

Well, from one of the discussions today, I was reminded of the concept of alpha as simply un-commoditized beta. And when I got back home, I found an email from HSBC about a new set of indices:

HSBC has announced the launch of its Global Climate Change Benchmark Index, together with a family of four investable global climate change index products.

The HSBC Global Climate Change Benchmark Index, developed by CIBM’s Global Research team, is a global reference index which has been designed to reflect and track the stock market performance of key companies that are best placed to profit from the challenges presented by climate change. The performance of the benchmark has been tracked back to 2004 and has outperformed the MSCI World Index by around 70%.

From this benchmark, HSBC has established four investable climate change indices that can be used to create portfolios for a diverse range of investment needs such as long only funds, hedge funds, exchange traded funds, discretionary funds and structured products. The indices are:

• HSBC Climate Change Index

• HSBC Low Carbon Energy Production Index (including: solar, wind, biofuels, geothermal)

• HSBC Energy Efficiency & Energy Management Index (including: Fuel Efficiency Autos, Energy Efficient Solutions, fuelcells)

• HSBC Water, Waste & Pollution Control Index (including: water recycling, waste technologies, environmental pollution control)

In creating these indices, HSBC has responded to changing investor sentiment in global equity markets. The HSBC research team has looked at a wide range of stocks and identified approximately 300 companies that are well positioned to benefit from the challenges of climate change.

Group Chairman Stephen Green said: “HSBC has long recognized the importance of climate change and has shown real commitment to addressing the risks and opportunities it brings. In developing tailored climate change indices we are providing real investment solutions which enable our clients to incorporate climate change into their investment decisions.”

By the way, attached to the email was a 24-page report from HSBC’s Global Equity Quantitative Research group and the lead analyst’s name is Joaquim De Lima. Please don’t ask me for this report as I don’t even know how I suddenly got on their mailing list. I provide this bit of info so that you can go to HSBC and make your own inquiry. Now my thoughts.

What can I say … another set of new indices. Am I surprised that again we see something introduced to the market within the realm of climate change? Not really. The entry of alternative energy related ETFs has shown no signs of slowing down and I have discussed this area several times in the past. By the way, have you seen how PBW has been doing?

Up nearly 40% year-to-date and despite some ugliness in concert with the markets this summer, a strong rebound in recent weeks.

Getting back to main topic, what I find interesting is that this sector, or perhaps parts of this sector, should be (only my opinion, of course) the domain of hedge funds. Although not a significant part of the above release from HSBC, ask yourself if the related space of carbon emission credits is really an efficient market. Take any of the above HSBC indices and ask yourself if there is an army of CFA/MBA/PhDs as well as Average Joes at home looking into these markets in the same way as Citigroup or Microsoft. No way … it’s just too new.

[FYI and another aside: I know that carbon trading is a hot topic and I’ve just mentioned it in passing here. According to the HSBC report, the sector breakdown of the overall Global Climate Change Index shows only three stocks (0.29% weighting in the index) to financials of which two (0.22% weight of index) positions are further classified as carbon trading. So basically, don’t think of this index or sub-indices as a strong play for the emissions trading market.]

Despite the fact that these new markets are relatively new, underdeveloped and lacking in the kind of information flow similar to most global large cap equities, I find it interesting that the commoditizing of what should be alpha-centric markets is happening with greater speed. This does not take away, of course, from the fact that within these markets there will certainly be traders, some of whom will be winners and likely many more who will be losers. Some will be alpha providers (losers) and some will be alpha takers (winners).

Thus, with new markets (relatively speaking when I use the term “new”), there will be opportunities for those with a beta point of view (assuming something like an ETF is quickly produced to commoditize that market) as well as those who are alpha-focused. This is not unique and goes simply back to the active versus passive debate which one must consider when investing in any asset class. My comment here, and what I find unique, is simply the observation that the commoditizing of alpha can be faster than one might imagine simply due to the evolution of the ETF industry away from broad market exposures and towards niche markets.

But coming back to the guys formerly at ABP: According to them, the beta point of view is actually a rather active set of decisions (timing beta) and thus leads to much less differentiation from the pure active point of view which is the hedge fund.

Confused? Then the newer niche ETFs likely have little meaning for you and a disciplined buy-hold strategy with a longer focus on the “hold” applies. Not so confused? Then maybe I’ll see you next week in Scottsdale Arizona for the “World Series of Exchange Traded Funds -West” conference where I hope to explore this topic and others in greater detail. Furthermore, for those in the Far East, keep your eyes on this blog as I’m hoping to get a spot in an indexing conference in Hong Kong as well as a fund conference in Seoul both in late November.

Hey, just thought of something. I just said that the speed of bringing an area of the capital markets to beta (that is, commoditized to beta in what would seem to be a healthy space for alpha oriented investors) has significantly increased. If that’s true then why is it that we’re only seeing the first international fixed income ETF coming to market now? Well, the shape of yield curves globally didn’t help as well as a nearly five year bull market whose growth rate looks steeper than what we saw in the 90’s (not including Nasdaq in the years before the top). So the commoditizing of alpha into beta is a concept which can not be gauged solely by monitoring the ETF marketplace. But it certainly does give a strong argument for the value and purpose of the many new entrants (and soon to be entrants) within the ETF community.

Thoughtful and significant exposures that have a real purpose within a portfolio construction process. If this is what new entrants in the ETF industry provide with their new product offerings, then I think it’s a good thing. As usual, the market will decide this.

We’ve seen a lot of big numbers both on the upside and downside in recent weeks in the markets, although in percentage terms nothing so dramatic. Truly an active manager’s market. However, with the indexes up strongly today, I also see an interesting report out from “Pensions and Investments Online” giving some interesting stats on the world of indexing. Key points:

• According to Pensions & Investments’ latest survey of the leading index managers, total worldwide assets under internal indexed management by the 53 managers surveyed reached $5.17 trillion as of Deember 31, 2006. This is up 13.5% from the $4.55 trillion as of June 30 but when adjusted for market changes, worldwide indexed assets increased 2.7%. Thus, not a dramatic increase for new indexed assets. But clearly, some decent returns from global indexes.
• The two size leaders, Barclays Global Investors and State Street Global Advisors, saw somewhat strong growth in assets: BGI reported $1.695 trillion in total worldwide indexed assets of Dec. 31, a market-adjusted increase of 0.45% over the six previous months. SSGA reported $1.517 trillion in worldwide indexed assets as of Dec. 31, a market-adjusted increase of 5.7%.
• For both BGI and SSGA, the main drivers for growth were the asset classes of international fixed income, domestic fixed income and internation equities. Domestic equity saw little to slightly negative change.
• Other names mentioned from the list were Vanguard, Northern Trust Global Investments, Mellon Financial and BlackRock.
• The top five index managers all reported market-adjusted drops in U.S. institutional tax-exempt assets under internal indexed management. In aggregate for this group, the decrease was 4.6%. According to Corin Frost of BGI, in the institutional tax-exempt space “… we continue to see a transformation from index mandates to enhanced and active strategies.”
• Furthermore, Northern Trust Global Investments saw the largest drop with a market-adjusted decreases of 12.1% in U.S. institutional tax-exempt assets. According to Robert S. Gray, director of sales at NTGI, “There has been a push for riskier products in general with more of an appetite for alpha. As a result, we are seeing money flow out of beta products such as pure indexing and into active and fundamental active products,” said Robert S. Gray, director of sales at NTGI.
• One possible reason why total worldwide assets are going up but U.S. institutional tax-exempt assets are going down is that investors around the world are reducing their home-country bias and investing more around the world, according to Maggie Ralbovsky, a managing director at Wilshire Associates.
• Enhanced indexed assets again saw a significant increase in assets. In the universe of U.S. institutional tax-exempt indexed assets, enhanced assets increase by 14.8% to $449.5 billion as of Dec. 31. The leading enhanced manager, BGI, saw its institutional tax-exempt enhanced assets rise by 18.5% to $150.7 billion as of Dec. 31.
• Total worldwide exchange-traded funds also saw significant growth. Total ETFs reached $451 billion as of Dec. 31, an 18.8% increase from $379.7 billion as of June 30. Only $5.5 billion of that total was institutional.

My thoughts:

First, a few short comments:

1. I wish we had some data from other asset managers in this area, especially the newer ETF providers just to see how their growth in assets compare over the same period.

2. Frost’s comments on the recent increased focus on enhanced and active strategies over indexing is interesting. Perhaps it’s simply behavioral finance. After over 4 years of a bull market (at the time of the survey), investors have simply accepted risk taking to a greater degree. Many might say that pure indexing and passive management is the greater risk due to poor performance during major market declines. But from what I read in S&P’s SPIVA reports, active managers don’t really do that well in bad times for nearly all asset classes. Adding active managers is simply adding on another level of uncertainty.

To me, the key point from P&I’s report is that indexing is still a powerful force but is showing some loss in momentum. Where do we see growth? Fixed income, international markets and enhanced indexing. Also some small mention of alternative investments but not in the context of index implementation. Why does this sound familiar?

No surprise we are seeing a significant push of new ETF products in these specific areas. BGI has made the strongest push recently for more fixed income ETFs but I hear of other providers having something in the pipe. There has obviously been a lot of product development both in North America and outside for international exposures. Enhanced indexing? Although the fundamental weighted ETFs from PowerShares and WisdomTree might not seem like it, they’re meant to be an improvement over market cap weighted indexing. I wouldn’t technically classify them as enhanced indexing but we can see in today’s environment that investors are striving harder for “better than average” returns. I suppose it’s a sign of the VIX@10 world … note that this survey was taken as of the 2nd half of 2006.

And of course, with ETFs covering private equity, commodities, real estate and infrastructure, the area of alternative investments is also within reach for investors. It’s this area, along with enhanced (and various forms of non-market cap weighted) indexing that I suspect to find the greatest growth in the ETF industry.

This is relatively good news for mutual funds and other active managers with sizeable assets. If the trend in indexing had continued its focus on tracking the traditional, low cost, broad market-cap weighted index, someone like a mutual fund company would have to bite the bullet and accept indexing as part of their investment philosophy or else chug along and hope for the best in an uncertain environment where investors don’t want to pay for sub-par performance. But simply getting into the pure indexing space just doesn’t make sense for the many professional investors who say “we buy good stocks and we sell/avoid bad stocks” (or something to that effect). Instead of going the full 180, they can use their marketing spin to adapt a quasi-index/quasi-active approach within their current fund lineup. So, instead of seeing another Fidelity take a swing at the ETF space in the way they did, perhaps we could see something more like what Invescap did with their acquisition of PowerShares.

This sort of logic leads to what I believe is currently a very short list of acquisition targets. Frankly, the ETF provider space is still way too small for a shopping spree of acquisitions. But it wouldn’t suprise me to hear of news related to WisdomTree or Claymore being bought … just conjecture. Also wouldn’t surprise me to see a hedge fund or two get into this beating out a mutual fund. Unlike most mutual funds, hedge funds are truly in the business of alpha and hedging their bets with a little bit of beta-based returns makes perfect sense to me. Although this logic makes perfect sense to me about 5 years ago.

Anyway, from all this, we get further evidence that the direction of the indexing and ETF space is onward and upward. No signs of slowing down unless you’re focused on the traditional origins of indexing. For those focused on further innovation in this space, not only does your future look good, I think you should be preparing for a potential financial event. Only at such a point in time, if and when we see a large number of acquisitions as described here, would you see me beginning to have significant concern for the health of the ETF industry.

Harry Kat, Goldman Sachs and a few other names have recently made news related to strategies designed to replicate hedge fund performance characteristics. HedgeWorld.com reports that Merrill Lynch has now joined the fray.Of importance is this paragraph:

“Our objective is to replicate the success of [exchange-traded funds] in the mutual fund industry and to apply it to the hedge fund industry,” said Heiko Ebens, head of the relatively new Americas Equity Derivatives Research group and one of the authors of the research that supported the new product. Concretely, this means the future creation of ETF products that would be linked to the new tracker, he said.

I’ve said it before and here’s further evidence that some form of ETF linked to an underlying hedge fund related instrument will one day be available. This in no way makes me a clairvoyant. After inflation indexed bonds, alternative energy, nanotechnology, private equity, infrastructure … you name it … it’s just a matter of time before the next domino falls.

But unlike what many including myself may have guessed, if this ETF is launched, it would not track a broad, commonly cited hedge fund index like those from Credit Suisse-Tremont or Hedge Fund Research. No, this one (again it’s “IF” … this is news on an index, not of an ETF yet) is quite specific referring to the Merrill Lynch Equity Volatility Arbitrage Index which attempts to replicate the returns of an S&P 500 volatility arb strategy. (Those fluent in the “greeks” can dig deeper.)

If you still have no idea what volatility arbitrage is, you know you’re not in long-only vanilla “let’s pick an ETF and plug it into our asset allocation optimizer” world anymore. Often, I try to comment on how ETFs may be used by hedge fund managers. Now we’re looking at how hedge fund strategies can be used by ETF investors.

How does a hedge fund strategy fit within a portfolio, especially one that is predominately implemented through the use of ETFs? There are many answers, but I’m not sure if going ETF all the way is the answer. I know that I’m not a fan of hedge fund indices, or some instrument whose underlying is an HFI, nor am I the biggest fan of a fund-of-funds in the vast majority of cases. Hell, I’m just not a big fan of hedge funds in general for the vast majority of retail investors period. At a certain size, the wealthy investor thinks about and implements the portfolio construction process in an “institutional” manner … whatever that is. The point is, after a certain threshold in size, fees are less onerous and detrimental to performance on a relative basis and the investor has the resources to apply the right amount (or at least better amount) of talent for the endeavor.

I’m going to watch this closely. Many investors may be enticed by the liquidity and perhaps added transparency of an ETF based hedge fund product. I wonder just how much in assets will make its way in.

Further to Matt Hougan and Roger Nusbaum’s recent entries, let me ante up and note that Russell Investment Group has launched an onslaught of over 300 new global equity indexes, covering roughly 10,100 securities. Russell has further acknowledged that talks are under way to develop ETFs based on these new indices.This move into globally oriented indices brings Russell toe-to-toe with MSCI whose iShares EAFE Index Fund ETF (EFA) and World indices have mass acceptance in the institutional space. To counter, MSCI has begun work to enhance its indexes and create additional benchmarks expanding its reach to roughly 98% of the world’s investable equity markets. This would match Russell’s coverage after the inclusion of their new indices.

So are we going to get hundreds of new ETFs linked to these new benchmarks? We won’t likely see new products for all of the new indices but we’ll see. I don’t believe that retail investors will want to have access to every country in Africa or central Asia (anyone interested in natural gas from Uzbekistan … I’ll bet there is!). But what about hedge funds? They are in the business of looking under every rock in every corner of the world. Certainly, hedge funds will have to expand further on a global scale and more significantly, into emerging markets. Within the ETF space, there is plenty of room for expansion in this area. There’s nothing specific for central/eastern Europe or the Mideast. What about Africa as a whole?

Perhaps it’s still early now, but hedge fund managers must be considering these areas if they have a global mandate. With hedge funds as significant users of ETFs, we will have to see just how realistic such a development is. The logistics are the problem. Will a market maker be able to provide the proper underlying requirements within the ETF structure in regions where capital markets are not as modern or robust? Hedge funds will find other means for exposure (private markets, etc.) but in time local market participants will surely do what they can to create locally domiciled ETFs to further their nation’s forward progression.

Keen ETF investors/observers should watch to see how new product development efforts continue in certain areas such as south-east Asia and other parts of the developing world.

According to Reuters, Standard and Poor’s were to launch Shariah-compliant versions of some of its equity indices yesterday. [Shariah forbids Muslims from receiving interest payments and from investing in companies involved in the production or sale of pork, alcohol, tobacco, pornography, gambling and non-Islamically structured finance or life insurance.] The indices - the S&P 500 Shariah, S&P Europe 350 Shariah and S&P Japan 500 Shariah – are very similar in nature to Socially Responsible Investing [SRI] indices such as those by KLD.This is not a new index in this space, by any means, as it comes out to compete with a similar index from Dow Jones which was launched back in 1999.

No details yet on how the S&P index is constructed, but the Dow Jones site gives the following description of the composition guidelines for its DJ Islamic Market Index:

The selection universe for the DJIM Index is the Dow Jones World Index, which covers approximately 95% of the float-adjusted market capitalization of 44 countries that are open to foreign investors. For the complete methodology of the Dow Jones World Index see Guide to the Dow Jones Global Indexes.

The DJIM Index includes all securities in the Dow Jones World Index that pass the following screens for Islamic compliance:

Industry Type: Excluded are companies that represent the following lines of business: alcohol, tobacco, pork-related products, financial services, defense/weapons and entertainment.

Financial Ratios: Excluded are companies whose:

* Total debt divided by trailing 12-month average market capitalization is 33% or more.
* Cash plus interest-bearing securities divided by trailing 12-month average market capitalization is 33% or more.
* Accounts receivables divided by 12-month average market capitalization is 33% or more.

Since 2000, there has been a fund traded on the NASDAQ which, although has the term “Index” in its name, could be classified as only a “partial index fund”. This is the Dow Jones Islamic Index K (IMANX).

According to Google Finance:

The fund normally invests at least 80% of net assets in domestic and foreign securities included in the Dow Jones Islamic Market indexes, as well as up to 20% of net assets in securities chosen by the fund’s investment advisor that meet Islamic principles.

So the fund is 80-100% passive, 0-20% active. More on the fund, its mandates and the managers who run it can be found on its website.

Performance wise, there’s not much difference to the S&P 500 as shown in this 3-year chart:

There’s also another Shariah-compliant index from FTSE and its site also gives details on its composition rules.

In terms of investable instruments and specifically ETFs, I don’t think there’s much out there. Here’s something I found information regarding an Islamic Index ETF but it’s traded in Kuwait.

Thus, for anyone interested in this type of mandate in a quasi-index form, the choices are pretty much limited to IMANX.

For those of you who have shown interest and may even be invested in the water ETF, PowerShares Water Resources (PHO), here’s some good news to bring water investing into a broader global perspective. According to AMEX:

The American Stock Exchange [Amex] [has begun] publishing Palisades Global Water Index [PIIWI] over the Consolidated Tape. The index will be published daily every 15 seconds between approximately 9:30 AM and 4:15 PM starting on Monday, December 11, 2006.

Palisades Global Water Index - PIIWI

The Palisades Global Water Index [PIIWI] is a modified equal-dollar weighted index comprised of companies worldwide that are engaged in the water industry. The benchmark Index includes international companies traded on major stock exchanges around the world. The component companies are positioned to benefit from the rapidly accelerating water resource challenges associated with the demands of growing world economies in conjunction with human health and ecological sustainability. The Index was established with a base value of 1,000.00 at the close on December 31, 2003.

Palisades Indexes expects the introduction of an ETF to track the Palisades Global Water Index as soon as Q1 2007.

The latest PHO related article from Alligator Investor provides some pretty strong material for the marketing team at PowerShares, who I would speculate is working on the global ETF version to go alongside PHO. With the heavy “home bias” seen in many US domiciled ETFs, it would not be surprising to see further product development in terms of global versions of existing ETFs.

Case in point, the news of upcoming leveraged and inverse ETFs from Rydex to go up against those from ProShares which have reached the $2 billion mark after launching only in June of this year. According to the prospectus there are 96 ETFs. Amazingly, they’re all focused on the US market. They’ve sliced and diced the market thinner than any Ginsu knife could. And so the opportunity arises. What ProShares has started, Rydex has saturated. I’ll again state the obvious - the market will decide which of these funds are worthwhile. As an ETF user, I’d like to have seen Rydex go that extra mile and provide some international exposure. I have a strong feeling that a new Canadian based ETF manager may provide these globally oriented mandates. More on that if and when it happens.

There was an interesting article from Bloomberg News on Monday about the strength of international equity indices. The story focuses on emerging markets and in particular, the iShares MSCI Emerg Mkts Index (EEM), but investors should also consider Vanguard Emerging Markets Stock VIPERs (VWO) as the lower cost alternative. As everyone knows, emerging markets have been simply hot even with a serious drawdown earlier this summer.(Performance note: from the peak on May 8th to the bottom on June 13th, EEM fell nearly 27%. From current prices, if EEM gains 4% it will break through the previous high of May 8th. Sounds like the Dow and a lot of other indices I’m watching.)

EEM’s Strong Performance
What I find interesting here is the comment on how the EEM has generally outperformed comparable actively managed funds:

The iShares fund has returned 30.6 percent, while 645 actively managed funds investing in emerging markets returned an average 29 percent before fees. In the United States, the trend is reversed: stock pickers have beaten the Standard & Poor’s 500 index during the past 12 months, although they underperformed in the 1990s bull market.

This result is confirmed from the latest quarterly “Standard and Poor’s Indices Versus Active Funds Scorecard” from October 13th, also known as the SPIVA scorecard. The report does not use the same benchmark index that tracked by the EEM (from one of S&P’s competitors, MSCI). The report states that “the S&P/IFCI Composite also outperformed 77.9% of emerging markets funds over three years and 89.6% over five years.”

A table near the back of the report shows that for Q3 2006, a choppy but overall sideways market environment for emerging markets in aggregate, the index outperformed roughly 53% of emerging market funds. It’s hard to beat the passive strategy long term and especially in long bull markets but there’s certainly a case for active managers in times of distress. The problem is how you time the passive/active call and whether your manager selection process is also correct. I think the likelihood of getting both calls right is tough.

By the way, on the bond side, the same SPIVA report states that “year-to-date, 52.4% of emerging market bond funds surpassed the Lehman Brothers Emerging Markets Index.”

Call that one a tie.

Emerging Markets Exposure: Hedge Funds or ETFs?
Whether or not the case for passive investing in emerging market equities will remain strong, clearly with hot performance in absolute terms, we should soon see a long list of new ETFs that spotlight emerging markets and focused on certain regions, specific countries and possibly even sectors.

As these markets continue to allow greater allowances for foreign investors, this is an area where we could see extreme divergences in investment strategy. In other words, investors will decide to go full passive [ETF] or full active (hedge funds). What we will need to see, however, is greater allowances for investors to make truly directional calls.

It’s just not realistic for a hedge fund manager to implement significant short positions in a diversified manner such as in a multi-country emerging market long-short mandate. At least, not anywhere close to a similar long-short portfolio of US equities, for example. In addition to this, measuring and managing the various risks in an emerging market hedge fund strategy is difficult to say the least. I’m not saying that it’s impossible to manage an emerging market portfolio in a hedge fund type mandate versus a long-only mutual fund type mandate because the classification does exist and the results are decent.

Here’s a table from Credit Suisse/Tremont:

The index had a 13.58% YTD return as of the end of October. This underperforms a buy-hold strategy on EEM by about 4%. Although I don’t have the statistics, I would guess that the emerging market classification of hedge fund strategies has one of the most wide range of performance results. I just add that comment here since the return for a hedge fund index or subclass is almost meaningless unless you have an idea of the dispersion of the underlying managers’ performance. And here’s a chart for the CS/T Emerging Market Hedge Fund Index:
I know I’m being repetitive here with my recent blog entries but again we find a case where it’s getting harder to be a mutual fund. I think most investors will make the shift to ETFs, possibly in combination with hedge funds, for emerging market exposure.

Wow. Not to soon after I write about the potential for hedge fund investing to morph into an exchange traded instrument, the Financial Times now reports that Dow Jones Indices is working on investable indices that are engineered to mimic the performance attributes of various hedge fund strategies.For those of you who follow hedge fund investing, you have to wonder if these new “replication strategies” will not only aim for return and volatility targets but also attempt to provide some control over skew and kurtosis.

These new “investable indices” sound a lot like hedge fund index investing, which has been around for quite a few years with limited success. The only difference now is that instead of having various underlying hedge fund managers (and the costs of managing them in addition to their inherent fees), we have a strategy based on implementation using direct investment into capital markets including derivatives.

Theoretically, this should lower costs dramatically. However, if new products based on these strategies actually do provide the expected performance results (high alpha, low beta) then I have a funny feeling that the fee structure will not be too far from existing fund-of-hedge fund products currently in the marketplace. We’ll see.

Professor Harry Kat, of London’s Cass Business School, has written some commentary on this subject. The concept of replicating hedge fund strategies using derivatives is one of Kat’s areas of specialty. I highly recommend his papers which, although not as technical as most academic papers are still, well, technical.

There’s an interesting new development in the alternative energy space that may soon apply to ETFs. The following is from Hedgeworld.com:

UBS today [Nov. 2] announced the launch of the first index to track emissions allowances. The UBS World Emissions Index will initially track two of the European Emissions Trading Scheme platforms and will potentially expand to include other emissions programs. The EU-ETS is the largest carbon dioxide trading scheme, and covers about 46% of European carbon dioxide emissions. The new index will be published in U.S. dollars, euro and Swiss francs.

This is an interesting play on what looks to be the big issue of this century: global warming. Further from this press release:

The timing for the launch of the new index couldn’t have been much better. Carbon dioxide emissions are seen as one of the main factors in climate change and global warming, and the index has been presented in the same week that Sir Nicholas Stern, head of the Government Economics Service [United Kingdom] and adviser to the U.K. government on the economics of climate change and development, presented his influential report, The Stern Review on the Economics of Climate Change.

Here is a short executive summary on this report (.pdf). And here’s the main page for further information.

Lastly, this section from the same press release gives an indication of current product development efforts as well as constraints:

UBS has already structured products on the new index, available in the index’s three denominations. “Open End PERLES on UBS World Emissions Excess Return Index” products were launched today, and the subscription period will remain open until Nov. 24, which will be the pricing date. The pre-announced bid-offer spreads—1.75% when markets are open and 3% when markets are closed under normal market conditions—are an indication of the currently limited liquidity in the underlying markets.

We could potentially see some form of fund structure providing exposure to this important new market in the not too distant future. Certainly, this would be a good compliment to PBW and uranium related holdings as diversifiers to long energy holdings.

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.