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

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

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

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

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

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

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

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

Obviously, something less gut wrenching is utilities:

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

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

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

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

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

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

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

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

A big thanks to David Hoffman at InvestmentNews.com (who covers ETFs in a big way!), as we now have more information on the new infrastructure ETF that I wrote about Saturday. SSGA’s infrastructure ETF begins trading today under the ticker GII. Some further details on the underlying index are in this latest press release from SSGA:

State Street Expands International ETF Offering

New SPDR Tracks Infrastructure Investments in Developed and Emerging Countries

BOSTON–Jan. 29, 2007–State Street Global Advisors (”State Street”)*, the investment management arm of State Street Corporation (STT), today announced that it will launch the SPDR[R] FTSE/Macquarie Global Infrastructure 100 ETF (GII) on January 30.

This SPDR seeks to track an index of developed and emerging country stocks involved in infrastructure industries such as pipelines, transportation services, electricity, water, and telecommunications. The Macquarie Global Infrastructure 100 Index, calculated by leading global index provider FTSE Group, serves as the underlying benchmark for GII.

“With the launch of this SPDR, we are responding to our clients’ demands for access to stocks that cover infrastructure industries on a global scale,” said Anthony Rochte, senior managing director of State Street Global Advisors. “This product is part of our steadfast commitment to provide quality offerings that precisely align with investors’ investment strategies.”

This SPDR complements State Street’s series of international ETF offerings. Recently, State Street launched the SPDR[R] MSCI ACWI (All Country World Index) ex-US ETF (CWI) on the American Stock Exchange[R] (Amex[R]). It is benchmarked against the MSCI All Country World exUSA Index and includes both developed and emerging markets outside of the United States.

State Street manages more than $113 billion ETF assets worldwide (as of December 31, 2006) and is one of the largest providers in the U.S. and globally, with a market share of more than 20 percent.** State Street continues to experience significant demand for these investment strategies and today manages a total of 70 ETFs worldwide.

About State Street Global Advisors

State Street Global Advisors, the investment management arm of State Street Corporation, delivers investment strategies and integrated solutions to clients worldwide across every asset class, investment approach and style. With S$1.7 trillion in assets under management as of December 31, 2006, State Street Global Advisors has investment centers in Boston, Hong Kong, London, Milan, Montreal, Munich, Paris, Singapore, Sydney, Tokyo and Zurich, and offices in 25 cities worldwide.

* The Funds are advised by SSgA Funds Management Inc., a registered investment adviser and a wholly owned subsidiary of State Street Corporation.

** Source: SSgA Advisor Consulting Services as of December 31, 2006

ETFs trade like stocks, are subject to investment risk and will fluctuate in market value.

Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.

Funds investing in a single sector may be subject to more volatility than funds investing in a diverse group of sectors.

The Macquarie Global Infrastructure 100 Index is a trademark of Macquarie and has been licensed for use by State Street Bank and Trust Company through its State Street Global Advisors Division. The SPDR[R] FTSE/Macquarie Global Infrastructure 100 ETF is not in any way sponsored, endorsed, managed, sold or promoted by FTSE International Limited (”FTSE”), Macquarie Bank Limited or its affiliates or subsidiaries, the London Stock Exchange Plc (the “Exchange”) or by The Financial Times Limited (”FT”). For further important information and disclaimers regarding Macquarie, see spdretfs.com.

The “SPDR” trademark is used under license from The McGraw-Hill Companies, Inc. (”McGraw-Hill”). No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by McGraw-Hill.

The SPDR[R] MSCI ACWI ex-US ETF is based on an MSCI Index. This ETF is not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such financial product or any index on which such financial product is based. The prospectus contains a more detailed description of the limited relationship MSCI has with State Street.

The Macquarie Global Infrastructure 100 Index ('’MGI 100 Index'’) calculated by the Financial Times Stock Exchange ('’FTSE'’) is designed to reflect the stock performance of companies within the infrastructure industry, principally those engaged in management, ownership and operation of infrastructure and utility assets. The MGI 100 Index is a composite of the broader Macquarie Global Infrastructure Index ('’MGII'’) which is based on 255 stocks (as of September 30, 2006) in the FTSE Global Equity Index Series. The MGI 100 Index is based on the universe of the MGII with a further country screen allowing only constituents in the FTSE developed and FTSE Advanced Emerging regions. Eligible countries from the MGII are then re-ranked by investable market with the top 100 being included in the index.

The MSCI ACWISM ex USA Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in all global developed and emerging markets outside of the US.

State Street Global Markets, LLC, member NASD, SIPC, distributor.

Note: Just after getting the notice yesterday of GII’s eminent launch, I find today that there’s nothing on my screen when I punch up GII. Being the sharp guy that he is, I see on Roger Nusbaum’s site (http://randomroger.blogspot.com/2007/01/gii-delayed.html) that he has seen the same. Wouldn’t it be funny (I guess not “ha ha” funny over at SSGA) if PowerShares or Claymore quietly launched their infrastructure ETF right about now? No, I don’t have anything at all as evidence that either of them, nor anyone else, is working on an infrastructure ETF but something like that would not surprise me at this juncture of the ETF industry’s development.

Bloomberg News has the scoop on an ETF for a new asset class. Well, ‘new’ except for the hundreds, if not thousands, of large institutional investors who have already implemented exposure to the infrastructure sector.

Details of the fund

The article states that the fund will track the Macquarie Global Infrastructure 100 Index. It also specifically mentions the following sub-sectors:

• Telecommunications companies
• Electricity companies
• Water companies
• Gas-distribution companies

For anyone outside of Australia, the name Macquarie is synonymous with nothing but infrastructure investing. A Google search on this index leads you to this FTSE website that covers the Macquarie Global Infrastructure Index Series which according to the site is composed of:

• Macquarie Global Infrastructure Index
• Macquarie Global Infrastructure 100 Index
• Macquarie Global Infrastructure Hedged Index
• Regional infrastructure indices: Australasia, Japan, North America, Europe and Asia Pacific/Japan/Australia/New Zealand
• Sector indices: global oil & gas pipelines, global transportation services, global telecommunications equipment and global utilities with subsectors of global electricity, multi-utilities, gas distribution and water.

A lucky break: If you check out the “Constituents” subpage, it actually provides details for only one index which happens to be the one in question, the Macquarie Global Infrastructure 100 Index.

We find that nearly half of the positions are from the US with the internationals consisting primarily of EAFE plus Canada. For those looking for some BRIC exposure, I only see three Brazilian positions. The Bloomberg article refers specifically to “companies in countries including the U.S., Australia, U.K., India, Brazil and Russia”.

However, contradictory to the article, I see nothing in terms of direct exposure to India or Russia on the constituent listing. Nothing in China. Likely, the Bloomberg article implies that many of the companies in the index have significant exposure to these countries, but it could also be an oversight.

Infrastructure – New hot sector?
Another hot sector justifying the pumping out of a new ETF? Not so in this case. Let’s look at a few existing closed end funds in the sector — I’ve limited them to those also from Macquarie:

Macquarie Infrastructure Company (MIC)

Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund (MFD)

Macquarie Global Infrastructure Total Return Fund (MGU)

OK, I lied. These funds are near their highs. Don’t pretend like you’re shocked. I, like many others, have been talking about this type of occurrence for a while. However, in reality, I don’t see this as a “hot” sector that is out of line in terms of overvaluation. Certainly, we’re not anywhere close to a mania in this area.

It’s true, large and sophisticated institutional investors (mega-pensions with over $100 billion in assets) are buying ports, toll highways and other large scale infrastructure projects, but I believe there is much more in the pipeline available for all other investors as various global economies are modernizing to something more similar to what we have.

Global exposure and the search for yield
Take the most often cited story of this decade: India and China. India’s “golden quadrilateral” super-highway and its associated network of roadways are in their early stages. If India is to be the US of the future, then what is to stop India from having a highway system similar to that of the US? Break out your atlas or give your globe a spin and you’ll see that, geographically speaking, India is about a third the size of the US. It’s not small and there is a large (understatement here) group of middle class workers who will want to experience the freedom of driving.

What about China? Like South Korea in 1988, there will be an explosion of tourists who will come after the Olympic games to explore China. China is already working on expanding its airports and highways for the expected traffic. They’re going to need it and more… aside from Beijing and Shanghai, most of China looks more like a truly developing country rather than a major cosmopolitan center. Although the prospects for an ambitious highway complex as in India may not be developed soon, there are so many other areas of infrastructure where China will need significant amounts of investment.

In terms of recent product development, State Street Global Advisors is on a bit of a roll with this ETF and their recent SPDR® MSCI ACWI (All Country World Index) ex-US ETF (CWI). Kudos to them on bringing a key and missing alternative asset class on line.

To some observers, infrastructure is an industry class just like technology or financials. I think that the institutions see infrastructure as an asset class because it is different in that it’s a bit like private equity in many cases, but more importantly it provides one thing that they, especially pension funds need: flow. Flow, meaning cars on a toll highway, planes passing through an airport, oil flowing through a pipe, data traveling through fibre optic cables. To them, this flow equals income.

If you go to the above charts online via bigcharts.com, you will be given some statistics along with the charts. For example, from the chart for MGU, we can calculate the 12-month price return as just over 30%. However, this does not include the 12.5% yield (according to BigCharts.com), paid through quarterly distributions.

Infrastructure is an area that interests me so I get updates directly from Macquarie. A December 6, 2006 press release mentioned the following:

NEW YORK, December 6, 2006 – Macquarie Global Infrastructure Total Return Fund Inc. (NYSE: MGU) (the “Fund”) yesterday declared its regular quarterly distribution for the period ending December 31, 2006 of $0.40 per share.

Based on the Fund’s net asset value of $29.37 and New York Stock Exchange closing price of $27.37 on December 5, 2006, the $0.40 per share distribution is equal to an annualized distribution rate of 5.45% at NAV and 5.85% at market price respectively.

The $0.40 per share quarterly distribution reflects a distribution policy of the Fund intended to provide shareholders with a relatively stable cash flow. This policy may be changed or discontinued without notice to investors.

In addition, the Fund declared a special annual distribution of $0.50 per share relating to additional short term capital gains earned on the sale of portfolio securities during the year.

This is just one example, but in the search for yield, infrastructure delivers. In this environment, this is not only true for the mega institutions, but for all investors. A significant global economic slowdown could put a dent into many sectors including some of those that may be classified under infrastructure, but only for a relatively short time. Infrastructure is one of those “must haves” in life. Again, kudos to SSGA.

To be perfectly honest, SSGA, like Barclays Global Investors, is more known for relatively low cost, broad exposures with their ETFs. If I were a betting man, I would have guessed that something as unique as this new infrastructure ETF would have been brought to market by one of the new and smaller players like PowerShares, Van Eck or Claymore.

I’ve been thinking lately that maybe the ETF industry would start to diverge where the big providers (SSGA, BGI, Vanguard) would go “Wal-Mart” and stick to broad, low cost exposures while the newer entrants would focus on higher margin niche products. I guess not. Everybody’s got to watch their back. Just the way I like it.

I received the latest press release form Van Eck Global. Earlier this year, they entered into the ETF market with their first offering – a gold producer ETF (ticker: GDX). As of September 30, 2006 it has over $250 million in assets and averages over 500,000 shares traded per day. It’s even option eligible. We maintain gold exposure through XGD, an iShare ETF domiciled in Canada giving exposure to stocks in the TSX Gold Subindex. Basically, this would be Canada’s counterpart to GDX. This is complemented with GLD. We’re holding no more than 5% in these gold related positions right now and don’t plan on touching these.Some news on two new ETFs from Van Eck Global from today’s press release:

Today, we are launching two new unique ETFs, one on Environmental Services and another on Steel shares. Both are based on indices developed and calculated by the American Stock Exchange.

Market Vectors Environmental Services ETF (ticker: EVX) is the only way we know of for investors to gain exposure through an ETF or mutual fund to the fast-growing environmental services industry. This ETF seeks to track, before fees and expenses, the performance and yield of the Amex Environmental Services Index [AXENV].

Market Vectors Steel ETF (ticker: SLX) gives investors a unique and important way to focus on steel, an industry that is fundamental to consumer durables, capital spending and construction and one undergoing significant change. SLX is the only ETF or mutual fund that we know of that investors can use to gain exposure to the steel industry. This ETF seeks to track, before fees and expenses, the performance and yield of the Amex Steel Index [STEEL].

More information on Van Eck and their “Market Vector” family of ETFs can be found at on their website.

With regard to EVX, I think about how it might play along with our clients’ positions in PBW (PowerShares WilderHill Alternative Energy ETF) which I have discussed in the past here and here. PBW casts a fairly wide net. It has utility companies that are relatively clean in terms of using hydroelectric power versus the burning of fossil fuels as one example. It also has significant “high tech” type exposure with companies in the clean energy industry. In fact, according to the PowerShares website, IT has the largest sector weight in PBW with 37.26%. For anyone interested in doing some “comparison shopping”, here’s the list of constituents in the Amex Environmental Services Index [AXENV) picked right off the AMEX website:

Amex Environmental Services Index [AXENV]

“Constituents as of September 29, 2006″

Ticker Component Name Shares

(ARS) Aleris International Inc. ” 112,920 ”

(AW) Allied Waste Industries Inc. ” 523,358 ”

(CCC) Calgon Carbon Corp. ” 801,254 ”

(CLHB) Clean Harbors Inc. ” 133,699 ”

(CVA) Covanta Holding Corp. ” 271,936 ”

(CWST) Casella Waste Systems Inc. ” 312,291 ”

(DAR) Darling International Inc. ” 1,411,638 ”

(ECOL) American Ecology Corp. ” 298,630 ”

(FTEK) Fuel-Tech N.V. ” 237,863 ”

(LAYN) Layne Christensen Co. ” 196,169 ”

(MTLM) Metal Management Inc. ” 212,749 ”

(NLC) Nalco Holding Co. ” 304,219 ”

(NR) Newpark Resources Inc. ” 1,069,342 ”

(RSG) Republic Services Inc. ” 433,275 ”

(RTK) Rentech Inc. ” 1,205,275 ”

(SGR) Shaw Group Inc. ” 234,497 ”

(SRCL) Stericycle Inc. ” 83,439 ”

(SYGR) Synagro Technologies Inc. ” 842,800 ”

(SZE) SUEZ France ” 383,091 ”

(TTEK) Tetra Tech Inc. ” 330,558 ”

(VE) Veolia Environnement ” 286,354 ”

(WCN) Waste Connections Inc. ” 149,905 ”

(WMI) Waste Management Inc. ” 475,926 ”

(WSII) Waste Services Inc. ” 370,612 “

Just below this list on the same page, AMEX gives daily price data going back to March 30, 2001 for all you backtesters.

For those of you more interested in the Steel ETF, here’s the low down on the Amex Steel Index (STEEL) from the same source:

Amex Steel Index [STEEL]

“Constituents as of September 29, 2006″

Ticker Component Name Shares

(AKS) AK Steel Holding Corp. ” 176,054,206 ”

(ATI) Allegheny Technologies Inc. ” 161,006,988 ”

(CAS) A.M. Castle & Co. ” 26,503,386 ”

(CGA) Corus Group PLC ” 797,929,419 ”

(CHAP) Chaparral Steel Co. ” 74,220,357 ”

(CLF) Cleveland-Cliffs Inc. ” 67,012,665 ”

(CMC) Commercial Metals Co. ” 193,332,833 ”

(CRS) Carpenter Technology Corp. ” 40,811,599 ”

(FSTR) L.B. Foster Co. ” 16,795,555 ”

(GGB) Gerdau S.A. ” 690,673,048 ”

(GNA) Gerdau AmeriSteel Corp. ” 488,139,610 ”

(IPS) IPSCO Inc. ” 75,477,624 ”

(LSS) Lone Star Technologies Inc. ” 49,212,576 ”

(MSB) Mesabi Trust ” 20,986,446 ”

(MT) Mittal Steel Co. N.V. ” 580,505,687 ”

(MTL) Mechel AOA ” 221,952,459 ”

(MTLM) Metal Management Inc. ” 43,028,612 ”

(NSS) NS Group Inc. ” 36,217,615 ”

(NUE) NuCor Corp. ” 258,252,205 ”

(NX) Quanex Corp. ” 59,128,351 ”

(OS) Oregon Steel Mills Inc. ” 57,282,440 ”

(PKX) POSCO ” 264,141,742 ”

(RIO) Companhia Vale do Rio Doce ” 1,905,989,847 ”

(ROCK) Gibraltar Industries Inc. ” 47,643,391 ”

(RS) Reliance Steel & Aluminum Co. ” 120,668,864 ”

(RTP) Rio Tinto PLC ” 213,201,208 ”

(RYI) Ryerson Inc. ” 42,017,680 ”

(SCHN) Schnitzer Steel Industries Inc. ” 49,162,989 ”

(SID) Companhia Siderurgica Nacional ” 416,449,219 ”

(SIM) Grupo Simec S.A. de C.V. ” 224,588,561 ”

(STLD) Steel Dynamics Inc. ” 80,868,198 ”

(STTX) Steel Technologies Inc. ” 20,871,276 ”

(TKR) Timken Co. ” 150,337,812 ”

(TX) TERNIUM S.A. ” 320,673,531 ”

(USAP) Universal Stainless & Alloy Products Inc. ” 10,298,075 ”

(WOR) Worthington Industries Inc. ” 141,868,054 ”

(WPSC) Wheeling-Pittsburgh Corp. ” 23,529,773 ”

(X) United States Steel Corp. ” 199,724,908 ”

(ZEUS) Olympic Steel Inc. ” 16,680,385 “

I see the Steel ETF as a potential building block for an infrastructure sub-portfolio. Thus far, I have focused on closed end funds from Macquarie (MIC, MFD, MGU, etc.) all traded on the NYSE. Stock selection makes sense here as well with positions such as CEMEX (CX) and Caterpillar (CAT). It’s amazing how this commodity plays into so many other asset classes. Another case aside from infrastructure would be alternative energy. I’ve heard from wind farm developers that one of their biggest costs is the price of steel. Another correlation play tying the commodity complex with alternative energy.

If you’re looking for the link that leads you to the above data, here it is.

Some further interesting notes about the composition of the two underlying indices from AMEX. This is from an October 3rd press release from AMEX found on PRNewsire:

The Amex Steel Index is a modified market capitalization-weighted index comprised of publicly traded companies involved primarily in the production of steel products or mining and processing of iron ore. The Amex Environmental Services Index is a modified equal-dollar-weighted index comprised of publicly traded companies that are engaged primarily in consumer waste disposal, removal and storage of industrial by-products and the management of associated resources.

If you read closely you’ll see that the Steel Index is market cap weighted. The Environmental Services index is equal dollar weighted. I would very much be interested to hear what Rob Arnott would have to say about this. He’s the first person I heard discussing the benefits of non-market cap weighted exposure with first the concept of equal weighting and then the concept of fundamental indexation.

From the same press release, the next paragraph states:

The Amex Steel Index includes common stocks or American Depositary Receipts (ADRs) of selected companies with market capitalizations greater than $100 million that have an average daily volume of at least $1 million over the past three months. The Amex Environmental Services Index includes common stocks or ADRs of selected companies with market capitalizations greater than $100 million, three-month trading price greater than $3.00, and three-month daily average traded value greater than $1 million.

It’s fairly clear that there are not a lot of steel companies that can be put into the Amex Steel Index. However, the environmental services is certainly an area for decent long term growth. I would expect to see hundreds if not thousands of potential stocks that could be in this index now and in the not too distant future. Keeping a $3.00 minimum average price makes sense if not simply to keep the cost of running this ETF reasonable.

I love these new ETFs breaking into new asset classes. Keep ‘em coming.

There’s been alot of recent news about new offerings being introduced by WisdomTree and Powershares and some not so recently by the bigger shops. I have two comments:

1. Market cap weighted indices. Rob Arnott is often credited with the introduction of an alternative to market cap weighted indices – specifically, the idea of an equal weighted cap index. The data looked conclusive and made a lot of common sense. In many ways, the basic idea overlapped well with the Fama-French 3-factor model which considers size (small versus large stocks) and value (high book-to-market ratios versus low BTM ratios) in addition to just market risk [CAPM]. So when the Rydex S&P Equal Weighted ETF (RSP) came out in 2003, which in highsight was a perfect long-term entry point after the bear market of 2000-2002, it looked like a good core holding for US equity exposure.Thereafter, Arnott’s writing moved into the area of fundamental weighted indexing and with it, a combination of various fundamental measures which could determine the composition of an index in a slightly more complex manner. More recently, Arnott’s firm Research Affiliates has worked with various manufacturers to introduce the next stage of non-market cap weighted ETFs, specifically PowerShares FTSE™ RAFI US 1000 Portfolio (PRF) as well as ClaymorETFs FTSE™ RAFI Canadian Index Fund (CRQ on the TSX), both based on his concepts of fundamental indexing. However, just like any other method of building an “index”, fundamental indexing will perform better than other manners of indexing in certain, but not all, markets.

WisdomTree’s new ETFs tread fairly closely to these also using the term “fundamental weighted indexing” in their marketing material (.pdf). I give true credit for a practical alternative to market cap weighted indices to Dimensional Fund Advisors. I find it interesting that DFA, the real pioneers of “thinking outside the box” in the world of index investing and whose funds revolve around the Fama-French 3-factor model, have not entered the ETF space. Their US-domiciled funds have a much longer-term track record compared to most ETFs, and have a loyal, almost “cult-like” following which is now growing internationally into the UK, Australia, Canada and other jurisdictions.

However, the way in which they market their funds through selective advisors does not lend well to a transition into ETFs. Furthermore, with the recent entry of WisdomTree, there may not be enough space in such a specific ETF market, but there still are some differences between the philosophies and methodologies at the two firms.

To me, the simplicity of RSP (equal weighted indexing) is magnified compared to the newer offerings of recent weeks or even the 3-factor model+. Costs seem comparable, but what we are seeing here is the move towards something that looks less like a traditional index instrument and more like a quasi-active fund. Powershares seems to be pushing the envelope the most as WisdomTree’s offerings lean more towards a simple dividend oriented bias.

Will someone try to build a fund that tracks an index whose underlying constituents are actively managed, such as a hedge fund index? Whether the logistics works out or not, I’d rather not see that happen. I can only imagine the spread between the market price versus the underlying fund’s NAV in addition to the numerous other potential complexities. Overall, it certainly is interesting what’s happening and I’m always eager to see what new innovation in coming down the pipe.

2. Although I am happy to see innovation in the ETF space as explained above with alternatives to market cap weighted indices, I am not so happy with what is broadly coined as “alternative investments”. Obviously, we’ve seen new products brought forth in conjunction with the commodities boom of the past few years, and especially very recently (GLD), (SLV), (USO), (DBC).

My concern with these is similar to the countless Nasdaq linked index products which came out just prior to the top in 2000. The idea of investing in materials and energy makes sense as components in a broadly diversified global portfolio. I just can’t see them being major (> 10% in each) holdings in this kind of portfolio.

Speaking of this type of portfolio, what would be a good model to follow? I like to see what certain large institutions are doing. Up here in Canada, we have a few pension behemoths that are quite innovative. In the US, there are far more interesting ones to choose from, but I’ll focus on endowments such as those at Yale and Harvard.

Without going to deep into details, I propose a read of Yale’s latest annual report (.pdf). A key excerpt that shows how different they think in terms of asset allocation:

Today, target allocations call for less than 20 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real estate dominate the Endowment, representing more than 80 percent of the target portfolio.

Furthermore, they state that:

The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

Clearly, there are challenges to building an ETF, or other highly liquid instrument, for certain of these asset classes. So far, for investors interested in building a portfolio more aligned to institutions such as Yale, the energy complex and real estate are areas where they have been able to participate.

For real estate, REIT ETFs (RWR), (IYR), (ICF) are a start and Robert Shiller has been making the rounds promoting housing futures that began trading on the CME in late April. So, for the next stage of the growing ETF universe, what about an offering related to timber? Investment returns related (among other things) to the physiology of trees sounds like something that should be uncorrelated to the broad markets and may also provide decent yield. Another interesting area is infrastructure. So far, closed end funds (MIC), (MFD), (MGU) are the only viable choice for non-institutional investors.

Despite the interest from institutions in both these areas, I doubt there’s any significant interest from the ordinary investor that could lead to an ETF. But how many large cap value funds (whether domestic, international, or whatever) can you have out there?