In May 2007 I put up two posts on this blog related to uranium.  The first was “Uranium Mania” which discussed the astronomical price chart for uranium prices.  One of the easiest ways to gain exposure to the commodity price, as opposed to the producers, is via Uranium Participation Corp (U).  Interesting how that post was written very close to the peak of uranium prices.

At that time, my thinking was that any exposure to uranium would best be accomplished with a combination of U plus Cameco.  Here’s the chart for Cameco over the past three years:

Very different performance patterns between the commodity and one of its major producers.  But it wasn’t until mid-August of last year that Van Eck came out with the first nuclear energy related ETF, the Market Vectors Nuclear Energy ETF (NLR).

For some reason, BGI with its newly listed iShares Global Nuclear Energy ETF (NUCL), must feel like being “second to market” ain’t half bad if the longer term outlook is strong.  I’m posting this blog after having seen this article in Canada’s Financial Post which gives some bullish views given the recently depressed price and a demand situation here in Ontario.  My interest is more related to significant energy policy shifts in the US (regardless of who wins the White House) and even more importantly, the choices made in the emerging world.  The developed world (well, mainly the US) complains about the relative lack of participation of the developing world in environmental policies such as Kyoto.  However, evidence from the annual reports of major uranium producers suggest that the market for them is the emerging world and that’s where they see the future growth.  Who would call that surprising?  Aside from foreign policy roadblocks for concerns that perceived unfriendly regimes would produce weapons grade materials, the necessity for the developing world to access nuclear energy is clear.  How can they compete with the US, China and larger (& more powerful) nations for oil?  I think they need alternative energy sources even more than the big guys.  I’m still a longer term bull for uranium.  The question is whether the exposure should be to uranium prices, the producers or a combination.

Well, aside from Uranium Participation Corp traded in Toronto, there are also uranium futures traded on the NYMEX.  The futures contracted started trading about the same time as my blog from May 2007 … as usual product development seems to be a decent market top provider.  And yes, it’s cash settled … no jokes about delivering 250 pounds of uranium.  That’s about it.  I’m kind of surprised that firms like ETF Securities in London or PowerShares (with their association to Deutsche Bank) haven’t created a uranium price tracker given their expertise in ETFs with futures based underlyings.  It’s just a matter of time.  I’m thinking that it would be nice to have this now and NOT near the next intermediate term top.

To go after the producers, like I said before, we now have two ETFs.  From a year ago, my simplified approach was to put it all in Cameco but for the passive fan, the ETFs would be the way to go.  Since NUCL only came out only about two weeks ago, we can’t do much comparison shopping.

Both have global exposures.  The newer NUCL is about 20bps cheaper in fees but with less holdings at 25 versus 38 for NLR.  The list of holdings for NUCL and NLR show some clear differences in the top 10’s in each as well as proportional weightings.  But what seals the deal for NLR over NUCL is the sector allocations.  Take note that for NLR, the breakdown of the top three sectors is 31% nuclear generation, 29.5% plant infrastructure, 28.8% uranium mining, with the remainder in uranium storage, nuclear conglomerates, uranium enrichment and nuclear fuel transport.  NUCL’s top exposure is in utilities (54.2%).  Their remaining catergory names are relatively generic like “energy”, “industrials” and “financials” (in that order, actually) and so part of their flaw is not doing a better job educating investors on the real uranium sub-sector breakdowns.  Hey, isn’t BGI the experts in ETF education?  You know I just like pickin’ on the big guy.

So, bottom line, this might be a decent time to get in to nuclear/uranium as an alternative energy and emerging market play.  The holdings list does not give enough information on its own so a bit of homework is required to see how much of each name is actually going out to places where energy infrastructure for the longer term is a concern.  Because the uranium producer space is limited to a few big names and many microcaps, it’s a tough call.  Pick a few of the big producers and you’ll do fine but if you’re from the industry or are a commodity freak, hopefully you’ve got some talent in picking the future successful producer (who will likely get acquired by one of the big guys).  Since that’s a tough sport, I think the focus should be on the uranium price for the longer term.  With limited instruments available, the challenge now is to decide between Uranium Participation Corp and uranium futures.  Until, that is, an ETF or ETN for this commodity gets launched.

It can be viewed quite simply. Derivatives are used by many as a hedging vehicle. A crop producer as well as the buyer on the other side. Bank and interest rates. Portfolio manager and a stock index. Gold miner. I can go on for a while. But of course, there’s always someone on the other side willing to take that bet.

This blog has focused, in my opinion, too much on the ETF industry. The derivatives industry has a similar story of excess, abuse and a picture that is not all rosy despite many participants in the capital markets focusing solely on the positives and rightly so. Don’t get me wrong … I’m pro beta (it is The Beta Brief, right) and that means pro-ETFs and pro-derivatives. However, that’s not pro in the absolute.  Because a very small number in this space manage to cause considerable confusion and/or distress, that’s the real shame.

This is an interesting posting on HedgeCo.net called Derivatives, Mutual Funds and Pensions.  The author, Susan Mangiero, starts with this eye popping opening sentence:

Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That’s a lot of zeros - $400,000,000,000,000.

I’m not sure if that would be a value approximating the global total of all derivative contracts if we were to take a mark-to-market measure at some point (24 hour markets so there is no close), open interest or some other measure. But $400 trillion is pretty much the biggest number I think I’ve ever seen in this industry. The US public debt figure is the only number I can think of that gets into trillion dollar territory. If the derivative markets increase by another $100 trillion, we can say that it’s at roughly half a quadrillion. I kid you not.

Mangiero refers to a recent article by Eleanor Laise of the Wall Street Journal and here’s a short intro to the piece:

Funds’ use of derivatives — which Warren Buffett once called “financial weapons of mass destruction” — is growing as the instruments become easier to trade and as mutual funds aim to stand out in a crowded field. More automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds. And with more than 8,000 mutual funds on the market, many managers believe it’s not enough to match a market index. They want to beat the market — and derivatives often help.

So mutual funds use derivatives. Is that surprising? Mutual funds might be dinosaurs, especially compared to ETFs and hedge funds, but that shouldn’t stop mutual fund managers from doing their best to manage risks. For funds with significant international exposures, shouldn’t they use forward contracts to deal with foreign exchange risk? I would hope so. Again, I can think up many situations where derivative contracts would be applicable for fairly simple mutual fund mandates.

But according to Laise and highlighted by Mangiero is the fact that “automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds” and that “mutual funds aim to stand out in a crowded field.”

The list of questions Mangiero provides in her posting makes sense and I believe she has the good intention of having investors focus on risk management when determining if their mutual fund holdings are prudent for their situation considering the possible use (and potential abuse) of derivatives. However, I think that in general, mutual funds don’t get involved in derivative markets for anything other than the most basic of hedging strategies such as the FX hedge mentioned earlier. They just don’t have the incentive (compensation wise) to be opportunistic with derivatives in the same manner as hedge funds. This doesn’t mean that the type of investigative due diligence suggested by Mangiero is unnecessary … I think it is necessary, especially if there is evidence that the manager makes tactical/opportunistic decisions using derivatives or the wording on the offering documents is unclear (sometime purposefully to allow for maximum leeway). I just think that for most ordinary investors, this concern regarding the mutual funds they hold may not apply.

For pension funds, it’s a bit different because the external managers they use are expected to come with an added level of sophistication. It’s in the institutional realm that Mangiero makes this point clear with this lead up to the list of questions:

“… a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager.”

So derivatives can be used for hedging, defensive posturing and prudent risk management. Of course, because of the requirement for someone to be on the other end of the contract, there must be a speculator. It’s this end that I believe worries many including securities regulators and other capital market watchdogs. And this brings us back to hedge funds. LTCM, Barings/Leeson, Amaranth … they’re all about derivatives and a lack of risk management in their application. Issues of leverage and the bravado that led to such massive bets should be thrown in there as well as they are surely key. I know Barings wasn’t a hedge fund but so wasn’t Enron … or were they? I’ve mentioned in the past of the convergence between various alternative investment strategies and asset classes such as hedge funds, private equity, real estate, infrastructure and commodities. What also has to be considered are more traditional situations like a bank or energy company whose operations, if fully explored could resemble more of what a hedge fund looks like than what you may believe.

If true, then regulation/oversight on hedge funds (only) in regard to derivatives use would be unfair. The issue of risk management over the derivatives industry isn’t an easy one. It’s been discussed for so long and I’m wondering if “the powers that be” are waiting to see what happens during and after the next LTCM situation gone fully nuclear. A scary thought.

The first line of defense is always at home.  Knowing the ingredients and recipe of what’s being cooked (or more importantly, what you’re eating) is in your best interest.

News today from the Associated Press about an early start to this year’s storm season. It’s a subtropical storm, not even a tropical storm never mind a hurricane, but with all the craziness in weather patterns in recent years, you can never be too cautious or prepared. On the investing side, this gives us (investors keen enough to read this blog!) some lead time before the official start of hurricane season which is June 1st.

First, some background reading on weather derivatives:

This article from Canadian Investment Review is from back in 2002 so you can see that weather derivatives are really not that new as an asset class. The article was written by Jason Wei, a professor of finance at the University of Toronto. This is a powerpoint presentation from Wei and Melanie Cao of York University. It’s even older but gives some deeper understanding of how the weather derivatives markets evolved to that time, the types of instruments available and the basic strategies for use.

One of the big problems cited from that time was the lack of investor interest and the resulting issue of liquidity. With hedge funds actively participating in the weather derivative markets especially over the past few years (along with re-insurance/catastrophe bonds due to the spike in extreme hurricane activity), this is not as big an issue. The purpose of these documents is simply to give an idea of where this quite esoteric area of investing came from. I mean, if you tell your friends that your recently established investment is dependent on the heat in Baltimore, you won’t get that funny look?

Now, let’s focus on where we are today. Here’s the link to the Chicago Mercantile Exchange’s weather derivatives website. In the opening paragraph near the top, I found the last sentence quite interesting:

This sector of hedging and risk management products represents today’s fastest growing derivative market.

Fastest growing derivative market. Well, I suppose the other broad areas of equities, interest rates, currencies, commodities and real estate have built well established markets in this space so weather derivatives, despite being around since 1999 (at least on the Merc), are still the new kids on the block. But perhaps it’s also the added focus from the press on the global warming issue and personalities like Al Gore that have moved environmental finance forward as part of a broader solution to what is clearly a massive problem.

Once you arrive here to this site, you’ll see a list of weather contracts, many of them related to temperature but some that I think are quite interesting like the ones for frost and snowfall. Here in Toronto, we’ve been experiencing summer-like weather for the past week and a half. We have no spring or fall here, just a long winter and about four months of summer. I exaggerate but unless you live up here, you just won’t get it. The idea of profiting over the cold months sounds appealing. The idea of profiting from times of heavy snowfall can somewhat compensate any northerner’s aching back after shoveling their driveway. A snowblower would make sense but I’ve just discussed the massive environmental problem, right?

But, of course the reality is that there are many industries who rely on these derivative instruments for serious hedging needs. Think of a utility whose electricity usage spikes up during a heat wave. And, of course, there are the hedge funds on the other side willing to take their bet. Again, one of the popular areas in this field is in hurricane futures which is one of the instruments listed on the CME website. According to this section of the website:

The CME Weather Product group has added CME Hurricane futures and options on five U.S. defined areas - Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. The underlying indexes will be calculated by Carvill, a leading independent reinsurance intermediary in specialty reinsurance that tracks and calculates hurricane activity. These contracts will begin trading March 12, 2007 for the 2007 hurricane season that begins June 1.

You would think that this type of recent product development would be getting a lot of press, but I just don’t see it. Good for me and my little blog but if this was an ETF? Sheeesh! There’d be coverage left-right-and-center. Probably most of it would talk about how the industry was yet again finding another thin slice of the market to exploit with an ETF product offering.

But hey, weather is an attractively uncorrelated asset class and I’ve discussed at length and in too many occasions about the fact that this investing world is troubled by highly correlated asset classes leading to synchronized, and due to the multiple compounded herd mentality, sharp down markets.

There’s a lot on the CME website and from the previously cited CME Weather Products main page, the tabs for Education and Resources should provide more than enough background before you begin to implement. Just don’t think that you’re ahead of the curve by exploring of actually entering into this market. Take a look at this chart showing, no surprise, another market with recent explosive growth:

This global liquidity thing … it’s really something. If there’s a market for something out there that isn’t getting a ton of attention and money, it’s a rarity. Domestic automobiles and not much else, I think. This chart cites its source but I found it from this good article from Financial Engineering News. The article is interesting as it gives a nice story as to who is interested in these instruments and why.

For me, someone interested in the asset allocation problem, I’m interested in understanding how plugging something like a weather derivative will affect the overall performance of a globally diversified asset allocation program. As someone also interested in underlying beta risks in multi-strategy and fund-of-hedge fund mandates, I’m keen on knowing if these instruments are useful ingredients in a recipe to provide the appropriate short overlay to offset unwanted long market exposures.

Many different reasons to consider these new products. For many who are simply fascinated by the strength of recent hurricane seasons, perhaps a visit to the National Hurricane Center website might provide evidence to entice them into the new hurricane futures market. To each their own, but I can’t stress enough the need for uncorrelated investments and this area is one of the few that requires investor attention.

With recent news of uranium futures contracts available through NYMEX beginning yesterday (May 7th), I was looking for a price chart for the spot price just to get my bearings on its rise which has been well publicized. It really is funny … go to Google, above the text box, choose “Images” and enter “Uranium price” for your search. You’ll get a LOT of uranium price charts all going from the bottom left to the top right. No surprise. But you’ll open one chart, say this one and you’ll think that the price is somewhere around 85.

The heading says that the data is up to February 2007, so your first guess is that this is a fairly up-to-date chart to start with. But then, through the same list of findings from your Google search, you also will find this chart:

Basically, this second chart only covers the rightmost section (roughly 1/5th) of the first graph. More importantly, this chart adds another couple of months which end up being significant as the uranium spot price has spiked even higher from around $85 to $113. That’s a 33% return in two months. That’s amazing but having this occur after a doubling of its price every calendar year for the past several years is actually quite scary. Kudos to anyone who jumped on uranium early (pre-2004) but a bigger and surely envious “congrats” to anyone who’s held on up till now.

From early April to early May, the price has remained quite flat around $113 and the second chart above (as with most short-term charts of uranium) shows that there are several instances where uranium prices will remain quite level for a period of weeks, if not months.

My point is that uranium has been rising (and rising and rising) over the past several years and to even have a 2-month old chart (geez, even a 2-week old chart in many instances) is playing with stale data.

Of all the news and commentary on this new futures contract, I found this article to be most insightful. It covers a lot of ground in a short read but similar to many of my posts, it goes into potential problems with this new derivative … just some things to think about before you dive in.

Also of note, NYMEX has teamed up with UX Consulting (provider of the 2nd chart above) on this derivative instrument and UX’s website is a great source of information for uranium in general as well as latest price charts … so you won’t have to go Googling for the latest chart.

With the way the ETF industry is moving, you’ve got to imagine that there are a lot of eyes on the launch of the uranium futures. The UPI article above discusses the issue of holding the underlying commodity. There are more than a few hurdles to deal with for an ETF launch for direct exposure to uranium prices. I’ve mentioned this in a few posts in the past but up here in Canada, the Toronto Stock Exchange lists Uranium Participation Corp (U) which might be the easiest way to gain exposure.

I titled this posting “Uranium Mania” simply because of the incredible parabolic curve of the price chart. The move to derivatives can, and likely will, help provide greater access to this market as would an ETF. I’m guessing that quite a few ETF manufacturers (and it’s not at all difficult to guess who they are) are watching developments with the new futures contracts and already have their business development people sniffing around to get a sense of demand for an ETF. News of an ETF would definitely bring us closer to a mania and it’s not difficult to forecast the final stages of the climb if this were to happen.

I’m thinking of an instrument (or instruments) that allow for upside and downside exposure to uranium prices that would best be accepted by the marketplace. Again, if you’ve been following this industry, a very short list of ETF developers come to mind.

But until then, for uranium plays it’s either:

1. Stock selection with big producers like Cameco and a small number of relatively large competitors but a large number of very small producers.

2. Uranium Participation Corp (and the added FX risk for non-Canadians)

3. Uranium futures with more information here

Good luck out there. Don’t get burned (sorry … bad one).

No analysis today. Just a reference to this article from the GARP (Global Association of Risk Professionals) website regarding real estate related risks.

For those looking to hedge real estate “beta” the best you could do today is some combination of derivatives, for example property derivatives out of the UK and Case-Shiller housing futures in the US, as well as maybe some of the real estate/REIT ETFs. Currently, the real estate ETF area is actually quite thin, especially considering the heavy bias towards REITs. The same can be said of real estate derivatives which have been around for a while but not in great numbers. This will change soon according to this:

That is one reason why real estate derivative markets — the lynchpins for hedging — are almost here, he exclaims. He goes on to list a number of indices either in the development or planning stages by such groups as National Council of Real Estate Investment and Fiduciaries, Standard & Poor’s (residential and commercial), and Real Capital Analytics, and for particular markets or sectors such the IPD Index for London, a new hotel index and Hong Kong real estate index.

“Everyone and their grandfather and sister will have an index,” laughs Edelstein, “so there will be plenty of opportunities for hedging.” On the buy side, the derivatives potential comes from demand by pension funds and other institutional investors, foreign investors, REITs, portfolio investors and even hedge funds. On the sell side, lenders, institutional owners, CDO (collateralized debt obligation) and CMBS (commercial mortgage-backed securities) managers as well as hedge funds, speculators and REITs can derive some benefit from derivatives.

And the reason for all this interest in real estate investment hedging? Answers Edelstein, “there is more risk now than there was five years ago.”

More risk? Clearly. I’ve shown many charts in the past few months and the concept of new highs is something that we haven’t seen in such amounts since the top in late 1999, early 2000. Today, we again can see this on a price chart of any real estate related ETF versus the broad market indices, except in Canada and a small number of regions.

Getting back to product development we can see that, just like the ETF industry, this shows that the derivatives markets are continuing to branch out in the global marketplace. Depending on your point of view, this will appear as expansion to narrower and unnecessary niches or more unique and interesting niches . Another example is in the area of timber, and here’s this notice also from GARP about derivatives for wood pulp.

You could say this is an offshoot of timber, but it could of course fit somewhere in the broader commodity complex. It’s interesting how, despite being perceived as fully saturated by many, the beta industry continues to punch out new products. A recent posting of mine regarding new metal ETC offerings from ETF Securities conforms with this.

Many industry participants in the ETF space may not be aware of what is happening in the derivatives industry. For example, not only can you get exposures to various interest rates through futures contracts but you can also get exposure to inflation. There’s a multi-faceted inflation-indexed fixed income play in there and that’s a fairly typical global macro trading strategy.

Bottom line: There is a big push of new products in the derivatives industry under way globally and its momentum began earlier than that of the ETF industry. It’s not getting a lot of attention except in certain parts of the institutional world. I don’t think it’s as big (or certainly, as well publicized) as the ETF industry but it is unfortunately getting the attention of many naysayers with crystal balls forecasting some impending doom. Derivatives, hedge funds … and even ETFs. They spell doom! Hardly. If the risk is in the use of leverage, that’s the one and only true risk. However, just like Amaranth (the biggest and worst case we’ve seen thus far), we’ll always have participants on the other side of the trade. Regulation will likely be increased over time with greater international cooperation from the regulatory community. However, it’s the market and its broad array of participants who I believe will keep things in relative equilibrium.

For me, derivatives play an essential role for many market participants. For some who see them as market exposures to have on the long side, perhaps even with certain levels of leverage, that’s fine. But others see them also as hedging instruments to offset unwanted exposures. In today’s world where hedge fund investments cross over to any and all other asset classes, it’s key for these managers to have the appropriate tools to properly control and maintain the adequate level of “beta” they require. It’s not an easy task, but without these new instruments, “difficult” is an understatement.

Let’s do a quick review of recent developments:

1. Tom Lydon at ETF Trends gives notice of some new SPDRs that were launched Friday covering various emerging market regions. Here’s the press release from State Street Global Advisors. From a previous posting on February 16 titled “All In All, It’s Just Another Brick In The Wall”, I argued that for most investors broad emerging market exposure could be done simply and cost effectively with maybe just two positions. On a February 14th posting titled “Is Emerging Market ETF Slicing and Dicing Necessary”, I suggested that funds focused on specific EM regions could be used for opportunistic trading including possible shorting in times of distress. And back in October 2nd of last year I argued that “More Regional Emerging Market ETFs Are Needed”. Bottom line: There must be a market for these as SSGA seems to be hitting some highly selective areas in recent months like infrastructure, international real estate and now these new emerging market ETFs. Somehow I don’t think the average investor, even the more experienced ETF-based investor would be a strong proponent for use of a mideast/Africa ETF or some combination of these emerging market funds. It’s got to be highly active professional investors like hedge funds, prop desks, mutual funds and even the internal asset allocation desks of large pension funds. Clearly, ETFs are not for mom and pop’s basic do-it-yourself retirement portfolio.

2. Next, we get news from Matt Hougan of IndexUniverse.com of a “hedge fund replicator” ETF. In fact, it is to be “… a suite of synthetic hedge funds strategies, which will use portfolios of ETFs to track the performance of the ten investable Tremont Hedge Fund sub-indexes. The group plans to offer low-cost mutual funds and separately managed accounts that will track each of the ten indexes.” So, the plan as I read it is not for ETFs with underlying hedge fund strategies but a mutual fund or separately managed account format with an underlying portfolio of ETFs that in combination will attempt to replicate the performance characteristics of certain hedge fund indices. Get it? At first, from reading the title from Seeking Alpha (”IndexIQ To Release ‘Hedge Fund Replicator” ETFs At Fraction of Cost”), you think an ETF with an underlying hedge fund is about to be released. In fact, it’s some other form of fund with underlying ETFs to mimic hedge funds. Clearly, the intersection of ETFs and hedge funds as I’ve been repeating so often over the past few months is something that will happen and in so many different ways.

3. One of the more common forms of such intersection is the hedge fund with underlying ETFs being used in an opportunistic fashion. It seems like one such new fund or mandate is popping up every day. For example, news of Morgan Stanley Investment Management’s former CIO starting up a hedge fund with other sell-side departees can be found here. According to the article, “The fund implements positions through futures, exchange traded funds, and customized baskets of securities” and will take long and short positions. Although not specifically mentioned, there will likely be use of leverage through the futures positions.

4. There are various other developments including life cycle funds that rebalance its underlying asset classes based on some pre-determined retirement date. This seems to take most of the fun out for the “do it yourself” investor but I can see a market for these. Just as ETFs will likely take a big chunk from the mutual fund market, these ETFs may do the same to the wrap market. There’s news of an upcoming natural gas ETF. Why is it that I thought of nothing but Amaranth when I read about this? This all follows ProShares’ massive set of levered and inverse ETF launches in February. All in all, this point and the three points previous to this point to the same direction: ETFs are built for active investors who are using beta as a means to obtain alpha. That could be in the form of searching for returns all over the world. It could be hedging (shorting) opportunistically. It could be used for long-short or GTAA strategies or even for some form of replication strategy. It could mean countless ways of extracting alpha.

5. I noticed this advertisement on one of the many ETF related sites I read:
No comments really. You can come up with your own.

Time For Caution

We’ve already heard from various sources that the ETF industry, at least in terms of the number of ETFs, will likely double within the next year. Who knows about the growth in assets but I think it’s fair to say it will increase even if there is a significant market decline. But are we close to the final destination? Are we there yet? I don’t think we’re even close. But only now am I beginning to question the value of new ETFs coming on line. In the past, there were a few ETFs that occasionally would give me reason to question their purpose. However, most have done well in terms of asset growth and trading volumes. I have greater reservations now about certain ETFs coming out now. There aren’t many, but I just don’t have the comfort level I had in the past. I’d like to think that the decision makers at the ETF manufacturers are launching products based on sound market research and overall business planning. That’s not where I have much doubt. I don’t want to dig into too much detail right now about which ETFs I think might not survive and the various banana peels I see or sense within the ETF industry. I’ll save that for a future posting.
Oh, and I haven’t even gotten to news of Bear Stearns’ SEC filing for an actively managed ETF.

Bottom line: I think we’re right about at the tipping point where the ETF industry has fundamentally changed. My bet is that the global capital markets don’t provide anything close to returns we’ve seen over the past four years or in the 2nd half of the 1990’s. Many may believe that, if my forecast is true, the ETF industry will lose its momentum. I believe that this sort of environment (whether flat overall or down over the next ten years) will be strong for ETFs. In a sideways or downward secular market, actively managed mandates especially hedge funds should do well. They certainly won’t all do well … in fact, the majority may not do well at all. But overall, the hedge fund industry should grow in terms of number of funds and asset size. If the hedge fund industry were to increase in that manner, as it surely would in that environment, so would use of their tools, that being primarily derivatives as well as ETFs.

Risk Magazine isn’t what I would consider standard reading in the financial services industry, as the last few sections of each monthly publication breaks out the math. I’m talking about equations that have few numbers and a ton of greek letters. Despite this, there is the occasional article that covers relevant industry developments for the non-quant. There is one article that discusses the recent push of products aiming to replicate hedge fund return distributions.Both Alpha Male at the blog, All About Alpha, and myself have commented on this topic and the work of Harry Kat, Andrew Lo, Bill Fung and Lars Jaeger (among others). But I find this article I find to be unique as it introduces the new term of “portable beta”. I’ve actually heard this term applied before within the context of the portable alpha framework. Basically, if you can transport an alpha engine (long-short emerging market equity, for example) on top of some beta component (S&P 500 index), it’s both the alpha AND the beta that can be transported and mixed in countless ways.

But in this case, we’re looking at research that has resulted in the application of beta in some unique and somewhat complicated fashion (combination of longs and shorts to various degrees in any number of different futures markets) in the attempt to replicate a certain hedge fund style/strategy’s performance characteristics.

There’s no argument here … the providers of these new products/services agree that what they are providing is beta, not alpha. And this is of little surprise when you see how correlated various hedge fund indices have been relative to standard benchmarks such as the S&P 500. If many (not all) hedge funds have high correlations with the broad capital markets, there’s little choice but to:

1. Be highly selective of the hedge funds one chooses in the hopes of having them deliver true alpha (at a cost).
2. Focus on gaining the beta exposures related to hedge fund investing at the lowest cost possible.
3. Do nothing and hope that the relatively high beta exposure that seems to have spread from the mutual fund industry to the hedge funds is a trend that reverses as the current bull market potentially/eventually comes to an end.

According to Steve Umlauf of Merrill Lynch:

“We do think there is alpha available out there through good fund managers. And if you can identify it and get access to it then it’s worth paying for. But if it’s just beta you’re getting, then it should be sold like an index fund - that is, in a liquid, low-cost, transparent format.”

Sounds pretty close to an indictment of the hedge fund industry from one of the big banks. Like other banks, ML must have hedge fund clients, in addition to their own alternative investment programs, so those words must have been massaged by more than a few people internally.. As an academic, Harry Kat of the Cass Business School in London has more freedom to speak his mind which he does here:

“Based on our research, we estimate that in 70-80% of the cases, a hedge fund manager’s contribution to the after-fee bottom line is zero or negative. Investors basically allow the manager to make a very good living using their money without getting anything in return. Unless one is genuinely attracted to this form of charity, in these cases it is worth replacing the manager in question by a synthetic fund.”

Harry has his own software program to go up against the big industry names so you can understand the direction he’s coming from. But like AlphaSwiss and Partners Group, you really have to wonder if the numbers used for all of these products has more of a bias based on recent data, specifically the bull market since 2002. The real question is how will these replication programs behave versus the comparable hedge fund strategies they aim to mimic?

If we are in the middle of a correction more serious than that experienced last summer, I’m afraid we will likely separate the men from the boys, so to speak. I doubt many funds with an absolute return mandate will do well. I’m not saying that there won’t be winners, I’m just betting that the vast majority will be losers. Just remember, there are a lot of hedge fund managers out there and they clearly all can’t be winners. The likely scenario will be a relatively small number of big winners with a relatively large number of “not so terrible” losers. Just my opinion.

This still leaves room for manager selection, but that sport is obviously getting tougher every day. Thus, this new area of hedge fund replication or portable beta should get broad acceptance if things continue as they’ve been. In reality, this development is just the transfer of indexing strategies to the hedge fund space but without it being the investable hedge fund index programs that were attempted a few years back with not much success. According to the Risk Magazine article, Lars Jaeger of Partners Group suggests “it is only a matter of time before more big investment banks and some of the index companies launch their own offerings in this market. Indeed, some participants predict portable beta could make up 40% of total hedge fund assets in just a few years’ time.”

It seems that anything (even hedge funds) that is considered alpha can and will be commoditized to beta in time as inefficiency becomes efficiency due to competitive forces. And this comment further confirms my thought that index providers and ETF manufacturers are catering more to the active investment crowd rather than the traditional passive investor. Index providers don’t need to promote an index for pensions to benchmark certain asset classes to … it’s been done to death and institutions are already there and may be considering moving away from that and to a portable alpha/liability driven investment framework. My guess is that the index providers are spending considerable resources in joint work with ETF manufacturers and other non-traditional work, including portable beta. They may not be working jointly on a hedge fund ETF … I’m just saying that index providers have focused a lot of their attention on ETF related business in recent years.

Getting back to the main topic, some questions that both the index providers and interested investors should consider regarding hedge fund replication strategies: Will they adequately replicate the underlying hedge fund strategies? Precision will be based on what comparison? If a particular hedge fund strategy (or strategies) does poorly in a bear market environment, will the replication strategy behave properly i.e. just as badly in that scenario? On the other hand, if replication strategies perform well in a continued bull market, will it build a strong following as investors dump high cost hedge funds that provide more beta and alpha in a rising market?

In any case, it’s getting tougher to be a hedge fund manager. It will be very interesting to see the performance numbers for February and even more interesting to see what happens in March.

Aside: VIX is roughly at 19. Looking at the short-term chart, you’d think that it’s high and it is since it’s spent many recent months closer to 10:

But if you look at the longer term chart you see that it’s actually fairly close to what would be considered it historical norm.

Like this past summer, it will be of little surprise to see asset class correlations spike up with the rise of VIX. Bonds and cash will provide some buffer but generally, exposure to beta of any sort will be painful if momentum builds. As I write this, the US equity markets are moving down but nothing like overseas markets. But you can feel the tension as investors consider the plug to be pulled. As VIX climbs higher, we move more towards an active investor’s environment. If you’re paying someone to make profitable decisions, you’ll want to make sure they’re not on vacation right now. If you are a long-term oriented investor, this is one of those times when your faith in long-term thinking will be tested. Take another look at that long-term VIX chart. We’ve recently seen historical lows with VIX spending some time below 10. Historical highs well above 40 haven’t been seen since the bottom of the bear market. Despite VIX’s recent climb, it still has the ability to move much higher.

Imagine a global market exchange that would allow investors to trade stocks, ETFs, futures and options all at one place. The CBOE Stock Exchange, known as the CBSX, will open for trading starting on Monday, March 5, 2007. CBSX is a subsidiary of the Chicago Board Options Exchange and more information on this event can be found at the CBOE website. This development increases the competition within the US exchange community; however, we have also seen similar growth in the Europe, East Asia and even in the Middle East. In the case of CBSX, the continued trend favoring electronic trading is clear: Trades will be implemented through CBOE’s electronic platform, CBOEdirect, which also facilitates trading for the options exchange as well as the Futures Exchange.

We’ll see how this new exchange will go up against Globex which handles about 70 percent of the Chicago Mercantile Exchange’s (CME) total exchange volume. The Merc announced its plans to purchase the Chicago Board of Trade a few months back for roughly for $8 billion in stock, rejoining the two financial institutions as CME Group, Inc. According to the Merc’s site the “CME continues to expect the transaction to close by mid-year 2007.” One result of this transaction would be the CBOT’s electronic trading brought onto Globex.

The CBOE’s move with their new CBSX platform is its attempt to deal with its neighbor who happens to be the 800-pound gorilla. And rightly so. The business of trading beta (ETFs and derivatives) is sure to grow. Everyone from institutional investors who have internally managed asset allocation programs to hedge funds to Joe Average are fueling growth in this area.

But what we still haven’t seen is the mass stampede of global M&A activity within the exchange community. It has certainly started but I’m guessing that we’ll see some very large acquisitions that will create global trading behemoths.

I’m not sure what the catalyst will be though. The regulators can’t force the situation but I’m guessing they would like less exchanges to keep track of and build relationships with. Perhaps it will simply be market driven should this four year bull market drive on beyond the recent bumpiness. At some point in time, people plugged into the market (shareholder of an exchange would count) will want to sell out.

What’s my point? Bottom line is the world of trading beta will get cheaper even if we see consolidation in the global exchange community. The advances in technology are progressing exponentially and thank goodness when you consider the in-step increased trading volumes. Much older and more widely discussed than the recent “anti-ETF” rhetoric, the arguments made against derivatives will certainly increase as the derivatives market continue to expand and like ETFs, in an exponential manner.>

I won’t get into the debate of whether the derivatives market is the ticking time bomb and potential weapon of mass destruction. To me, it’s just another tool like a stock or ETF. If there are concerns, they’re probably regarding leverage. Why not just pear it down?

It’s like the incredible amount of repetitive news regarding the subprime mortgage market. Every 4 year old who is learning the lessons of money knows the deal. You want to lend money to someone who doesn’t really qualify for borrowing, there’s a decent chance they’re not going to pay you. Should there be any surprise if the subprime mortgage market blows up? Come on.

Shouldn’t the same apply to the derivatives market? LTCM, Barings and Amaranth all deal with the use of leverage. Forget about rogue traders for now. If you have the exchange dealing with counterparty risk, there’s got to be a relatively easy mechanism to control the amount of leverage allowed based on the investor and what type of trading they’re involved with. I hate to say it but maybe it’ll take the regulators to step in and strongarm the situation. Maybe after one or two more Amaranths the industry will figure it’s time to strongarm themselves.

Despite all this, I’m still pretty happy as I think we’re moving closer to a world where trading beta, no matter what the asset class or instrument, in a rather effortless manner from virtually anywhere, can be achieved … with both a highly acceptable level of execution and cost.

We focus so much on ETFs in our own jurisdiction but there are many interesting instruments worth considering outside home. Currency risk aside (not in reality of course, just for the purposes of this discussion), these are the areas investors should consider when implementing their portfolio decisions. Diversification isn’t the perfect answer — aside from cash and certain bonds how have most asset classes done during the declines of this past week or this past summer? — but it’s one of many steps in protecting your portfolio.>

I’m hoping that I can trade a global list of ETFs and derivatives domiciled anywhere from my screen. It can be done now. But it can be done more elegantly in the near future. That’s not to much to ask for.

Recent news of more commodity ETFs (actually ETCs trading out of Paris) makes me wonder about some of the truly “high flying” sectors within the commodity complex. For example, here are some recent press releases related to steel:

AMEX STEEL INDEX UP 9.08% IN JANUARY

NEW YORK, February 5, 2007 – The Amex Steel Index [STEEL] rose 9.08 percent in January.* STEEL is a modified market capitalization-weighted index comprised of the common stocks or ADRs of publicly traded companies involved primarily in activities related to steel production. As of January 31, 2006, STEEL included 37 securities. STEEL is rebalanced quarterly. The next rebalancing will occur on March 16, 2007. The Market Vectors – Steel ETF (Amex: SLX) is an exchange-traded fund that seeks to replicate, as closely as possible, before fees and expenses, the price and yield performance of STEEL. SLX generally holds all of the securities that comprise STEEL in proportion to their weighting in STEEL. Options on SLX are listed on the Amex.

AMEX STEEL INDEX UP 40.70% IN 2006

NEW YORK, January 4, 2007 – The Amex Steel Index [STEEL] rose 0.77 percent in December and gained 40.70 percent for the year ending December 31, 2006.* STEEL is a modified market capitalization-weighted index comprised of the common stocks or ADRs of publicly traded companies involved primarily in activities related to steel production. As of December 31, 2006, STEEL included 38 securities. STEEL is rebalanced quarterly. The next rebalancing will occur on March 16, 2006.

The Market Vectors – Steel ETF (Amex: SLX) is an exchange-traded fund that seeks to replicate, as closely as possible, before fees and expenses, the price and yield performance of STEEL. SLX generally holds all of the securities that comprise STEEL in proportion to their weighting in STEEL. Options on SLX are listed on the Amex.

Here’s the chart since SLX’s inception:

Up about 22% over about a three and a half month period. How does this compare with some other related ETFs?

We see from this second chart how the Steel index moves in a fairly close pattern with the Vanguard Materials ETF (VAW), iShares Dow Jones US Basic Materials (IYM) and SPDRs Metals & Mining (XME). I’m surprised that SLX, being less diversified than the other ETFs mentioned here, has not shown more overall volatility over this period although it has shown greater strength in the run up over the past month.

PowerShares DB Base Metals Fund

But the real question is what’s going on with the PowerShares DB Base Metals Fund (DBB)? Based on the above chart, it’s the odd guy out. According to the fund’s site:

Description

The PowerShares DB Base Metals Fund is based on the Deutsche Bank Liquid Commodity Index – Optimum Yield Industrial Metals Excess Return™ and managed by DB Commodity Services LLC. The Index is a rules-based index composed of futures contracts on some of the most liquid and widely used base metals – aluminum, zinc and copper (grade A). The index is intended to reflect the performance of the industrial metals sector.

No mention of steel here, just aluminum, zinc and copper. More specifically, according to the fund’s fact sheet the underlying index is reset to have equal weighting to the three metals “annually during the first week or so of November. Throughout the year, the precise weight of each commodity in the Index will change based on price changes.” The current weights are updated each day. A quick scan of that link shows currently an approximate 41% weight in aluminum, 29% weight in zinc and 30% weight in copper.

Further to my blog entry yesterday about the commodities ETF launch by ETF Securities, I refer to some of their funds to see how these specific metals have done recently. A London Stock Exchange site provides a chart for an ETF linked to Aluminum from ETF Securities. They provide a chart for the zinc ETF and the copper ETF. So while most of the lines have been going up in the 2nd chart above, clearly DBB has been moving in the opposite direction due to significant weakness in zinc and copper prices.

Update on my entry from yesterday: As discussed, the new offerings (they’re termed ETCs) from ETF Securities will be launched on Euronext Paris, but they are already listed on Euronext Amsterdam, Deutsche Börse and the London Stock Exchange. For U.S. investors, the LSE is particularly interesting as the ETCs are USD-denominated on that exchange.

Here’s some information on the other ETFs mentioned above:

Vanguard Materials ETF

From the Vanguard ETF site specific to VAW (click to enlarge):

VAW seems quite well diversified (like IYM, it’s a broad materials fund as opposed to the others), including an 11.3% allocation to steel, all with a cost of 25bps … not bad at all. However, as a general materials fund, there’s significant chemical exposure.

iShares Dow Jones US Basic Materials

Information on the iShares Dow Jones US Basic Materials (IYM) can be found on the iShares site. Also note that BGI also has a global ETF called the iShares S&P Global Materials Index Fund (MXI). Like VAW, IYM has its biggest exposures (roughly 53%) in chemicals. Just over 12% of the fund is allocated to steel. No surprise then from my 2nd chart that VAM and IYM track very closely.

MXI only has a track record going back to September 12th of last year but as you can see, as a global version of IYM, it also tracks it closely (3-month chart):

SPDRs Metals & Mining (XME)

This ETF from SSGA is more focused than those from Vanguard and iShares. According to the fund’s site, and in particular it’s holdings list, there’s a lot of exposure to steel. So, here’s the chart comparing XME and SLX:

Fairly close, as expected.

So, what does this all mean? There are a lot of products that appear to be covering the same space. But in fact, the overlap is not as great as one might think. If you want exposure to steel in its purest form, it’s got to be SLX — though you’re getting exposure to an index of companies in the steel industry. For exposure to other industrial base metals (though in this case the exposure is directly to certain commodities markets), there is the PowerShares DB Base Metals Fund (DBB) as well as a similar fund from ETF Securities. For even broader exposure, and back to a basket of underlying stocks, there’s XME, IYM, MXI and VAW.

So despite a significant push of new offerings in the commodity space, and in this case specific to base metals, we can see that investors now have the opportunity to more adequately fine tune their exposures and be more precise with their opportunistic calls.

I see an opportunity here also for infrastructure and alternative energy (especially wind farm) fund managers to use an instrument related to steel for hedging purposes, although considering size, they may already be implementing hedges through the futures markets. Certain manufacturers in the computer hardware sector may be more interested in something like DBB. One can go on and on with examples of how certain investors would want (or need) instruments specific to a certain commodity.

Whether the relevant ETF instrument is redundant considering the availability of its counterpart in the futures market is an interesting thought — it all depends on the type of users that are out there and the demand from each segment.

I don’t believe I’ve ever written about ETF Securities out of the UK, which is a shame because I’m all for the little guy getting into the market and making a name for themselves… well, I wouldn’t actually call them small as according to their site they have just over $1 billion in assets under management.If you’ve never heard of them before, this might interest you. They’re best known for Exchange Traded Commodities (ETCs) and here’s the list of 31 ETCs (21 individual, 10 indices) to be launched on Euronext Paris:

OK, so this kind of takes the sizzle off of the recent related commodity ETF news from PowerShares but really it just allows for even finer tuning. Your scalpel just got a bit sharper. In reality, most active managers with a certain level of sophistication will know that all of the above is not really knew in terms of exposure due to instruments available in the futures markets. This really comes down to a choice of ETFs versus futures, assuming you’ve decided to play the commodity complex in a manner that warrants the use of such instruments.

The question now is whether the masses will see recent price strength over the past months (see 6-month chart below) as a buying opportunity, a shorting opportunity, or don’t know what the %&#@ is going on:

This recent article from Reuters seems to address what’s behind the increased pace of ETF development in the commodity space:

Investors are now more nervous of taking up long-only positions in the indexes, which traditionally have been the most straightforward way for pension funds, insurance companies and high net worth individuals to access commodities.

Analysts say much of the institutional money already invested in indexes is unlikely to exit in a hurry, but new money is expected to take more active approaches, which involve taking short as well as long positions.

If the commodity complex is an area where you don’t want to be “long only” because of its inherent volatility (I think this is so true), it only makes sense that ETFs and derivatives be the natural choice for investors who wish to manage the asset class actively. After the run up of the past few years, they might just have to.

Sidenote: There will come a day, hopefully soon, where we have something similar to Globex (Chicago Merc) so that investors can trade ETFs electronically, 24 hours a day, all over the globe in the same manner as derivatives are traded today. Perhaps with increased mergers between the large stock exchanges on both sides of the Atlantic, and with a couple from east Asia hopefully thrown in, this will happen sooner rather than later.