Just read something from a TD Asset Management letter where one of their US based fund managers said the following:

 

“A major step towards resolution occurred with the formal insolvency of Lehman Brothers and the potential of Merrill Lynch. While being rumoured for some time, these events are still sad and shocking for anyone in the investment business. But in relation to the markets, despair is a healthier phase than denial. For much of the past 18 months, we had been concerned that most financial companies and federal officials were acting as if the problem of too much debt could be solved with more debt which meant that loans just needed to be restructured so everyone could hold onto the assets they could not afford or accurately value. While we do not believe the credit crisis is over – given that there may be more global write-offs – we do believe the process of capitulation and healing has begun..”  Paul Ehrlichman, Chairman & CIO, Global Currents Investment Management

 

So that got me thinking about the stages of dealing with tragedy.  According to Wikipedia:

The stages are:

1. Denial:
• Example - “I feel fine.”; “This can’t be happening.”‘Not to me!”
2. Anger:
• Example - “Why me? It’s not fair!” “NO! NO! How can you accept this!”
3. Bargaining:
• Example - “Just let me live to see my children graduate.”; “I’ll do anything, can’t you stretch it out? A few more years.”
4. Depression:
• Example - “I’m so sad, why bother with anything?”; “I’m going to die . . . What’s the point?”
5. Acceptance:
• Example - “It’s going to be OK.”; “I can’t fight it, I may as well prepare for it.”

If the illness - it isn’t dead - of the global financial system, I think we’re still somewhere between stages 2 and 3.  I say global financial system but mostly we’re talking about the US - investment banks, PBGC which insures pensions as well as ESGs and other entities - but which have an obvious effect globally.  Denial was the bull market and perhaps even up to just a few months ago (say, the peak in May).  Thain saying everything was OK at Merrill Lynch and that they were getting into yet another round of financing (once it was discovered that they were in deeper crap) is a good example of the denial stage.

 

The stages of “Anger” and “Bargaining” can be represented as both investors bailing from the markets and the authorities trying to “band aid” things.  I hope we don’t lead to point #4 which ironically is not just a medical term but also an economic term.  But if capital can’t move around the planet well then that surely is a quick road to economic depression.  What else is happening but the major central banks of the world in a concerted effort trying to re-establish some form of normal liquidity?

I don’t mean to be a pessimist but it’s hard not to be one when watching the news and reading the latest coming online.  I think step #5 will not come for quite a while … certainly not this year but likely not in 2009.  These will be very volatile markets for some time.  It will interesting to see how the adamant buy-hold advisors/investors common to the traditional ETF industry stomach events.  Will the new alternative exposure ETFs (timber, intl real estate, real return bonds, gold/oil) and other altenative positions (hedge funds, private equity, etc.) do their job and provide the diversification needed to survive the storm?  Will they deviate somewhat from buy-hold to allow for some tactical asset allocation or … market timing?  If there’s ever been a time when investors of all types will be tested - this is it.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Recent market action in the US has made me think of what was going on about one year ago. Here’s the 2-year chart of the S&P 500:

A lot of market participants were prepared for what happened in May and June of last year. We weren’t the only ones with put options in play at that time. The run up from October plus a string of key indicators seemed to make a clear case for protection. In highsight, this graph above seems to make the drop in the first quarter of this year something even more foreseeable. Take a look at that (basically) straight line up from mid July to late February. If only life were that certain … well, an uneventful life isn’t great either. Whether it was the Chinese market’s sell off or any of a few dozen other reasons, that was a market that needed to let off some steam.

I have commented on VIX many times in the past. On the left margin of this page you can click on the “VIX/Volatility” link at the bottom of the categories list to find other postings that also refer to VIX. Here’s the 2-year chart of the S&P 500 with VIX overlaid:

And VIX in isolation, again for the past 2 years:

We’re not back to the historical lows of 10 but don’t let this graph fool you. 14 is not the historical average. Here’s the longer term chart from Yahoo Finance:

In this seventeen and a half year chart, 20 looks more like the longer term average. Note that when the markets fell (and fell hard) in late February, VIX spiked up to just under 20. It’s an understatement to say that we’re in a low vol environment.

Total speculation here but a pattern nonetheless: Note how VIX seems to have a longer term trend bringing it from the plus-20 range to the 10-15 range, like it did from 1990 to 1995. Likewise on the upside, VIX took a few years to go from the 10-15 range (1995) back up above the plus-20 range (1997-98). The downside trend from early 2003 to 2005 is another example. There’s no denying that there is significant “volatility of volatility” like we’ve seen from 1998-2002 and from early 2005 to now. These would seem to look like periods of a “sideways” trends on this longer term chart. The question now is if an upward movement of VIX would again happen in a 2-3 year period taking it from the 10-15 range back up to range in the plus-20s. My guess is it’s just a matter of time before VIX makes that climb up and I think it will be sooner rather than later. This is actually an area where I have been reading up on and if you search online, there are a surprising number of market participants and academics who discuss the longer-term views/forecasts of VIX.

Now, the 2nd chart above shows that in the shorter term, spikes in VIX coincide with sharp drops in the broader US market. However, the longer term chart above does not have the same pattern. Here’s the same long-term chart with the S&P 500 overlaid:

Note that I had to switch from a log-based vertical axis to a linear based axis to make the chart more easy to read. The key here is that in the shorter term, VIX and the S&P 500 can (but will not always) move in opposite directions. They move in opposite directions in times of extreme market movement. However, in the longer term, for example during the bull market of the late 1990’s, we can see that VIX and the S&P 500 can move in tandem. It’s all about the implicit volatility as measured based on prices of S&P option contracts but I won’t go into the math of Black-Scholes.

The follow up question then is how do you feel about this chart? S&P 500 (and just about every indicator for just about every asset class) is near or at historical highs. VIX is close to historical lows. The rubber band is being pulled tighter and reversion to the mean is providing some significant pull.

Let me be blunt: The S&P 500 is now somewhere above 1500 where it hasn’t been since September 2000. I see it’s closed today just under 1510 so it’s roughly 18 points short of its record close of 1527.50 back in March 2000. So another 1% rise ought to do it. Being up roughly 6.5% year-to-date, another 1% seems easy.

In addition, I’ve seen A LOT of commentary on this online but I’ll add it here anyway: The S&P 500 has gone up in 23 of the past 26 trading days — the longest such streak since 1944. Well, if you add today, it’s now 24 of 27 days. A hockey team with 24 wins in the past 27 games would be considered “on fire”. A boxer with a 24-3 record would likely be the title holder. But this ain’t no sport. 24 ups in the past 27 days should bring a cautionary “spidey sense” to investors.

[UPDATE/CORRECTION: According to this article from CNNMoney.com, the run of 24 ups in the past 27 days for the Dow 30 ties a record from 1927. I think this stat will be repeated SO many times in the next few days … and imagine if Tuesday is another up day!

Just a string of facts. A possible time for tactical measures? A boy scout would call it preparedness. I think that options should already be in play … if you’ve been invested in the S&P 500, then you have about a 6.3% return since the end of March. Some of that return could finance some put options for even a partial hedge.

So, next question (I think we’re up to number 3 now) is whether now is a good time, especially with volatility near historical lows, to buy some portfolio insurance?

The follow up to that is whether you want to go even further and set triggers for shorting futures or purchasing inverse ETFs. I’m still thinking tactically here. You have to do the same with your own philosophy of asset allocation. Are you more long-term oriented, thus focused on strategic asset allocation, or do you have a shorter-term perspective? If the latter, then you’re already thinking about tactical measures, if not implemented already.

Why not a few more charts? Everything below is charts for ProShares’ inverse ETFs showing performance since their respective inception date. Here’s the inverse and double-inverse for the QQQ:

Here’s the inverse and double-inverse for the Dow 30:

Here’s the inverse and double-inverse for the S&P 500:

Here’s the inverse and double-inverse for the S&P Mid Cap 400:

Here’s the inverse and double-inverse for the S&P Small Cap 600:

Here’s the inverse and double-inverse for the Russell 2000:

We can see from the first four charts that it’s been tough to go against the market. The small cap market, through either the S&P 600 or the Russell 2000 have only been available in an inverse ETF for a short time and there seems to have been little interest in them as shown by the trading volumes for the bottom two charts. My feeling is that all of these inverse ETFs, including the small cap exposures will begin to see increased trading volumes in the coming weeks. There is already a significant level of short interest according to communications from the sell side and we know that fund flows are coming out of equity funds and into bond funds. So, perhaps like about one year ago, investors are preparing for the storm.

This posting is not a recommendation for any of these inverse ETFs. For those of you looking to protect/hedge existing positions, only you know what you hold whether it be mega caps (you’re likely looking at DOG or DXD) or a tech heavy portfolio (consider PSQ/QID). Also note that ProShares also has short exposures to value and growth tilted indices as well eleven sectors. For these cases, all are for domestic indices and all have 200% short exposure. For those of you looking for something in the ETF space beyond these such as international exposures, you’ll have to consider shorting ETFs. I am absolute amazed at how long it’s taking other ETF participants (Rydex) to get into the inverse ETF space. I see a parallel here to the GLD/IAU situation in gold ETFs. If Rydex doesn’t get in here soon, they’ll “pull an IAU”.

Final note: If we’re basically talking about market timing here and all of the above seems pointless, you can simply take some profits and thereby build a cash position to buffer downside volatility!

I’ve made comments recently arguing against bond ETFs. Some of my arguments are really more about the rationale towards low bond allocations in one’s overall portfolio due to the existing, and projected, interest rate environment. Part of it is also the seemingly significant list of weaknesses of bond ETFs versus equity ETFs. I’ve discussed enough about the latter so I want to make a short comment on the former.

Yale University’s Endowment Fund is a top performer in its peer group and the envy of the institutional investing world. I’ve mentioned it by name several times on this blog as have countless others on the web. David Swensen and his group are respected as much for their forward thinking investment philosophy and methodology as their fund’s performance. On the Yale website, the annual reports going back to 2000 are publicly available. Each report shows data as of the last day of June in that year and in each report, the asset mix of the that year and the previous four years are shown on a table near the front of the document. From these annual reports, I’ve put together an asset mix table for this one endowment fund going back eleven years:

	Absolute Return	Domestic Equity	Fixed Income	Foreign Equity	Private Equity	Real Assets	Cash
1996	20.7%	22.8%	12.5%	12.5%	18.5%	11.5%	1.4%
1997	23.3%	21.5%	12.1%	12.6%	19.6%	11.6%	-0.7%
1998	27.1%	19.2%	10.1%	12.1%	21.0%	13.0%	-2.5%
1999	21.8%	15.1%	9.6%	11.1%	23.0%	17.9%	1.5%
2000	19.5%	14.2%	9.4%	9.0%	25.0%	14.9%	8.1%
2001	22.9%	15.5%	9.8%	10.6%	18.2%	16.8%	6.2%
2002	26.5%	15.4%	10.0%	12.8%	14.4%	20.5%	0.3%
2003	25.1%	14.9%	7.4%	14.6%	14.9%	20.9%	2.1%
2004	26.1%	14.8%	7.4%	14.8%	14.5%	18.8%	3.5%
2005	25.7%	14.1%	4.9%	13.7%	14.8%	25.0%	1.9%
2006	23.3%	11.6%	3.8%	14.6%	16.4%	27.8%	2.5%

Where do I begin?

One observer might say David Swensen is a revolutionary thinker in the institutional investing CIO space. Another might call him a lunatic or at least risky. I think it would be fair to call Swensen risky … in the institutional space, doing anything out of the ordinary and actually implementing an innovative plan would be considered by most to be risky. For example, a 12.5% allocation to fixed income as far back as 1996 with increased bearishness leading to an almost non-existent 3.8% in the latest annual report? Isn’t the purpose of a bond portfolio to provide yields and reduced volatility in the overall portfolio program?

Oh, by the way, when I said “risky”, I meant risky to one’s career. No one in the pension or endowment world wants to take on too much undue risk. They just don’t get compensated (as an employee) in the appropriate way for risk when volatility is nice on the upside. However, risk works two ways of course and if volatility is to the downside, it’s their job that’s on the line. Being close to the median is safe for your livelihood but is it good for the plan? It’s not just Yale but several innovative funds that have led to significant philosophical changes in the industry.

Taking a look at other asset classes, we see that Yale’s endowment fund also looks bearish on US equities having slashed its allocation to this asset class nearly in half over the eleven year time period to a level far lower than what most funds would ever consider to be reasonable. On the other hand, I believe that the foreign equity component would be deemed as reasonable by most investors although the variability in the allocation to this asset class as shown in the table only proves that Yale has been an effective market timer.

If the traditional asset classes of fixed income and domestic stocks have been greatly trimmed, it has been to the benefit of the “real assets” section of the portfolio which includes real estate, oil & gas as well as timber. Interestingly, Yale has had a nearly constant allocation to absolute return strategies (hedge funds) and private equity. In addition, hedge funds have been kept within a range of roughly 20-27% with private equity at roughly 15-25%. Clearly, this fund is a big fan of alternative investments with nearly two-thirds of the fund within this broad classification in the past few years.

Perhaps, if it weren’t for the fund’s great performance, Swensen might have long been considered as an excessive risk taker or worse. Fortunately, in addition to the returns, Swensen’s book Pioneering Portfolio Management provides great clarity in explaining the broad thought process that has underlined the philosophy and methodologies at this fund.

This is only one example of an institutional investor, albeit a very significant one. Bringing this back to the discussion of fixed income investing, you only need to see this chart of long-term interest rates to understand that Yale may have been thinking about reducing its bond exposures well before 1996. In fact, if Yale was a true maverick, the evidence should have led them to reduce these exposures about ten years earlier as shown in this chart.

But clearly, over the eleven year period covered in my table, there was enough evidence from the markets to see that interest rates were moving in one direction on a global scale. Although it’s easy to see this in highsight, the trend was unmistakable as of 1996 so this justifies the low 12.5% allocation to bonds by Yale at that time. Further decreased allocations since then were reasonable as the interest rate decline continued on a global scale to 2006 as shown in this chart:

And so here we are in 2007 with interest rates in a state of limbo (slightly inverted curve over a not so insignificant period of time) and the Fed having held short-term rates constant for longer than many may have thought when it stopped raising rates last year.

But depsite all of the above, there’s been considerable discussion lately over fixed income ETFs. After what seems like a “black out” period, suddenly we’re seeing new products and more in the pipeline. Could it be with all the talk of yield enhancement focus in products related to infrastructure, real estate and other asset classes, ETF providers are thinking that it’s time to restart the bond ETF assembly line? Considering all this and looking at the line graphs above, you (the bond investor or bond ETF provider) have to think a bit like a market timer and perhaps try to call the bottom of this long-term rate drop. The way the US dollar is going, investors must be thinking about rising rates. With the way the housing situation is playing out, the logic is for rates to drop further. The second line chart above is further evidence of globalization so the added wrinkle of determining if the synchronized fall of interest rates globally will continue is another piece to this puzzle.  There are more than enough economists commenting on this and, like them, I feel as though I’m providing way too many questions and no solutions at all. In fact, my only point here is to highlight whether bond investments (ETF or otherwise) are to be a significant component to the overall globally diversified portfolio. Yale, as well as many institutional investors, seems to think not. The recent ramp up of fixed income ETFs seems to show otherwise.

It all depends on:

1. Your income requirements and comfort with volatility that you expect from your portfolio, and
2. To what extent you believe bonds will be (or not be) able to facilitate these roles for your portfolio, and
3. To what extent you believe other asset classes or strategies are effective replacements for bonds within your portfolio.

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

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

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

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

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

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

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

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

Obviously, something less gut wrenching is utilities:

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

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

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

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

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

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

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

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

On Tuesday March 6th and Wednesday March 7th I attended and participated in my first ETF conference in the US. At the “ETF Evolution 2007” in New York, I learned quite a bit. The news from Amex regarding actively managed ETFs especially got me and a lot of people up and alert giving that it was near the very end of the event. Some of my thoughts after having given a week to mull things over:

First, this industry is small. Well, truthfully this event was rather small, but there are a relatively small number of participants in terms of organizations in the ETF manufacturing business. Of course there are the giants like BGI, SSGA and Vanguard. They were keeping a low profile at this event since it was about the ETF “Evolution” … and more like evolution away from what they do. I felt rather bad for the guy from BGI who was taking some shots from others in his panel where the discussion was on new ETF indexes. He seemed to take it well and I think it’s a fair metaphor for the 3 large firms. They’re comfortable now. But they have to admit that the growth of the industry is pushing against them.

What I’m talking about is the move away from the origins of classic passive investing. The broad consensus at this event seemed to be against the thought of investing in the CAPM framework. Thus, building portfolios based on market cap weighted indexes seemed to be generally out of favor to the benefit of alternative weighting schemes such as equal weighting or the various forms of fundamental weighting. Of course, market cap weighting is not dead as the push to international exposures and niche sectors usually still leads to this traditional weighting method.

I was very interested in listening to the index providers speak. They’ve had to significantly change their business model. I know first hand that the large index providers have put much less attention on the traditional business of providing benchmarking related services to pension funds – “been there, done that times infinity” … I’m pretty sure kids don’t say anything like that anymore. Instead, index providers are highly focused on building new indexes specifically tailored to ETF manufacturers. Maybe it’s not the dominant revenue generator in their business but it is an interesting shift. Just imagine going in for an interview at one of these firms. Instead of asking you about a broad US equity index, what if they instead said “So, give me a few ideas on a market exposure that you think could be engineered effectively yet sell to plug a space that needs exposure?” Sounds more like the “Give me three ideas” question you would expect from a hedge fund or prop desk. No shock then of news from most, if not all, of the big index providers about massive numbers of indexes coming on line in the near future. I’ve written in the past about Russell.

There’s been talk (not at this conference, of course) about the ETF industry looking a little “bubbly”. My only comment here is that, if true, we’re still in the very early stages. There are, at most, about a dozen small ETF providers each slowly building their niche in this space against the big firms mentioned earlier. The way I see it, we would first need to see many more new participants for me to think of this as being anywhere near bubble territory. Next, we’re starting to see merchant bank/VC type firms entering the picture to help finance startup ETF firms. But I know of only a couple of situations. There’s a lot of product out there but the numbers tossed around this one conference speak of a magnitude of new offerings that could see a doubling of ETFs within the next year. This event was quite US-centric so I will have to wait until the World Series of ETFs conference in Miami in a couple of weeks. Let’s say, that there’s a doubling in the number of ETFs globally over the next twelve months. That would certainly be interesting, but the key factor would be the corresponding values for assets under management. If we get into the same habit as mutual funds with a high proportion of ETFs versus the total assets invested in them, then I would agree that a problem exists and we could see some fund closures as a result.

However, with so many ETFs domiciled and focused on the US markets, it’s clear to everyone that the future expansion of the ETF industry will be based on international exposures. And I’m not talking just about super broad exposures like the new Vanguard® FTSE All-World ex USA Index Fund (VEU) or State Street Global Advisors’ SPDR® MSCI ACWIsm ex-US ETF (CWI). As neat as these are for those building a highly simplified core portfolio, the real demand is coming from investors who wish to be more nimble with their decision making. International exposures by region and sector still have some gaps that can be filled. We’re seeing the first shot at moving away from market cap weights in overseas exposures from firms like WisdomTree. Although shorting is a possibility as well as options (but not as robust a list as I’d like), there is still a gigantic void in terms of inverse ETFs for international exposures as another line of defense. Hey ProShares and Rydex: Before you completely super-saturate the market with a hundred more or so US-centric levered and short ETFs, what about a few for international markets?! Even an EAFE based fund and one for emerging market exposures would be nice to see. SEC hoops for these two can’t be that tough to jump through. Perhaps some locals have made their own levered/inverse ETFs for their home market. For example, BetaPro ETFs here in Canada have ETFs for both long and short exposure to the S&P/TSX 60 Index, both with 200% exposure.

I want to come back to actively managed ETFs. I’m not sure if it’s the biggest thing in the world to have this next step in the evolution of ETFs actually occur. We’re doing all right with ETFs on the passive side and closed end funds with underlying active strategies. There are flaws, as everywhere, but anyone can build a pretty darn good portfolio just with ETFs and CEFs (throw in some cash, certain futures and option contracts and then I think you really have all you need). The move to push away from market cap weight exposures is, in my opinion, the industry’s initial attempt at moving towards active management. I’ve discussed in previous posts my opinions on new rules-based ETFs and my belief that they’re not active management and thus they do not provide what I would call “alpha”, in a philosophical sense. However, if the numbers (historical backtests!) show some outperformance relative to market cap weights, then the related ETF providers will make their case for “statistical alpha”. And their case will always be strong as no one builds, and reveals, a historical backtest that sucks. People brag about their kid at U.Penn, not their kid at the state pen.

So, if what was introduced about actively managed ETFs in New York, and hopefully will be expanded further in Miami, is true and in full throttle, where will this take the industry? One participant at the conference mentioned that it wouldn’t make sense to see ETFs with an underlying hedge fund strategy as hedge fund managers wouldn’t go for the low management fees. True, hedge fund managers would see their fees cut to something probably close to a quarter (at best) of what they receive now. And I think this actually argues in favor of hedge fund strategy ETFs. If ETFs are about providing exposures to replicate the performance of a particular benchmark, region, sector or even strategy (anything from WisdomTree, Claymore’s new ETFs built with Robeco and I can name many more rules based products), then why can’t there be an ETF with an underlying hedge fund replication strategy especially considering the modern and informed investors’ loathing of fees especially if and when little value is demonstrated by the manager? Merrill Lynch, Goldman Sach and JP Morgan are three I-banks already promoting their work in this new space. A few smaller, yet still very significant European firms are equally, if not more advanced in their product development work. And their concept is the same: Build a product that replicates certain hedge fund strategies in a manner that can provide a low cost means for investing. I’m not saying that things will move this way next week or even this year. But if there’s anything we’ve seen in the ETF industry over the past few years, it’s that providers are finding ever more clever ways to introduce new and unique exposures to capital markets. Hedge fund strategy ETFs are just one example. I’m sure there are dozens if not hundreds of other ideas being considered today.

Lastly, I want to consider down markets or a potentially more serious bear market which, no surprise, was not a big topic at the event in New York last week. Let’s say we get whacked by a big one. Either something like 1987 or even worse, a longer more drawn out and painful decline. Well, if it brings us back to where we were in the early 1980’s, investors will be as unenthusiastic towards ETFs as they would be towards any other instrument as well as the markets in general.

But let’s just say that we’re in a period where we’re simply going to experience several down markets (who knows how often or the decline) very similar to what we saw last summer. Further to that, it’s almost irrelevant if the overall curve of the markets bends flat relative to the growth we’ve seen over the past few years or if the markets continue to zoom up of if it crashes. The question to ask is: Are investors well served by having a portfolio with a fairly standard asset mix consisting of a very small number of ETFs each with fairly broad exposures and focused on extremely low costs? I’m thinking about the countless “model portfolios” that hold something like ten or fewer ETFs.

I’m as big a fan as anyone of many of Vanguard’s ETFs, as well as some of BGI and SSGA’s broad ETFs which are dirt cheap. But simply adding a REIT ETF, a gold ETF and a few fixed income ETFs doesn’t make the portfolio protected. The unfortunate reality (Al Gore’s title sounds better) is that diversification won’t save your skin in today’s world. Not only are correlations among the vast majority of asset classes high, they spike at times of distress. Even asset strategies (hedge funds, private equity) don’t have the same diversification benefits they once had. I heard someone once say that diversification fails when you need it the most. This doesn’t mean that we all have to be market timers although there are various degrees of timing. When Warren Buffett says he can’t find good companies to buy and builds up his cash position, is that timing? The oracle believes in “buy and hold” but waits to buy in when the time is right. Moving into cash and potentially parking in a fixed income ETF or even a currency based ETF can be considered one form of defense.

What about sector rotation to re-allocate based on changes to the economic cycle? The new sector based ETFs could be used more for protection than for opportunistic and aggressive trading. What about fundamental based indexing? Doesn’t it just make sense that in times of market stress you would want to be more heavily exposed to companies that pay more dividends, have better earnings (assuming SarbOx is working and no one’s pulling an Enron) or are a function of a combination of various fundamentals? Of course, inverse ETFs in addition to outright shorting of ETFs is like a last line of defense.

Trade ETFs like a hedge fund and you can be aggressive with a somewhat shorter term perspective and a ton of choice. Construct a portfolio with defensiveness in mind, and there are also many ways that you can see the current ETF evolution as more of a solution than a problem.

We’ve seen the S&P 500 go up in a strong linear fashion since mid July. A bit extended perhaps? Here’s the 3 month chart:

  We’ve seen some fairly low values in VIX over the past few months as Here’s the 2 month chart for the VIX:

  Incredible to see a few days under $11. It’s been down at $11 before (even as low as $10) as seen in this 3-year chart:

  What’s interesting is the behavior of the S&P 500 relative to the VIX. Here is a chart showing the two:

  An obvious pattern shown clearly in the chart above is that the S&P 500 is climbing well when VIX is falling. This is usually over a 2-3 month period:

· May-June 2004

· mid August-early October 2004

· late October-Christmas 2004

· mid April-late July 2005

· mid October-Christmas 2005

· July-current 2006

If the current trend (upward S&P 500 and downward VIX) continues, then this would be a significantly larger and longer decline period of the VIX (going into 4 months). We’re currently just past the 3 month mark.

Looking at the 3rd chart above, $10 seems to be a fairly firm floor, although it seems like VIX doesn’t like staying down there. There’s almost a propensity for the VIX to bounce off $10-$11 and within a month reach $14-$15.

Bottom line: This looks like a good time to buy VIX call options. If the S&P futures look weak Wednesday morning, a quick entry may be in order … I started off this piece with the question if this rally may be a bit extended. Patient watchers may want to “wait and see” in the hopes of entering when VIX is closer to $11.

This is really a follow up to Roger Nusbaum’s piece on the oil sands ETF. I mentioned this ETF, albeit briefly, here. I know: home field advantage as the Claymore guys here in Toronto are only a 5 minute drive away from my office.By the way, the weighting of underlying positions in this ETF is based on three factors:

1. Current production in barrels per day

2. Production expected in 2015

3. % of total production actually in Canadian oil sands

When I first heard of Claymore and the oil sands ETF, I thought they would have launched it by mid-late summer. I just spoke with the prez of Claymore Investments and he says this fund should be out by the end of October or first week of November. Oh that’s some good timing.

But here’s the point, or rather question, in this blog entry:

Personally, I still like oil and have not dumped our energy ETF positions although for private client accounts they are somewhere at around 4-8% of the overall portfolio. However, although I like oil, I’m not so sure about natural gas.

To me, one is a global commodity play that has some geopolitics as well as obvious emerging market stimulus. The other is a regional weather play. I won’t get into El Nino or the supply/demand imbalance for natural gas.

Bottom line: Long oil and short natural gas may be in play for roughly six months. Futures is easiest to implement, but I wonder is there a way to play natural gas in the ETF or CEF space?

Aside: I often write more on SeekingAlpha ETF topics rather than energy, so my apologies if this oil/gas discussion is a replay.