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.

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.

Update! Last month I commented on some developments here in Canada that saw a closed end fund converted into an ETF. I asked if that was the beginning of a trend.

Maybe not a massive trend, but I now see that First Trust is doing the same with one of their closed end funds. It’s the First Trust Value Line® 100 Fund (FVL) and here’s the press release discussing the conversion. First Trust must really be commended for providing A LOT of information on their funds online.

Unlike the Claymore conversion in Canada that has a truly active manager with a classic active management mandate, the First Trust closed end fund seems to fit the model of other rules-based “quasi-active” ETFs such as their own new AlphaDex funds as well as the IntelliDex and fundamental weighted (FTSE-RAFI) funds both from PowerShares.

The question is if and when we’ll see more traditional closed end funds converting into exchange traded funds? Furthermore, if by doing so, would we hopefully see a minimal spread (premium/discount) between the funds’ market price and the underlying net asset value.  I’m sure that many investors who have exposures to the various country specific funds and thematic funds (infrastructure, for example) on the NYSE would be interested to see a structure, if possible, that would reduce, if not eliminate, this problem with closed end funds.

I’m fairly sure that a part three in this series will follow quite soon.

News of the coming actively managed ETFs has grabbed most of the attention in this young and growing industry over the past several months. The AMEX gave some details of an underlying structure for such ETFs at a conference in New York in early March. Even prior to that there were some media reports on this issue including this from John Spence at CBS MarketWatch. I have posted my views several times on rules based “strategy” ETFs and how I believe that they’re not really actively managed, although there are some that have very strong arguments. But what I’m talking about in this post is an actual actively managed ETF. No index tracking. An active manager making stock selection decisions on the underlying portfolio just like for a mutual fund. I sound like a broken record but again, the innovation comes from Canada.

First some background. On Thursday, April 12th, I attended a luncheon seminar organized by The Toronto CFA Society (their derivatives committee, in fact) to a full room of I’ll guess around 120 people. The first speaker was Howard Atkinson, President of Horizon BetaPro ETFs. BetaPro has a long and a short exposure set of levered Canadian equity ETFs linked to the S&P/TSX 60, the dominant large cap equity index in Canada. The underlying advisor for these funds is the same as those for the ProShares line of ETFs in the US. Howard is best known for leading the BGI iShares (formerly iUnits) group in Canada before recently moving to BetaPro and is also the author of “The New Investment Frontier” which is already in its third version. To me, it’s THE book for anyone (Canadian or not) on ETFs. Of course, there’s a big home bias in this book, but it still gives the important basics such as the underlying structure of ETFs (as well as other forms such as HOLDRs), the history and some stats on current funds … although with the pace of product development this book was already obsolete with the ETF-specific data even upon going to print … a problem with all ETF publications including the annual Morningstar ETFs 100. For every book out there, you really have to have an associated website to keep things up to date. To credit Morningstar, and despite concerns I have with regard to their analysis of ETFs, they do have a website with a section specifically covering ETFs. I didn’t say their ETF website was a good one or not. Frankly, I’m not a subscriber to their service so I can’t say whether their ETF-specific analysis is of any value or not … nor did I in my posting which I just referred to. If someone is a subscriber to their service and wants to comment on it here, please do. There are quite a few sites that have databases with a decent amount of ETF related information (they’re free but clearly not as robust as you’d find on a Bloomberg terminal) and many of them are listed on the left column of this blog’s main page under “ETF Information”.

Getting back to the presentation: Like much of his book, Howard’s presentation covered in broad terms the basic topics of history and underlying structure. More importantly, he discussed the confusion today about ETF liquidity as well as related discussion of “true value”. He also quickly went through some recent offerings and the different strategies that can be applied with ETFs.

The second speaker was Peter Haynes, Managing Director of Index Products/Portfolio Trading (Institutional Equities) at TD Newcrest also here in Toronto. I focus so much on the markets and beta related instruments outside of Canada that I hadn’t familiarized myself with the local ETF specialists and researchers on the sell side (thanks Howard for the names!). Peter is one of these few specialists and considering that he was one of the people working on the first ETF ever on the planet (TIPS in 1990 and HIPS in 1993 which eventually merged in late 1999 to become what is now the iShares S&P TSX 60 Index ETF), you could and should say that he’s pretty much been in the ETF business as long as anyone. Peter’s session focused more specifically on the Canadian ETF marketplace and the providers. He also had comments on the institutional use of ETFs and a behind-the-scenes look from the dealer’s side. In all cases, for everyone in the institutional space as well investment dealers with an ETF inventory … it’s all about risk management. No surprise there.

The big surprise, for me at least, was when Peter started to speak … in a rather “matter of fact” tone … about the first actively managed ETF. According to a slide from Peter’s presentation:

“In early March [2007], conversion of FIE.UN from closed end fund (CEF) to ETF resulted in the first North American Actively Managed ETF. Street (other CEF providers) are watching FIE asset retention carefully.”

I did some poking around and thanks to Andrew Leinwand of the Toronto Stock Exchange’s (TSX Group) Structured Products & ETFs Division we have this prospectus available on SEDAR for the Claymore Canadian Financial Monthly Income ETF (ticker FIE on the TSX).

By the way, “SEDAR” is the System for Electronic Document Analysis and Retrieval, a filing system to provide access to most public securities documents and information filed by public companies and investment funds with the Canadian Securities Administrators (CSA).

I couldn’t find a way to link to the pdf file directly through SEDAR so here’s how you go to download the prospectus.

1. Go here:

2. In the text entry box under “Investment Fund Name” enter [Canadian Financial Income] but of course without the brackets.

3. Under document type, choose [prospectus] then click [search].

You should get four matching results, the top one being the English language prospectus. The prospectus is actually for two ETFs. The second ETF listed is a fundamentally weighted fund with Research Affiliates as the underlying advisor. Claymore has anchored itself firmly in the fundamental camp in Canada with multiple offerings based on this indexing methodology from RA. But the purpose of this posting is to focus on the Claymore Financial Income Fund (abbreviated as FIE in the prospectus). The third paragraph found on the first page of this prospectus reads more like a description for a mutual fund than for an ETF with a clear objective related to active management. It reads:

FIE’s investment objectives are to maximize total return to its Unitholders, consisting of distributions and capital appreciation, and to provide its Unitholders with a stable stream of monthly cash distributions of $0.05 per FIE Unit. FIE’s net assets, together with borrowings under its loan facility, are invested in a diversified and actively managed investment portfolio consisting primarily of common shares, preferred shares, corporate bonds and income trust units of issuers in the Canadian financial sector (the “FIE Portfolio”). MFC Global Investment Management (Canada) acts as investment advisor to FIE.

I’ve emphasized the text with regard to the fund’s objectives. There’s no mention of tracking an index but rather maximizing total return. It also mentions the underlying investment advisor as MFC Global Investment Management, part of the global financial conglomerate Manulife Financial. If the part of this being an actively managed fund wasn’t clear, two paragraphs down is this passage we find this:

MFC Global Investment Management (Canada) (the “Investment Advisor” or “MFC Global Investment Management” or “MFC Global”), a division of Elliott & Page Limited, a Manulife Company, acts as the investment advisor to FIE and actively manages the FIE Portfolio on behalf of FIE. MFC Global, one of North America’s largest and most experienced asset managers, and its affiliates provide investment advisory and portfolio management services to institutional clients and investment funds and, as of September 30, 2006, had over $230 billion in assets under management.

Again, I put in bold text the key phrase. Also note that on page 5 within the “Prospectus Summary” section, under the “Investment Approach” subsection, the document gives greater detail on the degree and scope of active management applied within the fund.

But from the second quote above we again see quite clearly it states that the investment advisor “actively manages the FIE Portfolio on behalf of FIE” (as if the third party investment advisor would be hired to passively manage the fund?!), although it’s not very sexy in that the fund’s investment universe are securities in the Canadian financial sector. Funny, with all the talk of Bear Stearns’ SEC filing for an actively managed ETF, in this case it’s about active management within money markets. For those interested in doing some comparison shopping, here’s the link to the Bear Stearns prospectus. I found this link from Matt Hougan’s article on IndexUniverse (registration required but it’s free) with early news on the filing.

I would be wrong to not highlight the fact that this Claymore ETF has a 100bps management fee. That 100bps fee seems to fit the smell test … this guy’s actively managed. The fundamentally weighted ETF has a management fee of 65 bps and I don’t consider it nor other rules based strategy ETFs to be actively managed. By the way, here’s the chart which shows that it’s only had a few days of trading and despite it being an interesting development, clearly it’s not that interesting when you consider the trading volume:

One more note: I just received the latest “ETF Worldwide Guidebook” from Deb Fuhr at Morgan Stanley along with the usual set of additional guidebooks. Page 44 of this guidebook has a listing of Canadian ETFs including the Claymore Canadian Financial Income ETF although it only lists the name of this fund not any additional detail such as ticker symbol or cost (TER). But it does again confirm the fact that this actively managed fund is classified as an ETF.

The ETF industry seems to be taking baby steps into active management … and that’s a good thing. A lot of people (in Canada at least) are looking at these late events and are eager to be second to market. I’m eager to see the response from outside Canada once I post this story. Despite all the comments about the importance of being first to market in the ETF industry (think GLD versus IAU), there’s little point in being #1 and swinging for the fences when you have no clue what to expect.

But this makes me think of all the news in the US of actively managed ETFs and the dawn of a new age [Please note that when I talk of an “age” in the ETF timeline, we’re talking about a year, ok?] So, there was some news of an actively managed ETF out of Germany (some say it’s not) and now we have this CEF to ETF conversion that could potentially lead to other CEFs switching sides. Will we see a mass migration of this sort? More importantly: Why hasn’t this news in Canada made headlines elsewhere … actually, I don’t think it really made headlines here either. Why is that?

This would seem like the forgotten, or somewhat undiscovered passage for the move towards truly actively managed ETFs. Or maybe not. Perhaps, like Peter Haynes had said, there are many other participants in this market watching developments here in Canada as well as in the US. And if so, then there could be some very interesting further developments in the closed end fund/exchange traded fund world. As a review/primer for those unclear about the difference between CEFs and ETFs, I bring this excerpt from a recent article on the Morningstar website:

Most individual investors never deal directly with an ETF the way they would with a traditional mutual fund. Individuals and financial planners buy and sell ETFs among themselves via a broker. In this way, they are similar to closed-end funds. But the similarities end there. Closed-end fund shares can trade at large premiums or discounts to the net asset values of their underlying portfolios. ETF discounts and premiums tend to be much smaller, though, because ETFs can do something closed-end funds can’t: continuously create and redeem shares in-kind. This means that the ETFs exchange fund shares for baskets of their underlying securities and vice versa.

This in-kind creation/redemption process creates an arbitrage opportunity for large institutional investors and market makers, known as authorized participants, who deal directly with the ETF. This helps keep ETF premiums and discounts narrow. When ETF shares trade at a discount to the NAVs of their underlying holdings, the APs buy the ETF shares and sell the underlying securities. If the ETF shares trade at a premium, the APs buy the underlying securities and sell the ETF shares. In the process of taking advantage of these arbitrage opportunities, the APs drive ETF market prices and NAVs close together.

That was from Dan Culloton. In addition to this article being well written in my opinion, by linking to this Morningstar webpage, I also wanted to show that I’m not completely … almost, but not completely … anti-Morningstar. Let me be clear: I’m not so sure of the value of someone telling me “this” mutual fund is better than “that” when a strong majority of these funds are closet indexers. Not all, but a very good number of them. I’m even less sure of the value when applied to ETFs. Furthermore, the star system, to me at least, seems to be the absolute perfect example of the phenomenon of “chasing returns”. I wonder if anyone has ever run a mandate where long positions were established for funds with the top ranking and shorts were established for “no stars” (if there is such a thing as no stars)? I know, that would be stupid but I’d just be interested to see the results. Backtests are only shown for successful backtests. If there is none for this “strategy” (I use quotation marks for obvious reasons), then we probably know why. End of rant.

Back to CEF to ETF conversion story. I’m hoping that this posting leads to a lot of discussion and if so, I hope to follow up with some Q&A with various analysts in the ETF space. I’d like to get some reaction on this particular fund conversion process and their outlook on the future of actively managed ETFs both here and in the US.

In essence, the closed end fund story is quite simple. Just like any index can be traded on an exchange through an ETF, so can a mutual fund (so to speak because it’s actively managed and has a net asset value) be traded on an exchange as a CEF. The well publicized flaw of CEFs is the spread between the CEF’s market price and the underlying fund’s NAV thus if the conversion to ETFs appropriately deals with this, as it should, yet also makes economic sense for the fund provider, this could lead to a significant number of actively managed ETFs on the market. But there’s a big “IF” in there. With all the uncertainty of this, I’m thinking that if this was such a great idea, it would likely have already been done. I’m guessing it’s simply an issue of going through the regulation process and if so, that’s fine. What’s the rush, right? But then, this makes me think of a long list of additional “IFs”:

• If a mass conversion of actively managed closed end funds to ETFs occurs, what are the ramifications to the other participants in the ETF industry, in particular the mutual fund industry, but also to the broker/dealer community, and heck just about everybody?
• If developments lead to a robust and growing actively managed ETF industry, would this further confirm my feelings of a divergence in the ETF space: low cost broad market cap weighted index exposures at one end, and pretty much every else with a higher fee attached to it on the other end.
• If this were to happen, then suddenly the new infrastructure and real estate ETFs (among many others) brought to market recently would have more direct competition from relevant CEFs that become converted. Same with many other asset classes and sub-categories. I wonder what the mutual fund executives think of this? Not another dagger. Certainly, many will have to adapt: Hey Morningstar, you’re back in business! I hear a sigh of relief from mutual fund analysts everywhere as active management truly makes it way to ETFs. Caveat: remember that it’s “IF” such developments occur. Just kidding … there’s really nothing for mutual fund (or active management) analysts to worry about. The financial services industry was built for active management and it’s just a matter of time before the ETF industry gets pulled in.

Last “If”: If John Bogle didn’t like the direction the ETF industry was taking in 2006, you have to wonder what he thinks about it now.

Why am I picturing floodgates being opened?