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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Although based in Toronto, I focus so much of this blog’s content on the US marketplace simply due to the massive amount of industry development in the area of ETFs and derivatives. Of course, there is also news in this space that comes out of Canada, Europe and other regions of the world, but for some reason, I don’t seem to get the same amount of information flow.

In recent months I have spoken at ETF related conferences in the US but since beta (and alpha) are global beasts, I’m trying to gain some added exposure outside of the US. So, in a bit of self promotion, I’d like to comment here on two events I’ll be speaking at here in Toronto.

The first is the Canada Cup of Investment Management scheduled fo June 12-13. Here’s the link to the event’s website. But before I comment on the conference, I thought it might be interesting to give some insight to the history (albeit short) of this conference as I attended the first one in 2002. That conference was called “The Canada Cup of Indexing and Related Products”. If you follow this link, you’ll see that five years ago the world, or at least Canada, had a sophisticated view of the beta world. Of course, if you read the names of the speakers, you’ll note that this was a primarily institutional event although there were many sessions for the retail adviser/investor audience. For retail advisers/investors interested in the ETF/indexing space, I highly recommend that they try to attend these types of “institutionally oriented” events to keep up with what is happening at the leading edge.

In time this event has morphed into the Canada Cup of Investment Management. When this name change occurred in 2004, the byline was “where active and passive management meet”. So it wasn’t a complete departure from beta and this agenda from the 2004 event still shows the focus on indexing and ETFs and related products. In other words, I’d say that it was at around that time in 2004 when indexing became rather mainstream. It makes sense. It was at about that time when BGI and SSGA began to see the beginning of a new wave of competition in the ETF industry. It’s only been in the past year and a half when things have begun to grow rather exponentially.

Coming back to 2007, we have the following agenda for the coming event. I provide the links to the agendas for these events to give you the following insight:

• the list of sessions gives you an idea of what are the hot topics of that time.
• you get a general direction of the trend in the industry and the perception of beta and alpha as drivers of portfolio performance.
• people - who are the experts of what
• new asset classes and strategic thinking

You’ll note that I moderate a discussion on, what else, ETFs (Tuesday, June 12, Track B, 1:45pm) and speak again later that afternoon (3:00pm) on how financial advisers can think about building model portfolios based on what institutions are doing. Both are pretty broad topics and I’m excited about the speakers who I will be working with.

The second event I am involved with is the Hedge Funds World Canada conference (October 9-11, 2007). This event is quite a few months away so the agenda is incomplete in terms of the speaker listings however it does give an idea on the broad topics to be covered. Many may believe that the hedge fund industry in Canada is limited to stock pickers going long and short while focusing on a small group of industry sectors such as oil & gas, gold and uranium. Although there are many who specialize in the commodities complex, this conference agenda shows that the talent pool in Canada is quite broad although perhaps likely not as robust as in the US and Europe … it’s just a matter of time I believe.

I think it’s interesting that the Canada Cup of Investment Management is an event that has a significant level of content related to beta (indexing, derivatives, ETFs, etc.) based on its history, whereas Hedge Funds World Canada focuses more on issues related to alpha as opposed to beta, and rightly so. Everyone has been talking about the separation of beta and alpha over the past several years but it has been common to see philosophies and methodologies pop up recombining the two. Portable alpha is the most common term thrown around.

Perhaps it may be in the group of sessions on the first afternoon of the Hedge Funds World Canada event where this type of discussion will bring some new thinking in this area. The last three sessions of day one of this event fall under the broad heading “Alpha Beta Portfolio Construction”. Note that I’ll be leading the discussion for the first panel discussion on how beta relates to alpha. Here is what’s shown on the latest version of the online agenda for the afternoon section:

ALPHA BETA PORTFOLIO CONSTRUCTION

Panel session: How does beta relate to alpha?

· Beta sources – identifying the sources and choosing benchmarks

· The availability of exotic beta

· Getting comfortable with derivatives – financing costs, leverage and liability

· Rebalancing

· Liquidity

Panel session: Identifying alpha

· How to identify alpha in a hedge fund

· What is true alpha vs alternative beta?

· Hedge fund replication

· The combination of alpha & beta; implementing a 130/30 strategy

New opportunities from new strategies: Hedge fund replication and alternative beta

· Alpha and beta: an ever more blurry line

· What aspects of hedge fund should actually be replicated?

· A review of four different replication approaches

· The prospects of hedge fund clones

Not one mention of portable alpha. That would not have been the case over the past few years. Instead, 130/30 funds and hedge fund beta (commonly termed as alternative beta) are front and center. I have commented on the growing field of hedge fund replication strategies in the past with these postings:

· The Latest In ETFs Makes Me Think: “Are We There Yet?”

· Index Providers: Commoditizing Alpha To Portable Beta

· Merrill Lynch Releases New Hedge Fund Replication Index

· Hedge Fund Replication Strategies: What’s Under The Hood?

· Harry Kat And The Art Of Replicating Hedge Fund Performance

As a practitioner involved in the inclusion of alternative investments and hedge fund programs within a broader portfolio, and more generally also as an asset allocator, I find the evolution of ideas within this area to be both exciting and yet leading to many broad philsophical questions. Where will this lead in terms of the way the largest of defined benefit pension plans think about beta and alpha? Will they think of the asset mix problem differently in the future? I can list other broad questions but the devil is in the details and although many large institutions have already implemented 130/30 type programs, I wonder how hedge fund replication strategies will fit into the mix. For those interested in digging deeper in this area, a further source of information is All About Alpha, a blog I’ve mentioned before also based in Toronto. By the way, Alpha Male, the blogger at AAA will be leading the discussion during for the 2nd panel right after mine.

Today I put some focus on hedge funds and although my blog is called “The Beta Brief”, you will likely know by now that I have an interest in the use of beta within the hedge fund arena.

I saw this story, regarding the debunking of various hedge fund related myths, on Hedgeworld.com (registration required but it’s free). It summarizes and comments on a paper by Ed Easterling of Crestmont Research which can also be downloaded via the Hedgeworld website.

By the way, there’s a lot of interesting information on Ed Easterling’s corporate site including graphs and charts which normally don’t get put online for the viewing public. Good stuff.

I won’t comment too much on Easterling’s “debunking” of hedge fund myths. Hedge funds are relatively new to the broader investing world. Frankly, I believe that the vast majority of individual investors should not be anywhere near hedge funds. It’s not just chasing returns and the probabilities related to both 1) picking a hedge fund manager and 2) that manager being successful during your time of investment. That’s part of the fund investment problem and investors in that realm should understand the statistics involved within this process. More importantly, it’s also the issue of costs related to hedge fund related instruments with small investable amounts. Large institutions can negotiate costs down somewhat but retail investors are often paying MERs that would be considered absurd by most standards.

Even worse are hedge fund programs wrapped in a principal protected note structure. Often with an underlying “fund of hedge funds” mandate (of course with a great real track record) these investment products are built simply to allow smaller investors in with small investable amounts. But not only are the investment management and performance fees high but the costs for engineering and financing a guarantee structure make the problems even worse. Often times, I see historical graphs in marketing material for these products showing decent returns but with incredibly low volatility … the hallmarks of a good, well diversified multi-manager hedge fund program. And this makes me wonder: Why wrap such a program within a principal protection structure? You wouldn’t put that added cost and complexity to an underlying money market mandate. Many times there’s a tax advantage argument put forth in such structures but clearly, it’s because of the various “myths” associated with hedge fund investing and the risk of complete annihilation of one’s investment. However, a properly diversified program would likely not need such protection unless they had a handful of Amaranth-like situations that all happened at or near the same time. I wonder if Nassim Taleb would call that a purple swan with white polka dots?

Due to the fact that hedge funds are relatively new to individual investors and their advisors, it’s not surprising that we have a long list of hedge fund “myths”. But I think it’s important to note that we’re not in the same space we were a few decades ago. It’s a different hedge fund industry with an incredibly more saturated environment - with so many participants investing in so many markets with countless strategies each with its own little twist.

All I’m saying is that hedge funds are not for everyone (especially in the retail space) and the decision to go in or not requires a different skill set than one would normally consider in the fund selection process. It certainly requires enough resources (especially time) to fully process this decision.

Thus, the decision for many investors (even many institutions) to get into hedge funds is not easy. I hear stories from 2006 and 2007 of institutions thinking of pulling fully out of hedge funds if not decreasing allocations significantly. It’s certainly not the trend, far from it. In fact, Aaron Siegel at InvestmentNews has an article today on the record inflows into hedge funds in the first quarter of 2007. The numbers really are quite amazing:

The hedge fund industry posted record inflows of more than $60 billion during the first quarter, bringing total assets under management to $1.57 trillion, according to data released today by Hedge Fund Research Inc.

This record inflow is a big jump up from the same period last year:

The net inflows reflect a 295% increase over the fourth quarter of 2006, when the industry recorded $15.7 billion in new fund flows, and was equal to nearly half the record $126 billion in assets gathered in 2006.

I’m wondering if this is simply a large timing bet. If investors are worried of the lengthy bull market we’ve experienced and the relatively quick recovery to new highs that the markets have shown in the summer of 2006 as well as over the past few months, then it would make sense to see big inflows into hedge funds as a means for defensive preparation. We have not seen a lenghty, drawn out bear market in a while so it will be interesting to see how the hedge fund industry (and various hedge fund indices as guages, faulty or not) perform during such a time. I am confident that there will be a good number of hedge funds (single strategy, multi-strategy and otherwise) that do well but as many including Easterling have mentioned, it’s not just raw numbers but the meeting of client expectations that causes some discomfort after the fact, and thus further confusion within the hedge fund industry.

Due to my background as a CIO/portfolio manager I have a top-down view of the portfolio construction process. Unlike PMs with a fundamentally or technically based bottom-up approach, I often am involved in mandates that limit the use of stock selection to where it is the last course of action. So, if I want to have timber or uranium exposure, for example, I’m pretty much stuck and will have to pick some stocks or perhaps select an active manager in that space, whatever I feel is more appropriate. If I were involved with a very large institution, then this type of investment would be direct and through private as opposed to public markets.

When I look at any asset class and then instrument or manager, I think of it as I would any piece on the chessboard. How does it fit in the overall strategy? What is its purpose? ETFs are tools that were created to be replacements for certain parts of the traditional components of a portfolio. These traditional components could include direct investments in stocks and bonds as well as some form of managed product such as a mutual fund. Some may argue that ETFs are passive and hence should not be thought of as “managed” products but they are to some degree, albeit to a lesser extent compared to mutual funds. If ETFs are not managed, then why do they charge a management fee? Simply put, on the active versus passive spectrum, ETFs have been closer to the passive end but as we’ve seen lately, the industry is attempting to move slowly closer towards the active end. I personally think that the push will only go so far. Investors of all sorts will remain vigilant with regard to costs. Furthermore, the “performance to cost” ratio will be something investors focus on more as the market environment changes. In a time of relative calm and bullishness as we’ve seen over the past four years, investors have become less risk averse and less concerned about costs. True, investors are becoming more aware of costs but it usually takes a back seat when times are good and performance dilutes the effects of costs. But should we experience a serious market decline as we did after 2000, the expectations of investors will be recalibrated and decisions made thereafter.

Will investors remain long-term oriented as they say and stay the course? Or will they shift greater allocations to actively managed products such as hedge funds to hopefully reduce the pain of a downside market? If it is for the latter, the shift may come too late. Furthermore, I’ve commented repeatedly about the sorry state of the hedge fund industry. It’s not that hedge funds are all bad. But here’s a quick list of points that stack up against hedge funds as an investment for the vast majority of investors:

• The search for alpha: Alpha is out there. Whether there’s more or less alpha than there was ten, twenty or thirty years ago is academic to me. There will always be winners and losers in the market. In the days of Soros, Robertson and Trout there weren’t many hedge fund managers finding the inefficiencies in the market and exploiting them. Today, there are many more participants due to the low barriers to entry into this field. So even though the amount of available alpha may be the same (or more, or less … it doesn’t really matter I think), the point is that the amount of “alpha per capita” has been greatly reduced.
• I read recently that Soros was only right roughly 30% of the time. When he was wrong, he was wrong a little. When he was right, he was right big. Further to bullet point #1, it’s tougher to be right big when there are so many other participants in the markets. Unfortunately, this pattern is not symmetric. Amaranth was an example of a manager that was wrong big. Clearly, there were many other participants on the other side who were right small. That might be the future of hedge funds: Not swinging for the fences but maybe hitting more like Pete Rose. I didn’t say betting like Pete Rose, I said hitting like Pete Rose!
• With the low barriers to the entry into this field, we have two further problems. First, many new hedge fund managers are simply focusing on simple long/short strategies or other traditional and more established hedge fund strategies. Obviously, with greater competition in a certain space, the harder it is to attain success. So perhaps newer yet more esoteric strategies (carbon credit trading, for example) may be areas where a manager can have a legitimate shot to attain some sort of advantage. For those who stick to the more traditional hedge fund strategies, it will only get more difficult. Just because you were successful as a long only manager (to what degree of success?), doesn’t mean that running a long/short program successfully is assured. Furthermore, the evidence shows that a very large proportion of hedge funds have incredibly high correlations with broad capital markets, especially the equity markets, likely due to the long bias as a result to one’s traditional investment management background. Problem 2: Paying 150bps for a “closet index” mutual fund manager is bad. How about paying 2% + 20% performance fees for a closet index hedge fund manager? Clearly, an effective quantitative screen is required to filter out not only the poor performers but those that provide more beta than alpha.
• On the plus side, there are a relatively good number of young hedge fund companies (sometimes run by young hedge fund managers) that have shown success in their performance, and thus in the overall sustainability of their company. These “emerging” managers seem to be able to exploit one or two (or basically a small number) of inefficiencies in the market. In fact, there have been a significant number of academic studies that have demonstrated that a universe of younger funds is a better place to start hunting for hedge funds with the potential for greater performance.
• Oh, the potential for greater performance … with increased investor attention towards hedge funds, the sport of “chasing returns” will have moved to the next level. Chasing performance is tough enough in the mutual fund space but the risk transfer is not significant. Because of the high correlations that mutual funds have with the markets, investors are basically taking on market risk whether invested in mutual funds or directly through positions in the market. It’s different with hedge funds. With hedge funds, investors are (supposedly) taking on manager risk to offset market risk. If a hedge fund is truly beta or market neutral, then this is true. However, if there’s the high correlation I’ve mentioned earlier, then it’s still market risk that’s the concern. Plus the manager risk! The worst case scenario is where a hedge fund manager has a small and operationally “loose” environment where performance is highly correlated with the markets. Ideally, you want an operation run like a submarine or some form of military operation. You want the precision where everyone knows their job and there is an appropriate system of checks and balances. Discipline means that no one person has the ability to go beyond some pre-determined threshold or risk parameter. The moment they do go beyond their bounds, there must be some form of disciplinary action. Success is not so much about beating the competition, but being able to fight on the following day. The metaphor may not be perfect, but I believe it’s the discipline, or lack of, that often gets one in trouble.
• The retailization of hedge funds. Based on all of the above, I believe that retail investors may be best to avoid hedge funds and any alternative investments with significant non-market related risks. It’s a fair statement to say that selecting hedge fund managers for one’s portfolio is difficult. The problem isn’t just picking managers with good performance and hoping that their performance continues to be strong. It’s also about the qualitative due diligence required to avoid the blowups. Actually, blowup risk is actually quite low. However, many hedge funds simply close down not due to a blowup but for a large variety of reasons. Of course, the large institutional investor cares about performance, but they spend an incredible amount of resources studying the sustainability of potential hedge fund managers to be added to their roster. They want to avoid the worst case scenario: Having their name on the front page of the morning paper and their beneficiaries noting that they were involved in a big hedge fund blowup. Returns highly correlated with the S&P 500 is bad. A banana peel scenario like Amaranth and the well publicized problems at a fund like San Diego thereafter is much worse.

Many of these discussions I have presented in posts I’ve written in the recent past. The point is that for many investors (including many institutions), the decision to get into hedge funds is a tough one. What’s an investor to do in preparation for a potential bear market? If correlations among asset classes are high, than the benefits of diversification have a limited effect. As I’ve explained, asset strategies such as hedge funds are no safe haven due to a variety of risks as well as costs. Market timing by either shifting to cash or by shorting (whether truly shorting or by way of inverse funds/ETFs) is an appropriate response for those not willing to ride through a prolonged bear market. But what else?

You would think that after such a sustained bull run, Wall Street would be ramping up the product development for defensively oriented instruments. There are a lot of hedge funds coming to market, that’s for sure. Private equity has been hot as well and in this case returns have actually been quite exceptional. But when you look at the ETF space, most of the products coming on line have been linked to an asset class or sector that has shown exceptional performance of late. It’s almost like the perfect form of inverse market timing. With new funds for international real estate, infrastructure and listed private equity, you have to wonder what institutional investors are thinking. They have been invested in these areas for quite a while. The truly smart and innovative pension and endowment funds may have been invested in them for over a decade. If I were them, and I saw significant global assets being funneled into ETFs, CEFs and other instruments (not direct investments) in these areas, I might be itching to get my finger on that trigger to pull out, or at least reduce. I don’t think my argument here is for the ordinary investor to not invest in these areas. They should just be aware that there’e nothing innovative by getting exposure to these asset classes or strategies and they may in fact be a bit late.

Perhaps the easiest solution to a market meltdown is simply to reallocate one’s portfolio to cash and bonds. This leads to my final thought: fixed income ETFs. I think Canada is like a testing ground for ETFs: first ETF ever, first BRIC ETF and yes, the first fixed income ETFs. Barclays Global Investors introduced the first fixed income ETFs in the world here in Canada back in 2000. One was a government of Canada 5-Year bond ETF, the other was the same but for 10-Years. Interestingly, these ETFs did not track an underlying Canadian bond index but rather invested in one (YES, ONE!) Government of Canada bond that had a time to maturity that closely matched the benchmark bond maturity. As a result, these ETFs never held more than one security at any time. BGI simply rolled over the respective bond within each ETF, always holding the one that was most liquid. This is the origins of bond ETFs! Why no indexing but just one underlying bond? Clearly, indexing with bonds is not the same as indexing with equities and the benefits are not the same with both.

The idea of an equity index as a highly diversified means for market exposure is straightforward. With bonds, it’s just not the same. Bond indices can consist of hundreds or likely even thousands of underlying bonds however the correlations among the bonds is quite high … significantly higher than among stocks within an index. Because the gross returns among bonds are not that great, there is greater importance to costs within a bond ETF. The Canadian bond ETFs had a 25 bps MER. Even back in 2000 when the ETF industry was still in its relative infancy, I had many discussions with BGI Canada suggesting that they drop their MER somewhere below 5 bps, which I thought was more appropriate than 25bps. They never did that. But the important thing to note is that with bond ETFs, costs matter. I think that’s the number one rule of thumb when considering fixed income ETFs. By the way, you’ll be glad to know that about four years later in December 2004, BGI Canada converted the 5-Year Government of Canada Bond ETF into one that tracks a short term (less than 5 year maturity) bond index. The 10-Year Government of Canada Bond ETF was converted to track a well accepted Canadian bond index that includes various underlying government and corporate bonds. Although I easily stand by comments about diversification within a bond ETF, anything beats an ETF with one underlying position!

We’re at the point today where in Canada we have bond ETFs that cover various areas of the yield curve for government bonds as well as coverage for corporates and real return bonds, very similar to where the US iShares business was not too long ago before BGI introduced their second wave of fixed income ETFs. Incredibly, despite having raised well over $20 billion in assets in their six bond ETFs, BGI waited about four and a half years before launching this second wave. And during this time, no one came to market with competing products. I wrote back in January about Vanguard’s (still not yet to market) bond ETFs which provide lower costs but not too much more beyond that. You’ll note in that posting how I hope for expansion in the bond ETF space to push internationally but I end up being disappointed. With all the innovation in the ETF industry, what’s going on in the bond side?

I think the question is: Who would use a bond ETF? If investors are more price sensitive to financial products, they must be hyper-sensitive to the costs of bond ETFs as for reasons described earlier. Furthermore, if ETFs are bought for the benefits of diversification and bond ETFs provide little of that, then right away you have two big strikes against you. Whether right or wrong, I think that most ordinary investors can easily build their own laddered portfolio with a relatively adequate level of fine tuning to provide the income they require. Thereafter, diversifying by credit worthiness and a simple mix of government, corporates and even real return bonds will likely be sufficient for the vast majority of investors. For financial advisors and fund managers, this sort of bond portfolio management makes bond ETFs unnecessary.

Recently and over many postings, I have suggested that hedge funds are the big users of ETFs. The shift in product development towards niche sector ETFs and other highly specialized products leads well to the continued growth of both the ETF and hedge fund markets. Another strike for the bond ETFs, but I would find it hard to believe that hedge fund managers would find any interest here. If they wanted to play the fixed income markets, they would go directly into the bond market otherwise find exposures through interest rate derivatives and other derivatives such as credit default swaps.

What would I do if I were to build a bond ETF? The quick and easy answer is I wouldn’t because the solution might have to include an MER somewhere well south of 10bps. But if I had to, I’d really try to get one with simple international exposure. Think of it like the SPDR MSCI ACWI ex-US ETF (CWI) from SSGA but with bond exposure instead of equities. I think that emerging market bonds have the same potential (both in terms of risk and return) as emerging market equities. It’s unfortunate that the logistics of establishing underlying positions for EM markets within an ETF structure make it impractical. Perhaps doing something like what we see on the equity side is the next logical step for bond ETFs. Either moving towards a quasi-active state or simply moving away from pure indexing to something more like an index-plus strategy would be more receptive to investors, as long as costs still remain in check. Bob Smith of Sage Advisory Services moderated a panel discussion at a recent ETF conference and his company website describes a “Core Plus fixed income strategy” product. I informed Bob directly, both during his discussion and immediately thereafter, my thoughts on the future of bond ETFs. For reasons described above, my opinions are clear: It’s not an area that is well suited for the ETF marketplace. Not only did no one step up to challenge BGI over the past four years, a US based ETF provider focused on bond exposures actually closed down after only about a half year of operations, this all happening near the beginning of the decade. Even in the ETF space, there’s always a risk to being “first to market”! And I didn’t even get to the fact that interest rates have ridden a secular trend from highs in the early 80’s to lows only a few years ago as shown in this chart:

If investors think the trend for interest rates is down and the US will look more like Japan in terms of monetary policy, then that’s one thing. If not, and rates are to begin a long and slow climb upwards, then perhaps there’s a reason why even pension funds don’t have as high an allocation to bonds as many might guess. The macroeconomic rationale for bonds, with yields not that much higher than cash equivalents considering the risks, could be one of the more fundamental reasons why bond ETFs are not high up on the list with ETF providers.

I’ve just attacked hedge funds and bond ETFs. Two opposite ends of the spectrum but both commonly added to the equity based portfolio to dampen volatility. Clearly my intent is not to propose that these instruments have no place in the market and thus should be entirely avoided. I believe that hedge funds are an integral part of a large, well diversified portfolio where the manager is fully congizant of the role of active managers and the sources of risk and return when venturing out to certain types of active strategies. If there is a market for the ultimate “couch potato” portfolio, bond ETFs could fit nicely in there. My intent here, as in previous posts is to highlight the potential flaws in products or services that may be getting a lot of attention as an all encompassing solution.

My tone may be bearish but I am more concerned of the overall market than I am for the ETF industry. As such, I believe ETF providers should be thinking carefully about how their products, or products in the pipeline, fit in a portfolio context and how they may (if at all) help investors during major market declines. Advisors should be thinking about strategies for their client portfolios, perhaps even something once thought forbidden like market timing or tactical asset allocation … perhaps something simpler such as option overlays to help prepare for major market declines which I have repeated many, many times is something we really haven’t seen in many, many years.

Let’s do a quick review of recent developments:

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

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

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

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

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

Time For Caution

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

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

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

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

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

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

According to Steve Umlauf of Merrill Lynch:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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