Tom Lydon’s piece on trends for 2007 and various other recent entries here at SA have noted the recent expansion, and supposition of continued growth, in the ETF products around the globe. Although I believe in the KISS principle and the use of very low cost ETFs, I do have a strong interest in new product development and where this could lead the industry and those who are interested in it:

• Hedge funds and other who use these instruments
• Mutual fund companies and other investment management dinosaurs who realize that they might need to acquire ETFs and/or hedge funds to adapt to the changing environment
• Index providers who are caught somewhere between trying to figure out the new benchmarks that institutions will want to have their portfolios (or parts of) linked to and determining where the ETF product development people are finding potential demand

There have been recent developments where new forms of ETFs have begun to expand globally. For example, what ProShares, and soon from Rydex, have done with levered and inverse ETFs, we have seen similar launches from BetaPro ETFs in Canada and Société Générale Asset Management in France. There could be more of these types of ETFs in other countries and if so, please add a comment further to this entry (oh, the beauty of blogging!).

But let’s step back and get back to basics. There was a press release on a new ETF from SSGA launched on January 17th. This ETF, the SPDR® MSCI ACWI (All Country World Index) ex-US ETF (CWI) should be of great interest to US investors who believe in the most extreme forms of KISS … aside from the fact that the name of this ETF is “SPDR® MSCI ACWI ex-US ETF”. Killer. Add a few addition signs and and arrow in there and you could have a chemical formula (remember high school chem class). Hey marketing people … come on!

But seriously, in one trade, exposure to the MSCI All Country WorldSM ex USA Index can be established. CWI provides for the first time robust international exposure that includes both developed and developing markets and this places this instrument in a fairly unique space. I don’t think that any sophisticated investor would use CWI as a component of a globally diversified asset allocation program in isolation. Perhaps another “5 position ETF portfolio” will be created suggesting CWI for international equity exposure along with a US ETF, a bond ETF, etc, etc, etc. Not a bad idea for the small and highly novice investor but considering costs, they might do best with no load index mutual funds. Nevertheless, with regard to these “one stop simple portfolios” … are we done with those yet?

For everyone else, for the purposes of transition management or quick cash equitization CWI is ideal. For many investors in times of transition (acquiring a new client account, starting up a new fund, etc.) CWI could be an ideal launching pad before breaking out into EAFE/VWO combinations and further allocations divided by region, industry sector, style and other factors.

This line of thinking makes me now think of SSGA’s recent international real estate ETF (RWX) also mentioned in the press release. That could be an ideal starting point for then tweaking allocations to various regions for real estate exposures. Problem is that we don’t have ETFs for this yet but CEFs and other direct securities selection will allow for this.

Clearly, despite recent news of potentially hundreds of new ETFs coming down the pipe, there will always be new areas where someone will say “Build one for this, too!”

Sometimes I kind of look at what I do as similar to a sell side analyst at a big I-bank. The only difference is instead of looking at stocks in a particular industry sector, I study ETFs. So consider this when reading below, as the first half is news regarding a revamping of index constitution and the second half is my speculation on changes to Canadian ETFs as a result.Thanks to Credit Suisse’s Quantitative Trading and Derivatives Strategy group for their “Index Analysis” report last week on some changes that will occur to S&P/TSX Canadian equity indices:

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- S&P has announced that the S&P/TSX SmallCap index methodology has been revised and the index will now be independent from (and may include overlaps with) the S&P/TSX 60 and Composite indices.

- The S&P/TSX MidCap index will be renamed the S&P/TSX Completion index - containing the stocks in the Composite index that are not in the S&P/TSX 60.

- These changes will become effective at the March quarterly review on March 16th, 2007.

- There are relatively few assets indexed to the current MidCap or SmallCap indices, so there should not be much index trading resulting from the changes.

Structurally, the new SmallCap index will have significant overlaps with the S&P/TSX Completion index (and by association the S&P/TSX Composite as well). Best guess, roughly 67% of the SmallCap index cap will be in the Completion/Composite indices (conversely, about 25% of the Completion index cap will be made up of SmallCap constituents). Therefore, this means that funds indexed to the Composite index would be “double-counting” a sizable portion of stocks if they decided to track the SmallCap index as well.

S&P decided to make this change after consulting with the Canadian investment community and feeling that this was what they wanted. In many ways, it is similar to Russell’s introduction of their MicroCap index in the U.S., which overlaps with the Russell 2000 SmallCap index. So far, it doesn’t seem as if the Russell MicroCap index has gained much traction, with many investors questioning the logic of having two indices that overlap so much.

At the same time, MSCI decided recently to do the opposite with their global index products. MSCI is moving from an independent small cap index, which also had overlaps with their standard indices, to a modular set of indices that fit together by cap.

It will be interesting to see who makes the most headway in the small cap space, and if the modularity of the MSCI indices entices any index funds away from S&P in Canada.

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In the Canadian ETF space, specifically in traditional market cap weighted equity index ETFs, Barclays has the dominant, if not exclusive market. I don’t know what MSCI can do in Canada within the ETF market since BGI basically has all its ETFs aligned with S&P indices.

As S&P makes the above changes, I see little doubt that BGI will make adjustments to the mandates of its ETFs. The problem is that there will likely be some confusion as the small cap and “completion” index have underlying positions that overlap. This double counting will make both indices partial small/mid cap indices or or the commonly termed “SMid”. It will be interesting to see how BGI deals with these changes by S&P. Changes to mandates is not new as BGI’s bond ETF changed from a fixed government bond ETF to one linked to the Scotia Capital Bond Universe Index. In addition, BGI recent revised its gold company ETF from Canadian miners only to a global mandate.

With all the potential changes described above, after all is said and done, we could see (although I can not guarantee this as it will of course be dependent on BGI Canada):

1. XIC to cover the broad market

2. XIU for the large caps

3. XMD for the mid caps with some small cap exposure, or as they call it the “completion” index

4. X?? for small caps with some mid cap exposure

From this link bringing you to the following Standard and Poor’s website (http://www2.standardandpoors.com/portal/site/sp/en/ca/page.topic/indices_ts xsml/2,3,2,3,0,0,0,0,0,5,2,0,0,0,0,0.html) I have found the following information on their existing Canadian small cap index as of November 30, 2006:

Probably not surprising that there is a heavy (60%) weighting to commodities.

Bottom line: We could be seeing a new small cap ETF from BGI in the 2nd quarter of 2007. There has been considerable ETF development in the small cap scope globally especially from WisdomTree, but I don’t know of anything specific in terms of Canadian equities.

For interested investors, the idea of the existing mid cap ETF (ticker: XMD on the TSX) becoming more of a Smid ETF may sound interesting for some resource tilted exposure on the lower end of the capitalization scale.

For those familiar with the US ETF industry, you’ll know that the US equity market has been overly sliced and diced by market cap, style, industry, etc. For investors interested in exposure to the Canadian equity markets, the choices have been relatively limited. Although the potential addition of a small cap ETF provides only a small, incremental addition for investors, it could be a sign of future growth potential in the industry. We could see more slicing and dicing of other geographic regions in a similar manner, although likely not to the same extent as the US market. Although good in terms of choice, this could increase the average costs of ETFs.

Take the Canadian ETF space as an example: With XMD, the Canadian mid-cap equity ETF currently at 55bps MER (same as BGI’s sector ETFs), I would guess that a small cap ETF would be at best 55bps but wouldn’t be surprised if it were a bit more expensive.

This push to relatively expensive niche ETFs will hopefully be offset in kind by relatively large and broad ETFs with sub-10bps MERs. The ETF industry clearly appears to be moving in this direction of polarized product development.

An ASEAN ETF will soon be trading on the Singapore exchange … we can only hope a similar version will be made available in North America. This may be possible as Barclays Global Investors is the underlying investment advisor for the ETF. The sponsor is a Malaysian based financial services group called CIMB. The FTSE/ASEAN ETF will track the FTSE/ASEAN 40 Index that holds the top 40 stocks weighted by market cap and free float adjusted in Singapore, Indonesia, Malaysia, the Philippines and Thailand. No idea yet about the allocation among the five markets but I hope it’s not too heavy in Malaysia since it already has its own ETF (EWM).The Association of Southeast Asian Nations [ASEAN] is a political and economic organization of countries founded by the five nations included in the index. We hear of this group every year when they have their annual meeting but market watchers have made numerous comments recently regarding the ASEAN markets’ recent success: up roughly 110% over the past five years.

In the ETF emerging market space, there really isn’t that much choice in terms of broad regional exposure. iShares Emerging Markets Index (EEM) and Vanguard Emerging Markets ETF (VWO) have the shotgun approach, and iShares S&P Latin America 40 Index (ILF) provides Latin American exposure. That’s about it although of course you have direct country exposure such as iShares FTSE/Xinhua China 25 Index (FXI) for China and iShares MSCI Brazil Index (EWZ) for Brazil. For other EM regions like central/eastern Europe or the Mideast, North American domiciled ETFs just don’t exist so investors are left to find closed end funds or other means.

Each one of the emerging market trading regions (Latin America, C/E Europe, the Mideast, and emerging Asia) should have their own ETF. Perhaps not so much of an argument for a Mideast ETF. For me, EEM is very broad in scope yet has always been heavy in certain names like Samsung Electronics which has been the heaviest holding at roughly 6% for quite some time.

Some strategic asset allocation shifts among various emerging market regions may be required should the US economy slow down in a significant way. Each of these regions has different trading patterns and trends with the US, among other developed and EM regions and also within markets in its own region. Trying to manage this through the existing list of ETFs available (EEM, ILF and various country specific funds) can be onerous. Managing an emerging market sub-portfolio of just three positions (east and southeast Asia, central/eastern Europe, Latin America) through ETFs or CEFs would be my ideal method for now.

I saw this piece over at Indexuniverse.com:

In an era where indexers are slicing the market into finer and finer segments, here’s a breath of fresh air: A new index that measures everything.

The new Capital Markets Index is the brainchild of Warren Schmalenberger, president and CEO of Dorchester Capital. It is the first index to combine the performance of U.S. stocks, bonds and money-market instruments.

The index is calculated every 15 seconds, using a sample of 2,500 securities, and is published on the American Stock Exchange [Amex]. The full value of the index is updated overnight, looking at … well, looking at everything. Schmalenberger says that he downloaded four terabytes of information to compile the index, and that he receives 200 million additional pieces of information each day.

Schmalenberger expects to see investment products tied to his index soon, and also expects his index to become the ultimate asset allocation benchmark against which U.S. investors will be measured. As of mid-May, the index was composed of 51 percent equities, 31 percent bonds and 16 percent “liquidity,” or money-market instruments. Historically, the size of the equity market has swayed from 37 percent of the total market to 66 percent of the market; the size of the bond market has varied between 21.5 percent and 42 percent; and the money-market portion has ranged from 12 percent to 31 percent.

The Amex will publish the index under the ticker CPMKTS, along with three sub-indexes: CMPKTE (stocks), CPMKTB (bonds) and CPMKTL (liquidity). The liquidity index itself may be especially useful, as there’s no comparable index on the market (money-market managers, welcome to the harsh world of active versus index comparisons).

Schmalenberger said that a global index is in the works, but that it might take a few years.

The importance of this is that, if investment products do become tied to this “index”, then the ETF space will truly overlap the active management/mutual fund space. Any product linked to the index mentioned above could be classified as a balanced fund or asset allocation fund, I suppose depending on the maximum/minimum constraints on the three asset classes within.

I’m not suggesting that this is a worthwhile investment … I’ll need a bit more on the portfolio construction process/methodology beyond “four terabytes of information to compile the index, and that he receives 200 million additional pieces of information each day.” But again, we are seeing some interesting innovation in the ETF marketplace. Not revolutionary, but also not another dividend fund or sector (oil again!) oriented fund. To me this is a continued spin-off of the fundamental indexation story, or basically quasi-active management moving in on the traditional, index oriented, ETF industry. We have portfolio weights based on specific portfolio composition “receipes” derived by Research Affiliates and WisdomTree and their ETFs like PRF and DLN. The question is: what exactly is the secret sauce from Dorchester Capital and other future, similar ETF products?

On a separate note, I know that institutional investors are demanding greater transparency from their external hedge fund managers. As hedge funds fight for this business, and keep it, and thus in some cases allow greater degrees of transparency, is there a convergence story here with the quasi-active (I don’t feel that’s the right term here, but not sure what is) ETFs? I can see the Dorchester strategy being of interest to someone like CalPERS and other large sophisticated institutional investors. I understand from an industry contact that Rob Arnott’s Research Affiliates manages roughly $1 billion for CalPERS in a RAFI mandate.

For those of you interested in managing your money like the institutions (I’d start by reading Swensen’s “Pioneering Portfolio Management”), then you might be interested into watching how quasi-active management moves into the ETF space in addition to new (although not to institutions), alternative asset classes like timber and infrastructure.

CPMKTS 1-yr chart:

A thought about correlations and what looks like the start of significant rebound. Here’s a look at some ETFs that have given up significant amounts but are up a good proportion relative to the drawdown since peaks of May:iShares MSCI Emerging Markets Indx (EEM): Peaked at 111.25 on May 8th. Bottom at 81.35 on June 13th, a drop of about 27%. It is now around 88.88, up around 9.25% from the bottom. More importantly, the gains from only yesterday and today have erased about a quarter of the one-month decline. We can dig into what technical indicators are showing but if you are a long-term investor with a long-term bullish fundamental view on emerging markets, this may be a good time to enter (or add to existing holdings).

A quick note on India which is not a significant part of EEM. According to a fact sheet on EEM on the iShares website, as of March 31st, 2006, only 5.3% of the fund was allocated to India. Here’s the chart for the India Fund (IFN):

Looks a lot like EEM so it’s very much the same story here. Even more massive decline, this time down 43.6%. Up a whopping 20% since its bottom on June 13th. Eyeballing this chart, it looks like again this very short rally has wiped out about a quarter of the total decline.

There is something happening here in the emerging market space. What about in the broader international equity ETFs? Here’s iShares MSCI EAFE Index Fund (EFA):

High of 70.65 on May 10th. Bottom of 59.40 on June 13th, a decline of -15.9%. Currently around 62.40, up about 5%. Again eyeballing the chart, it looks like roughly a quarter of the decline is gone.

For investors that have not sold during this decline and are trying to decide, this may be a time to wait and see if this rally continues. If I continue with a chart for the S&P 500, we see that the world markets really are highly correlated at times of extreme movement:

Another case of roughly a quarter of the declines erased (in this case a bit more).

We’re beginning to hear talk about this being a ’stock picker’s market’. I think this is a macro manager’s market. From the above charts, I argue that it’s more important to get the general market direction correct and securities selection is a far second in importance.

The question is whether to get in now with what looks like a good start to a serious market rebound. I could see some continued volatility but eventually I see a short term high in the equity markets, possibly even retesting highs of early May sometime near the end of this summer.

My focus however is not so much on potential upside in 2006 but more on the downside. Any rally that pushes us anywhere near or beyond the highs of May will force me to do what we did in April (buy puts, load up on cash) and maybe go further (greater amounts of cash/puts, buy VIX calls, heavier allocation to bonds versus stocks). I think this will be an important discussion for later this summer.

On the bond side, I can’t see the bond ETFs doing that well in the very short term with considerable debate now about rate hikes possibly well into the rest of the summer.

Regardless of the viewpoint (for next 3 months or 6 months or beyond), I strongly believe that considerable cash positions must have been built in the past few months not only for allocation to equities (now?) but also into bonds (possibly a few months from now?).

Synchronized markets mean that trading ETFs and derivatives will be an effective means for implementation.