A down market would do this.  That is, bring out a debate on the benefits of hedge fund-like investing.  With indexing and ETFs, one would think it’s all about gaining exposure to markets (hopefully on the upside) and reducing or eliminating exposure when required as a defensive measure.  You can call that effectively tweaking the asset mix or full out market timing.

However, today’s ETF industry is one that has evolved.  With inverse ETFs, any investor can now literally “build their own hedge fund”.  Shorting and the use of options requires a margin account which is not a big deal but now as long as one can open a trading account of the most basic kind, there’s not much to it to gain short exposure.
So this brings me to an email I received today care of Google Alerts which is a pretty amazing service.  You can basically tell Google to email you when anything new appears on the web related to a specific search.  Of course, for this blog something like “ETF” and “exchange traded fund” would do it.  The bad side to the service is you can easily have a big pile of emails in your inbox.

Anyway, here’s what I received today:

So on one side we have Bill Schmick and the other is John Bogle, the latter care of Tom Lydon at ETF Trends.  With Schmick and Bogle, it seems more appropriate to consider this debate as David and Goliath.  Although I understand Bogle’s comments regarding the newly filed Direxion ETFs with 300% market exposure, let’s be real … their appeal will be limited.  There will be no domino effect with new or existing ETF providers following up with leverage of 400% or higher.  If by chance they do, shame!  I’m certain market forces will simply laugh such products off the street.  Let me be clear:  Investors of all types will generally pass on Direxion or anyone else who goes down the path of even higher leverage than what we seen in the ETF marketplace today.

Is there demand for extreme leverage?  Of course.  Hedge funds play this game all the time.  Part of the basic reasoning is simply to juice the returns of strategies that don’t have the same bang they once did (crowded markets).  But these market participants use the derivative markets where they can better fine tune their required exposures, not simply some multiple of 100.  And of course, we know the difference between the returns provided from futures markets compared to the “daily return” limitation of levered/inverse ETFs.  Truly sophisticated investors will understand when to use levered/inverse ETFs and when to go to the futures market, swap market or other market for their required exposure needs.  So Bogle’s worries about extreme levered ETFs, I believe are in themselves, extreme.

Schmick on the other hand seems quite reasonable in his comments.  Unlike Bogle who might find some degree of the sector ETF universe unnecessary, I would side with Schmick on the benefits of sector ETFs for defensive strategies.  It’s unclear what Bogle would deem as “reasonable” as opposed to “absurd” in sector ETFs but I’d guess that the lineup from HealthShares would be the example given for the latter.  Since assets in this family of ETFs is relatively small, the point is moot.  But whether it’s the exposures provided by HealthShares ETFs or other rather new and esoteric areas like nanotech or cleantech, there are many reasons why investors implement sector based exposures, defensive or otherwise.  I wouldn’t want to take that away from them.  Market forces will take away the undesirables as required.

To reiterate what I’ve said many times before: In today’s highly correlation markets, diversification is the first line of defense but can only get you so far in addition to shifting the asset mix to increased cash holdings when markets decline for a prolonged period.  Sector rotation is one of the few defensive strategies left to investors.  The use of put options as an insurance policy to be bought in extreme up markets is another good one.  The use of inverse ETFs to join in on the momentum on the downside thereafter is good as well.  It would seem that the most classic of index/ETF proponents would want to stick with the strict buy-hold, rigid asset allocation philosphy which is fine.  But not for everyone.

A tough stomach is required in times of distress.  I’d hope that in today’s market (not meant to mean short-term oriented “today”), investors do not make rash decisions and completely overhaul their game plan.  My cynical views on active management and hedge fund performance still lead me to believe that there’s something to be learned from Bogle and those in his camp including not just Vanguard but DFA.  However, I think that investors, either with or without financial counsel, should consider what degree of non buy-hold thinking applies to their portfolio.  How much deviation from the policy asset mix should be allowed?  What alternative asset classes and strategies should be considered if any, and at what price?

The risk, as I see it, is that much of the most classical portfolio theories and methods we read in textbooks are based on a time when we didn’t have all the information or the tools to properly handle the information.  Today it’s different.  Sure, we have the tools to compute with greater speed and power than the early days of Markowitz and Sharpe.  These tools can even fit in a thin letter size envelope.  But despite all the information out there, it’s tough to manage it effectively so as to lead to a more thoughtful, elegant and even effective portfolio.  Until ETFs came around.
Maybe the new “active management” of investing does not revolve around picking managers but allocating among beta exposures.  That’s what institutions like CalPERS are doing by internalizing passive mandates (by first reducing active exposures where there’s more beta than alpha to be had).  I’m not trying to lead this thought to the “All ETF portfolio” but something rather close to this, with a healthy balance of traditional and alternative exposures, access to developed and developing markets, customized for income requirements and volatility tolerances.  Clearly, this thought process would seem to be elegant and “true to form” as just described if implemented mainly through ETFs and similar instruments.  15-20 positions might seem like a lot but without passive exposures, a more traditional “old school” portfolio built under the same premises would likely hold a couple of hundred securities at a minimum.  I’m assuming that someone who wanted some inflation indexed bond exposure wouldn’t just buy one bond.  Same with emerging market equities.  Or US small cap.  Or REITs.  Or even non-ETF related possibilities like hedge fund … well, maybe if it was a fund-of-funds but for some investors, even one of these might not be enough.

In my previous blog post (whoa … two posts in one week … easy there), I focused my attention on diversification.  That’s definitely what ETFs are about despite all the recent product development on narrow sectors and relatively small countries.  But ETFs are first and foremost about innovation.  This is good because it gives anyone access to ideas (water as an asset class), new regions (frontier markets) and a wide variety of capital markets that may not be as easy (logistically, cost wise, etc.) for many investors to reach.  This is also bad because the risk is that the ETF industry focuses too much on ideas rather than the true economic need for capital to be allocated in that “idea”.  I don’t see the ETF industry going down this latter path similar to the dot-com craze however, as in everything, a healthy balance is all that’s required.  Somewhere between Schmick and Bogle - they likely aren’t even the extremes on the spectrum - is the right balance for each and every investor.  Dictating what’s right and what’s wrong, limiting choice by not allowing for certain products (ETFs, hedge funds or whatever) and thus not allowing investors to choose where they lie on that spectrum in NOT the answer.  ETFs provide choice by allowing access in a meaningful and efficient manner.  The allowance for choice will be dictated by the user as in any market.

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 can’t believe it’s already a year since I was in Miami and soon thereafter writing my synopsis of the event, one of the first ETF conferences I attended in the US. At this year’s event, the 8th Annual U.S. World Series of Exchange Traded Funds East, being held this coming Wednesday and Thursday in Miami, I’m participating in two panel discussions and you’ll notice the common theme in both as found on the online itinerary:

ROUNDTABLE: THE SEISMIC SHIFT FROM BETA TO ALPHA
Previously, the onus to generate Alpha was squarely on the shoulders of the advisor as he utilized the Beta products the industry provided. Now the industry is prepared to shoulder the burden as evidenced by the amount of actively managed ETFs in development.
• What is the distinction between actively managed indexes and actively managed funds?
• How are absolute return and 130/30 strategies provided for within the ETF structure? • Will these products take the place of, or complement, core holdings?

ROUNDTABLE: DELIVERING ON THE PROMISE OF ALPHA VIA BETA EXPOSURE THROUGH SECTOR INVESTING
Many advisors rely on the ability to over/under-weight sectors in order to deliver Alpha for their clients. During this session, we will elaborate on the various characteristics that define the broad array of sector funds.
• How does one differentiate between economic sectors and industry classifications?
• What are the merits and constraints of established classification providers versus niche providers?
• What are examples of the strategies advisors can employ?

No surprise that investment industry events are having a lot of discussion related to both alpha and beta. Everybody wants to have the beta exposures during the long and steady bull market but with the volatility and downward pressure over the past nine months or so, the talk is all about minimizing the pain. Another session (following the 2nd one above) is titled “Preserving Capital While Pursuing Non-Correlated Returns With Fixed Income ETFs” so I suppose the common theme here is using beta (ETFs) to deliver some broader form of alpha (not at the “group of stocks in a particular asset class” level but at the broader asset mix level). The question one must ask is whether this type of outperformance, whether in down markets or generally speaking, delivered by tilting and/or actively rebalancing a portfolio based primarily or exclusively on ETFs can generally be described as alpha? I’d say a definite “yes”.

Well, I think it truly is alpha if you’re really doing something different and I’ve already outlined in my recent interview with IndexUniverse.com what I think about defining alpha and beta. Now that we’re in the middle of a serious down market, the kind of which we haven’t seen since 2000-2002, it’s interesting to see the timing related to what is now happening in the ETF industry. More rules based approaches and now even further in that direction … certainly the big topic of the ETF conferences … full blown active management. In my mind, the questions to ask are:

• what sort of actively managed ETFs will we see and will they provide value to investors, and
• will they, in aggregate, gather significant assets under management within the first few years

To me, if the vast majority of actively managed ETFs are nothing more than mutual fund-type mandates listed on an exchange, I’d be very disappointed. My guess in such a situation is that investors would not find much value there even with a significant reduction in management fees and furthermore when considering the various additional fees found in mutual funds but not in ETFs. But that’s not the real problem.

The ETF industry has its origins in classical indexing. Something more akin to benchmarking than what may be considered an investment strategy. It just so happens that market cap weighted indexing seems to do very well versus a broad array of active managers who, for whatever reason, are constrained by various measures such as a limitation on how much cash to hold, the inability to short securities, etc. For decades, the indexing and then the ETF industry have espoused the benefits of low cost, broad diversification, tax advantages and various other arguments for passive management. Now the ETF industry is simply going to add the active management chant? I’m not so sure if the chorus will be in harmony. But should it? I don’t think it has to … know one said the ETF industry is supposed to be only about indexing. Fundamental indexing and inverse ETFs are examples of pushing the boundaries within the ETF marketplace.

Perhaps what we’ll find are a relatively large number of small ETF providers focused on active management strategies along with a smaller number of large ETF providers (PowerShares would be the obvious example) competing with them. PowerShares and a few other existing ETF providers have never shared the same arguments of indexing and passive management as Vanguard, BGI and State Street have. With fundamental indexing and other rules based strategies as well as various thematic (water, cleantech) and unique sector exposures (nanotechnology), there seems to be a logical progression for PowerShares to move into pure active management.

To be fair, it should not come as a surprise for anyone familiar with BGI and State Street’s institutional business to see them come out with actively managed ETFs as well. For those who know, both BGI and SSGA run alpha-oriented programs (I don’t know if they call them hedge funds) and even run them along with the beta mandates - for example in portable alpha programs. Somehow, I see these behemoths taking a “wait and see” approach to recent regulatory developments. On the other hand, in an earlier post, I speculated on how the global reaching investment banks would be a logical provider of alpha oriented products in the form of ETFs.

Getting back to my main argument - let’s move beyond the ETF provider and to the ETF user. Let’s take financial advisers and investment counselors since they are a large and growing group among ETF users. For those in this group that have made ETFs a staple in their portfolio construction process, I believe they all have a common set of themes. It likely revolves around the limited role of manager selection, securities selection and market timing. They likely focus on fairly basic strategic asset allocation and an even greater focus on the use of the most vanilla of ETFs as core holdings. Depending on the type of client, they may also employ significant use of mutual funds from either Vanguard and Dimensional Fund Advisers, if not both. Do you think many of these advisers use actively managed funds? I’ll bet many if not virtually all of them do. A more important question to ask is what proportion of their client portfolios are weighted towards active funds versus passive funds. For the many pro-ETF users globally that I know, the use of actively managed funds is rather limited. Thus, I don’t see them getting excited about actively managed ETFs as a replacement or even an improvement over mutual funds. The same is true in my opinion for the do-it-yourself investor. Are the advantages of the ETF structure over the mutual fund so great that one would use the Fidelity Magellan ETF over its existing mutual fund counterpart?

I believe that the vast majority of investors who will get into actively managed ETFs will already be very familiar with existing (passively managed) ETFs. They’ve been bombarded for quite some time on the benefits of ETFs and the “evils” of active management. Let me be clear: I’m not against active management … I just don’t think that building an actively managed ETF with an underlying active strategy typically found in a mutual fund will do well. The typical ETF investor knows too well the difficulties for a US large cap equity fund manager to beat his or her relative benchmark. So what do I think might be a better approach?

Well, what we’ve seen in recent years is the ETF industry’s move towards alternative asset classes and themes. We’ve recently seen the introduction of an international inflation indexed bond ETF. Commodity related ETFs have come to market in such an intense wave the likes of which I haven’t seen since Nasdaq related products in 1999 and 2000 (market top signal?!). Part of this is chasing the hot market but part of it is also an attempt to cover new ground in terms of capital market exposures not yet “ETF’d”. Ideally, these new markets (frontier markets, carbon credit markets, etc.) may have great diversification properties although the ability to turn them into ETFs may be difficult logistically at this time. And so …

And so perhaps the successful actively managed ETFs will be those that continue this trend of providing some uncorrelated or risk-focused approach as an “add on” to what most ETF users already have. I suppose what I’m saying is that actively managed ETFs may be looked upon by the majority of existing ETF users as the “satellites” to a fairly basic “core-satellite” approach. And the core? Check the stats for AUM in the ETF industry and it’s the standard names (SPY, EFA, QQQQ, EEM) providing broad exposures. From the tables provided in this Street.com article, it seems that investor attraction to these traditional core products is solid. It even surpasses the 80-20 rule. From what I can see, nearly 80% of total ETF assets are in top 10% of ETFs. At the extreme, we find that 93.6% of total ETF assets are in the top 25% of ETFs. That means 6.4% of total ETF assets are in the bottom 75% of ETFs. This table from Street.com says that the aggregate net assets for ETFs are at $561.4 billion and that there are 649 ETFs.

Breaking out my calculator, I find that 6.4% of $561.4 billion is $35.9 billion. And 75% of 649 is 487 (rounded to the nearest whole number). That means that there is $35.9 billion in the bottom 487 ETFs. Thus, there’s $0.074 billion on average per ETF. Assets under management of $74 million on average per ETF in the bottom 3/4 (based on size). It would be interesting to see the dispersion of AUM over these 487 ETFs. What percentage of these funds have AUM under $20 million and can they survive for long at this level or less?

Clearly, it’s tougher to really hit a home run in the current ETF marketplace. The concentration of assets within a relatively small number of very large ETFs tells us something especially when you go down the list. Aside from gold (GLD), China (FXI) and Brazil (EWZ) in the list of the 25 largest US domiciled ETFs, everything else is fairly stock or bond index ETFs. Still, we see that a few new offerings from truly unique providers like ProShares seem to be making their mark and there will certainly be those in the actively managed space who will find similar success. But they’ll have to do something even more unique to get the interest of investors. I have a few ideas on what they might be. Broadly speaking, I think they’ll have a philosophy similar to the general hedge fund mantra: market neutral or very low correlation to markets. Or perhaps some sort of “Black Swan” effect to help during times of extreme market distress (not just a VIX ETF). The imagination of Wall Street never disappoints so we’ll just have to wait and see what they deliver. But again, providing a mutual fund in ETF form … well, we’ll just wait and see if that idea works but my guess is that in 3 years we’ll find that:

• the split between the ETFs of today (index and rules based) versus truly actively managed ETFs will be somewhere like 90% to 10% respectively at most. The wild card might be actively managed closed end funds that convert to an ETF structure but even then, I still believe the far heavier weighting will fall to the more traditional ETFs (non actively managed) of today.
• of the actively managed ETFs, I think the largest ones will be some sort of multi-asset class strategy as opposed to a single asset class strategy which fits in some form of fund classification (like Morningstar’s). This would include “ETFs of ETFs” which for some reason seems to be an idea that I think will catch on well and become a highly competitive arena.
• although I don’t believe hedge fund managers will use an ETF format to gather assets, I think that some similar strategies (hedge fund replication, 130/30) will find their way in. Further evidence of my alpha/beta convergence theory mentioned in recent posts.
• I wonder if the tax advantages existing today for ETNs will continue and if so, would underlying actively managed derivative-based strategies be employed. I believe that high frequency derivatives trading is generally treated as income and I wonder if wrapping it in an ETN provides a delay for the realization of a taxable event for investors.

Lawyers and accountants are likely having many conference calls with ETF providers these days over the recent news regarding actively managed ETFs. These participants will help drive the ETF industry in one of several ways. Some of these paths I foresee leading to similar difficulties now found in the mutual fund industry. Others do not but lead to other problems. It will certainly be interesting to see how things develop in this next stage in the industry’s evolution. One thing’s for sure: With the recent news of potential streamlining of ETF filings with the SEC as well as the introduction of actively managed ETFs, just think of floodgates opening. Any commentator complaining of too many ETFs better start resting well and taking your supplements … you’re likely going to be shouting the same from rooftops by the end of this year.

Well my continued lack … well, maybe a better word is reduction … in blogging has been compensated by increased conference speaking. Aside from the event in Singapore I participated in last week, the other recent big ETF event was the “Inside ETFs” conference in Palm Beach Gardens Florida in January. The organizers of that event are a multi-armed entity called Index Publications LLC who publish the ETFR (Exchange Traded Fund Report) and the Journal of Indexes. IndexUniverse.com is their online portal and, in my opinion, along with the published work of Deborah Fuhr at Morgan Stanley provide pretty much all there is to know about indexing and ETFs on this planet.

I know that I’m keeping up with these experts after having bumped into Jim Wiandt (President of Index Publications and Publisher of IndexUniverse.com) in an event last year in Hong Kong. I’ve seen Deb Fuhr at basically every ETF related conference I’ve been to in the past year including the one in Singapore and we’re both speaking at an emerging markets derivative/indexing conference next week in London that should be very interesting as there’s great debate these days of the merit of investing in the developing world given the global market turmoil.

But this post is to let you know that IndexUniverse.com has put up an interview I did with them recently. I’ll likely get a bump in traffic to this blog (heartfelt thanks to IU) and I only wish I had more recently published material up for new visitors. Truth is that I have about a half dozen drafts sitting on the back of this site ready for finishing touches … some of them written many months ago with data/charts that need updating. I suppose I should be writing about the latest regulatory news about actively managed ETFs or maybe something on ProShares’ upcoming 130/30 ETF. There’s actually a lot of interesting new stuff out there in terms of product and industry developments but what interests me even more is the broader picture and what’s happening in this major down market. So here it goes …

I believe that this is where all the more interesting ETFs will “make it or break it”. What has been the trend in ETF land over the past couple of years? Not plain vanilla, low cost ETFs but the exact opposite: Niche sectors. Emerging markets. Thematic funds. Inverse exposures. Many of these have very low correlations to the bread and butter SPY/QQQQ type of holdings. The inverse ETFs go further in providing the zig while the markets zag. Yet, of course, we find what happened with Claymore and their fund closures. Clearly, there will be winners and losers. But these are exciting times for the industry. Many of the new products should do well in this tough environment but many won’t. There’s a parallel to hedge funds (I always do this!).

Nearly every hedge fund manager must have been sweatin’ it during the long and continuous bull market of 2003 to 2007. Basically every hedge fund manager should be in nirvana in this current market environment. The truth is that many are taking advantage of what the market is now providing them but I’d bet that many, many more are in their own version of hell. It’s tougher and tougher to find alpha out there and doing well in down markets is not the same sport for hedge funds as it was thirty, twenty or even ten years ago. Just darn too competitive. Finding a really good hedge fund that isn’t closed to new investors is tough. Thus, building a robust portfolio of hedge funds must be close to impossible. Certainly, the evidence from hedge fund indexing seems to show that the more you try to diversify hedge fund holdings, the more it becomes simply ultra-high cost closet indexing.

I believe that successful hedge fund investing is possible if you have the adequate resources. The term adequate usually evokes a feeling of minimal requirements … this does not apply to hedge fund investing. I’m not talking about minimum investment amounts but the acumen required to provide the necessary qualitative due diligence as well as forensic accounting needed to properly filter the good from the bad. Unfortunately, not everyone can be Yale. And for too many investors, the premium for giving up liquidity and transparency is simply not enough. ETFs, way over at the other end of the active-passive spectrum provide both liquidity and transparency … and now access to the small corners of the global capital markets complex.

Could this be why ETFs and their move towards niche offerings and now active management have the potential do grow even within a lengthy down market? That has always been the argument against indexing and ETFs … they fail to do their thing in bear markets. But if ETFs are no longer just about tracking plain ol’ S&P 500 and MSCI EAFE but providing inverse equity index exposures and currency hedges and low correlated commodity exposures and so on - well then it’s certainly possible to be bullish on ETFs in a bear market.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

• HSBC Climate Change Index

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

My February 22nd article appeared with an unfortunate title that may have suggested that WisdomTree was “Moving From ETF Evolution to ETF Pollution”. As mentioned in that article, I did find it surprising that WisdomTree would introduce a new lineup of ETFs based on a new fundamental factor (earnings) when all of their previous product development had focused investors’ attentions on the benefits of dividend-based indexation. My main inquiry was whether a portfolio construction process based on earnings as the determinant for weightings within an index would provide a significant divergence in performance versus one similarly based on dividends.Not a surprise, I soon had a call from WisdomTree . Many thanks to Luciano Siracusano, Director of Research for ETF firm WisdomTree Asset Management, for taking the time to give me some of the thinking behind WisdomTree’s new product line. Luciano is no stranger to the blogging environment and here are some of the main points I gathered from our phone conversation:

If the Russell 3000 represents the broad US equity market, an indexing strategy based on dividends will provide a subset of roughly 1500 stocks or 76% of the market. Based on this, if the remaining 1500 stocks represent the remaining 24%, you get an idea of the capitalization that is left out. Of course, investors in this strategy would be still be missing out on certain big names like Google (GOOG) but it’s fair to say that you have a fairly strong value and large cap bias.

A fundamental indexing methodology that uses earnings instead of dividends would have broader representation. Clearly, you have to have earnings before you can give out dividends. But, the difference is quite significant: Using the Russell 3000 as the overall market again, with an earnings based filter, you have access to roughly 2450 companies or 95% of the market.

The earnings based methodology provides a strategy and fund that appears to be a lot more like the traditional market cap weighted index fund. Sector weights are more similar, especially compared to the dividend based methodology. Overall returns for the earnings based funds should be highly correlated to market cap weighted funds.

Perhaps the idea from WisdomTree is to use dividend based indexation as a highly defensive measure and earnings based indexation as a pure replacement for traditional index exposures. In other words, if you have a broad US equity position like SPY, an investor could consider the WisdomTree LargeCap Dividend Fund (DLN) as a potential compliment (or outright defensive replacement) and the WisdomTree Earnings 500 Fund (EPS) as a potential substitute.

The evidence on non market cap weighted indexation (equal weighted such as Rydex’s RSP, or fundamental weighted from PowerShares/Research Affiliates and WisdomTree) seems to suggest an outperformance relative to market cap weighted indexation of at least 200bps per annum on average over the long term. Dimensional Fund Advisors is in the same boat as they also have de-linked from traditional indices … although they’ve been doing it for a very long time. DFA has shown incredible strength in their asset gathering despite focusing on the mutual fund structure and not joining the ETF bandwagon. Whether they do a “Vanguard” or not, the continued interest and product development in non market cap weighted index instruments will surely continue. It’s just one of many trends away from the origins of passive management, CAPM.

Like I said in my earlier piece, I’m not sure about the future success of WisdomTree’s new earnings based ETFs. The dividend based ETFs seems to make sense and a serious down market will surely prove their worth as a diversifier. If the earnings based funds are somewhere between the dividend based fund and the traditional index fund, I wonder if enough interest can be created based on something that seems “stuck in the middle”. Frankly, I see a lot more marketing for WisdomTree versus the FTSE-RAFI based ETFs coming out from PowerShares, so I would not be surprised to see them have success with their new products. Thinking for a second about the FTSE-RAFI fundamental index methodology which is based on four factors, I wonder if WisdomTree is considering the remaining two factors or, more broadly, any other fundamental factors for future product development?

It makes me think of the FTSE-RAFI funds like a BRIC fund. It could make sense to have separate funds for Brazil, Russia, India and China for global asset allocation decisions. But what about comparing the FTSE-RAFI based funds versus WisdomTree’s focus on dividends and now earnings? For now, I understand the reasoning behind WisdomTree’s launch of the earnings based funds to go along with their dividend based funds. I don’t see much use in bringing out further product lines focusing on other fundamental factors, the remaining two from Research Affiliates (the “RA” in the rather convoluted FTSE-RAFI acronym) being book value and sales. I’m sure there are a plentiful number of academic papers to suggest other factors (cash flow?) which may also outperform the market cap weighted index and provide other tangible portfolio benefits.

We’ll see. I am sure that the marketing minds at WisdomTree are many miles ahead of me. And I am now even more interested than I was a few days ago about the future success of WisdomTree’s recent efforts.

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

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

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

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

According to Steve Umlauf of Merrill Lynch:

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

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

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

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

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

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

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

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

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

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

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

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

Further to recent articles by Tom Lydon we find continued interest in the exponential growth in ETF product development. The movement to more thinly defined sectors as well as alternative index weighting methods seems to be of great interest to many. Just yesterday I saw something from WisdomTree (WSDT.PK) about their upcoming earnings-weighted index ETFs.I wonder what’s the longer-term plan at WisdomTree? They’re certainly pushing the envelope with arguments against market cap weighted indexation in favor of fundamental weighted indices. But with their first wave (actually, multiple waves) of product offerings, the focus was on ETFs whose underlying portfolio is weighted based on each position’s cash dividend payout. The question I have now is why the shift to ETFs that track an underlying index whose focus is on another fundamental factor – in this case earnings? According to the press release (.pdf) these new offerings are very similar to WisdomTree’s existing “Domestic Dividend ETF” lineup. For example, the first ETF listed in the press release is the WisdomTree Total Earnings Fund (EXT) which has a 28bps MER. It seems to be the exact counterpart to WisdomTree’s Total Dividend Fund (DTD) which has the same MER. Little surprise to me, the backtested performance of the two underlying indices do not have significant deviations as shown on this chart on a page (.pdf) from WisdomTree site.

Despite what seems like a potentially redundant new set of ETFs due to what could be future performance within very close proximity to existing ETFs (is cannibalization a concern?), WisdomTree does give some suggestions for how an investor may decide to focus on one factor over another:

How Do I Decide Which Approach Is Right for Me?

All of the WisdomTree ETFs provide investors with an alternative to market cap-weighted ETFs, and all are designed to be used as core holdings within an investor’s portfolio. If you are seeking the potential for income-generating yields and relatively lower volatility, you may want to consider the Dividend Family. If you are seeking broad market exposure or exposure to traditional sector classifications through companies with an earnings track record, you may want to consider the Earnings Family.

I’ll be very interested to see the growth of assets in this new family of earnings based ETFs. Even more interesting, I’d be interested to know what market environment would cause any sort of significant deviation between WisdomTree’s dividend based ETFs versus their earnings based ETFs. I’m guessing not very many situations. If so, my feeling is that this provides more fuel to the existing discussions of there being too many ETFs. As Richard Ferri of Portfolio Solutions LLC puts it:

“What I am seeing is a rapid shift from ETF evolution to ETF pollution.”

As Keanu Reeves so eloquently said in The Matrix, “Whoa”. The above quote is from John Spence’s recent article “ETFs wade into a dead pool”, he puts out an argument that suggests a significant market decline could not only slow down ETF product development (he suggests consolidation and I’d buy that), but also close down some as well. I’d buy that too but to a lesser degree.

Let’s be honest. Fund manufacturers including ETF providers are just as bad market timers as any other investor. TD Asset Management up here in Toronto had to close their ETFs a few years back. They had a nice lineup of ETFs with broad market exposure to Canadian equity markets even with some value and growth biased ETFs and this was at a time when ETFs weren’t considered to be so “weed like”. Perhaps Canadian investors just didn’t have the will to accept the passive approach at that time to warrant product offerings beyond what Barclays had already been providing the market. But we also saw the same with a small US provider of bond ETFs. They didn’t last long either. Clearly, many of the new niche funds are providing investors access to markets which are hot and at or near their all time highs. Furthermore, the fact is that nearly all markets are at or near their highs. Beta is hot and thus ETFs are the flavor of the day. If we were in a 1970s-like environment we would surely see less interest in ETFs and more interest in hedge funds and defensive strategies. Perhaps even more likely the popular choice would be term deposits … I’m thinking an environment like the beginning of the 1980’s when no one talked about the stock market.

But we’re in 2007. After the risk taking environment of the late 90’s to the sudden risk aversion during and immediately after the bear market of 2000-2002 and the shift to “risk management” thereafter (Basel, Sarbanes Oxley, growth of hedge fund use, etc.) we find ourselves now again at a time of relatively high risk taking. That’s what a four and a half year bull market and VIX down to 10 does to the collective psyche of the global investing public. By the way, have you seen where VIX has been in the past week?! And don’t think that the Bank of Japan’s 25bps rate hike changes the carry trade situation.

It’s also little wonder that hedge funds are having a hard time finding stocks to short. Actually, it kind of sounds like value managers in the late 90’s saying they can’t find good stocks to buy. Shorting is a tough sport in today’s environment. The stock you might want to short could be the same one Carl Icahn is looking to take private, turn around and resell to the public market. It’s tough to be a hedge fund these days. They’re dying to finally get some decent performance fees. They need a bear market badly. Whether they actually do well in a future bear market is another story. Some will and some won’t. Maybe cash really is king. But until then, ETFs are king.

Unfortunately (or fortunately, depending on your view of monarchies), Kings get dethroned. Spence has a heading within his piece called “Shades of 1999”. He doesn’t mention this but it made me think if the ETF explosion could be compared to the dot-com bubble. Well in the one case you have money chasing various asset classes or sectors. In another case you have money chasing stories with no fundamentals to back them up. A broad generalization but enough for me to think that it’s not the same. Still, we’ll definitely see some ETFs disappear as Spence has given some examples similar to mine above. I don’t think it will be like all the tech mutual funds that closed up during the bear market. The King may get hurt, but I don’t think he’ll get dethroned.

What I don’t think people realize is that ETFs are not for the buy-hold investor. They can be; but the direction or trend of the industry is focused towards the more active investor who either prefers a slightly more tactical rather than strategic asset allocation framework or the investor who wants to do some sector rotation … or in fact a multitude of other active approaches including hedge fund like strategies.

Can’t it be possible that there is a level of “micro” efficiency within asset classes such that ETFs provide an ideal, or at least preferred, means for exposure whereas in the more broad “macro” world there can be a significant of overall global inefficiency such that some active management of positions (whether ETF or not) is required?

If so, then the active management of ETFs has some merit. The level of comfort, proficiency and experience as well as other factors will determine to what degree of activity one will allow for their own portfolio. Again, it’s good to have ETFs so as to allow investors that choice. If there is to be a concern, the concern should not be about instruments such as ETFs, but for the overall risk appetite in aggregate within the investing world and what repercussions that may have in a much broader sense if things turn for the worse.

Chris Holt sent me an article from TheStreet.com summarizing a video interview with Jim Cramer on his opinions of ETFs.The article’s a bit vague on details, but the video is quite clear. I’d say that Cramer goes to great lengths to bash the industry as one that does not really care about the needs of the client/investor. He starts out by characterizing the industry as one involved in a “corrupt process”. Just like any merchandiser, he says they’re “pushing products”. I can’t really argue with that. In an industry revolving around money, there will always be conflicts and biases, some more visible than others due to one’s position or background within the industry.

Whether the comments made on the industry are especially relevant to ETF providers, I’m not so sure. Like mutual funds, it’s all about building the assets under management. Newer products with better sizzle are what sell. For better or for worse, ETFs seem to be what’s hot right now. Could it simply be that ETFs are gaining market share from traditional mutual funds? (More on that later when I bring up some recent stats from AMG Data.)

There are many points in the video that are obviously one sided. Commissions driving the ETF push? What about I-banks pushing stocks with buy recommendations left, right and center even after all the regulatory brouhaha after the market collapse of 2000-2002? What about prime brokerages doing whatever they can to fight for hedge fund business that pays top dollar for various services and with the desk making great margins on the related trading activity? I don’t see the ETF push being that significant in the realm of commissions versus other entries in the income statement for the I-banks.

With regard to the idea of “anti-diversification”, Cramer’s talking about the new wave of ETFs that are highly focused in a sector like nanotechnology or a certain area of healthcare (cancer drugs for example). No doubt he’s got a point there. But, his example of 5 stocks (Microsoft, Marvell, HP, CA, Merck) versus an ETF is unclear. I suppose what Cramer is saying is that whether you choose a few tech stocks or one of the newer, highly niche sector ETFs, in both cases you’re not getting diversification. That’s true and I’m betting that anyone who implements in any of these two ways is consciously and purposely making a bet in that sector. The question is if you want to make a bet in a specific sector, do you go with some direct stock picks or a sector fund/ETF? To each his own, but not everyone is a pro with the resources (especially time) to make a precise decision. This is just one of the many reasons for the ETF.

The issue I have with the above is highlighted when Cramer says “… I want to be in a sector fund which is an ETF” at about the 1:50 mark of the video. The context of this quote is not that Cramer wants to be in a sector fund/ETF, but that he equates sector funds to ETFs. So you can see he is focusing on the new niche sector ETFs. Like I said earlier, his is a worthy comment if the point is that there are too many products being pushed into the market, each covering a very specific area. But like I’ve also said many times before, if the market is allowed to take its course, unwanted funds will disappear. Maybe there’s a flaw there, but the Pontiac Fiero and Aztec are other examples where the market decided and the product was pulled earlier than likely expected by the manufacturer.

Simply put, equating sector funds with ETFs is wrong. Cramer knows that ETFs are more than simply a means for a sector play. You can get broad global exposures, regional exposures, country specific exposures as well as style based, cap based and sector based exposures. We’re also getting into alternative investment territory. ETFs are like tools in your toolbox, animals in a biosphere and hedge funds. There are many types, all with varied purposes some more useful than other depending on your point of view.

Near the end of the video clip, Cramer says ETFs should be avoided and that a portfolio of ETFs is just a mutual fund. That is somewhat true if you are overdiversified, long only and are in a generally static state. What’s hilarious is the fact that that he thinks it’s preposterous to try to be anything like an index fund because of the “… empirical nature of the returns I’ve been generating on my show.”

There you go. Some may perceive ETFs as a threat to their OM. As more investors use ETFs, they have less use for shows like Cramer’s and specific stock calls.

But let’s be honest… they’re no threat to Cramer or anyone else. Indexing, ETFs and related methods will never be a threat to the active investor, Jim Cramer or his media efforts. We live in a world where everyone (or at least nearly everyone in the investment industry) thinks they’re better than the rest. It’s part of the modern capitalistic world and it’s what allows for progress and innovation… and that’s good. Greater effort leading to greater achievement should be rewarded. Our industry is one where most have been leaders and overachievers since the sandbox. Thus, based on this, how can we then possibly settle for “average”? Many investors can’t. The investment industry won’t. So, indexing as a means of investing will never take over the world… and rightly so.

Aside: The evidence from Standard and Poor’s and their SPIVA scorecards seem to show that index returns are anything but average. The index return may not always be top quartile, but long-only managers seem to be having a hard time keeping up with the “average” in the longer term.

What I believe is that, in the search for alpha, ETFs are just another trading instrument like derivatives, closed end funds, or specific stocks or bonds. For some investors, having a portfolio of 5 ETFs held for the long term is what’s appropriate. For some, it’s trading a portfolio of 50 to 100 stocks with roughly 200% annual turnover. To each his own. ETFs can be played in so many ways just as derivatives or even a small basket of actively managed stocks.

Think of these as ingredients. I can give ten ingredients to ten chefs and you’d get ten menus of varied offerings (ever watch the Iron Chef?!).

The market would seem to agree. This is from Friday morning’s “Early Look at the Market” email from Bear Stearns:

Including ETF activity, Equity funds report net cash inflows totaling $10.756 billion in the week ended 2/7/07 with Domestic funds reporting net inflows of $8.486 billion and Non-domestic funds reporting net inflows of $2.270 billion;

Excluding ETF activity, Equity funds report net cash inflows totaling $2.571 billion with domestic funds reporting net inflows of $1.210 billion and Non-domestic funds reporting net inflows totaling $1.361 billion. – AMG Data

Equity inflow statistics show that it’s the ETF activity that is significant. Thus, it’s not surprising that nearly every business media outlet has some sort of coverage in the ETF space. This even includes TheStreet.com. From this recent article you get an update on TheStreet.com Ratings’ model ETF portfolio which is a “theoretical portfolio of 10 ETFs that we use to track market trends”. Furthermore, the article states that “TheStreet.com’s Ratings coverage universe now consists of 216 of the 362 actively monitored U.S.-traded ETFs.”

So, first, TheStreet.com seems to have enough coverage of ETFs to even warrant the construction of a sample portfolio consisting only of them. Second, although I won’t comment on the merits of this portfolio specifically, it does look nicely diversified to me.

In isolation, a niche sector fund may be anything but diversified and I think investors realize this. Using ETFs, whether exclusively or not, within a broader portfolio is an excellent way to establish the required diversification for any type of investor. Not everyone will buy in to them but many will for many, many different reasons. ETFs allow for more choice. If Cramer really cared about the investor… no reason to think he doesn’t… he’d realize that that means something.

S&P has been publishing their Standard & Poor’s Indices Versus Active Funds Scorecard [SPIVA] results long enough for investors to understand that indices beat comparable funds more often than not. Fees and the costs of implementation are the main culprits for the difference. Really, the comparison should be with similar ETFs, not the index. What is interesting in the latest SPIVA report from July 19th is that S&P has extended their work into international equities, including emerging markets. This is an area where many observers have commented on the outperformance of active managers versus their respective benchmark. Here are some comments from their press release related to the results of international equities from the report:

International Equities

SPIVA now reports on the performance of international funds versus their relative international S&P benchmark. For the first half of 2006, the SPIVA scorecard shows that indices outperformed actively managed funds. The S&P/Citigroup PMI outperformed 59.7% of global equity funds, the S&P/Citigroup PMI World ex U.S. outpaced 62.5% of international funds, the S&P/Citigroup EMI World Ex U.S. outperformed 63.3% of international small-cap funds, and the S&P/IFCI Composite outperformed 80.9% of emerging market equity funds. Similar to domestic equities, international indices outperformed actively managed funds over a three- and five-year basis.

While indices have historically outperformed actively managed domestic equity funds over long periods of time, our report provides the first evidence of this being true for fixed income and international equity funds,” says Srikant Dash, Index Strategist at Standard & Poor’s. “Even in relatively inefficient asset classes, such as Emerging Market Equities and High Yield Bonds, a majority of active funds underperformed benchmarks over five-year horizons.

Wow. 81% of emerging market equity funds underperformed the index. I’d like to know what the number is versus something like the MSCI EM Index. 81% just seems so big to me, but it really was a very bad May and June.

From the looks of it, core holdings for international equities should still be:

· Broad EAFE exposure: EFA or a combination of VGK/VPL
· Emerging market exposure: EEM or VWO
· Also watch to see what comes down the pipe from PowerShares (FTSE/RAFI) and WisdomTree

It’s looking more and more like we have to move towards a “portable alpha” world. If these numbers are correct, even emerging markets is an asset class where a passive instrument may make more sense than an active manager in the long run… or at least hold more ETFs than managed funds. Truly alpha oriented (beta-neutral) strategies, if they really exist after fees and are repeatable, is the only domain left for active management.

Otherwise, investors will have to become more like pension funds and give up liquidity to enter areas like infrastructure, timber, private equity and other alternative investments.