I’ve made comments recently arguing against bond ETFs. Some of my arguments are really more about the rationale towards low bond allocations in one’s overall portfolio due to the existing, and projected, interest rate environment. Part of it is also the seemingly significant list of weaknesses of bond ETFs versus equity ETFs. I’ve discussed enough about the latter so I want to make a short comment on the former.

Yale University’s Endowment Fund is a top performer in its peer group and the envy of the institutional investing world. I’ve mentioned it by name several times on this blog as have countless others on the web. David Swensen and his group are respected as much for their forward thinking investment philosophy and methodology as their fund’s performance. On the Yale website, the annual reports going back to 2000 are publicly available. Each report shows data as of the last day of June in that year and in each report, the asset mix of the that year and the previous four years are shown on a table near the front of the document. From these annual reports, I’ve put together an asset mix table for this one endowment fund going back eleven years:

Where do I begin?

One observer might say David Swensen is a revolutionary thinker in the institutional investing CIO space. Another might call him a lunatic or at least risky. I think it would be fair to call Swensen risky … in the institutional space, doing anything out of the ordinary and actually implementing an innovative plan would be considered by most to be risky. For example, a 12.5% allocation to fixed income as far back as 1996 with increased bearishness leading to an almost non-existent 3.8% in the latest annual report? Isn’t the purpose of a bond portfolio to provide yields and reduced volatility in the overall portfolio program?

Oh, by the way, when I said “risky”, I meant risky to one’s career. No one in the pension or endowment world wants to take on too much undue risk. They just don’t get compensated (as an employee) in the appropriate way for risk when volatility is nice on the upside. However, risk works two ways of course and if volatility is to the downside, it’s their job that’s on the line. Being close to the median is safe for your livelihood but is it good for the plan? It’s not just Yale but several innovative funds that have led to significant philosophical changes in the industry.

Taking a look at other asset classes, we see that Yale’s endowment fund also looks bearish on US equities having slashed its allocation to this asset class nearly in half over the eleven year time period to a level far lower than what most funds would ever consider to be reasonable. On the other hand, I believe that the foreign equity component would be deemed as reasonable by most investors although the variability in the allocation to this asset class as shown in the table only proves that Yale has been an effective market timer.

If the traditional asset classes of fixed income and domestic stocks have been greatly trimmed, it has been to the benefit of the “real assets” section of the portfolio which includes real estate, oil & gas as well as timber. Interestingly, Yale has had a nearly constant allocation to absolute return strategies (hedge funds) and private equity. In addition, hedge funds have been kept within a range of roughly 20-27% with private equity at roughly 15-25%. Clearly, this fund is a big fan of alternative investments with nearly two-thirds of the fund within this broad classification in the past few years.

Perhaps, if it weren’t for the fund’s great performance, Swensen might have long been considered as an excessive risk taker or worse. Fortunately, in addition to the returns, Swensen’s book Pioneering Portfolio Management provides great clarity in explaining the broad thought process that has underlined the philosophy and methodologies at this fund.

This is only one example of an institutional investor, albeit a very significant one. Bringing this back to the discussion of fixed income investing, you only need to see this chart of long-term interest rates to understand that Yale may have been thinking about reducing its bond exposures well before 1996. In fact, if Yale was a true maverick, the evidence should have led them to reduce these exposures about ten years earlier as shown in this chart.

But clearly, over the eleven year period covered in my table, there was enough evidence from the markets to see that interest rates were moving in one direction on a global scale. Although it’s easy to see this in highsight, the trend was unmistakable as of 1996 so this justifies the low 12.5% allocation to bonds by Yale at that time. Further decreased allocations since then were reasonable as the interest rate decline continued on a global scale to 2006 as shown in this chart:

And so here we are in 2007 with interest rates in a state of limbo (slightly inverted curve over a not so insignificant period of time) and the Fed having held short-term rates constant for longer than many may have thought when it stopped raising rates last year.

But depsite all of the above, there’s been considerable discussion lately over fixed income ETFs. After what seems like a “black out” period, suddenly we’re seeing new products and more in the pipeline. Could it be with all the talk of yield enhancement focus in products related to infrastructure, real estate and other asset classes, ETF providers are thinking that it’s time to restart the bond ETF assembly line? Considering all this and looking at the line graphs above, you (the bond investor or bond ETF provider) have to think a bit like a market timer and perhaps try to call the bottom of this long-term rate drop. The way the US dollar is going, investors must be thinking about rising rates. With the way the housing situation is playing out, the logic is for rates to drop further. The second line chart above is further evidence of globalization so the added wrinkle of determining if the synchronized fall of interest rates globally will continue is another piece to this puzzle.  There are more than enough economists commenting on this and, like them, I feel as though I’m providing way too many questions and no solutions at all. In fact, my only point here is to highlight whether bond investments (ETF or otherwise) are to be a significant component to the overall globally diversified portfolio. Yale, as well as many institutional investors, seems to think not. The recent ramp up of fixed income ETFs seems to show otherwise.

It all depends on:

1. Your income requirements and comfort with volatility that you expect from your portfolio, and
2. To what extent you believe bonds will be (or not be) able to facilitate these roles for your portfolio, and
3. To what extent you believe other asset classes or strategies are effective replacements for bonds within your portfolio.

Further to my posting back in January giving details of Vanguard’s low cost (they are kind of like the Walmart of the ETF industry, right?) fixed income ETFs, we get news today of four new offerings:

The four corresponding ticker symbols respectively are BND, BSV, BIV and BLV.

There’s no doubt that the appeal for these new ETFs (well, for Vanguard in general) is the low cost. But my feelings on bond ETFs still lead me to believe that the diversification benefits of an indexed bond holding aren’t really that great, especially compared to that among equities within a broad equity index. If having minimal tracking error to a particular bond index really matters to you (then you are likely an institutional investor), then some form of index holding matters. But if you are an institution, you’re clearly not using an ETF or ETFs for your fixed income exposures … well I suppose you could be, but if your board of trustees knew this you should be cleaning up your resume.

Unless you’re a complete novice who can’t build a laddered bond portfolio (or acquire an advisor who can do this), then bond mutual funds or perhaps these bond ETFs should be one of your final options to gain fixed income exposure.  It’s almost like the opposite as what might be done on the equity side where you might have a core group of ETFs with stock selection as a “satellite” strategy.  For fixed income, a laddered bond portfolio could be the core and fixed income ETFs could be used as “satellite” positions.  That might not make sense on a first read especially with regard to the use of bond ETFs.  However, I think that we will see a breakthrough in this space where more actively managed fixed income ETF mandates appear as investors continue to push the limits to extract more yield from their portfolios in what is a tough, low-yield world.

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.

The fixed income ETF space is another area where we could see some serious expansion. International bonds, even in emerging markets, has been of great interest to a wide variety of investors in the global search for yields. So the good news is that along with BGI’s release of new fixed income ETFs on top of the six they had at the end of 2006, Vanguard is coming along with their first foray into the space. Vanguard has filed a registration statement with the SEC to offer ETF versions of four existing Vanguard bond index funds. Vanguard ETFs are structured as separate share classes of an existing Vanguard mutual fund counterpart.

The bad news is that Vanguard isn’t really venturing into new territory. Here’s the lineup with a table from Vanguard’s website:

With an expense ratio of 11bps, these are cheap especially in comparison with the appropriate iShare counterpart. For example, for the broadest exposure, Vanguard’s Total Bond Market ETF is nearly half the cost of AGG which sits at 20bps. They both track the Lehman Brothers Aggregate Bond Index.

Comparisons between the remaining three Vanguard ETFs with their iShare counterparts is not as simple. First, the Lehman 1-3 Year Treasury Bond Fund (SHY), Lehman 7-10 Year Treasury Bond Fund (IEF) and Lehman 20+ Year Treasury Bond Fund (TLT) all have a 15bps fee which is not that far off Vanguard’s proposed 11bps. Next, you’ll note the difference in benchmarks:

In this environment, and at first glance when looking at this table, you might not expect to see any significant performance differences between the Vanguard and iShare ETFs within each of the three groupings. However, a little digging on their respective websites leads to some interesting findings. The first thing I notice is the number of holdings in each fund.

I couldn’t find data as of the same date, but despite this you still see quite a difference here. Just as an example/proof, the page from the iShares website shows the 10 holdings in TLT and, yup, they’re T-bonds going out about 20 to 30 years.

TLT’s ETF counterpart from Vanguard will be a share class of their Long-Term Bond Index Fund [VBLTX]. Although their data is a bit dated (as of September 30th, 2006), it does confirm that the number of holdings is roughly around 650 securities and lists them

Unlike TLT which is limited to US treasuries, Vanguard’s version is quite diversified in terms of type of issuer, maturity and credit quality.

A quick review of the other Vanguard mutual funds (VBISX, VBIIX, VBLTX) show a similar degree of diversification far beyond what iShares provides. So, although at the very beginning I said that Vanguard is not venturing into new territory, they are providing something different and at a low cost.

So, for the short-term fixed income group, here’s the 3-year comparison price chart:

Here’s the 3-year comparison price chart for the intermediate-term fixed income group:

Here’s the 3-year comparison price chart for the long-term fixed income group:

Not too much to comment on with these three charts. In the chart for the short-term funds, we see greater month-to-month volatility in Vanguard’s fund versus the iShare which is not surprising. What surprises me a bit is how similar the month-to-month volatility is for the 2nd and 3rd charts. There are a small number of months, like April 2005, where there’s a bigger jump in the iShare versus the Vanguard fund, but otherwise they move almost in lock step.

Last thought. I wonder why Vanguard didn’t enter with a real return bond ETF? Vanguard’s Inflation-Protected Securities Fund Investor Shares [VIPSX] tracks very closely with iShares’ Lehman TIPS Bond ETF (TIP):

With TIP priced at 20bps, Vanguard could do what they did against AGG with an 11bps fee (along with other situations like (EEM) versus (VWO)) and force BGI to consider their overall ETF pricing strategy. With many of the recent and proposed ETF offerings venturing into new spaces, and with their associated relative higher costs, I’d like to see BGI go toe-to-toe with Vanguard in the more traditional asset classes and bring costs down.

I saw this piece over at Indexuniverse.com:

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

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

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

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

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

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

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

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

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

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

CPMKTS 1-yr chart:

Whether you believe that the correction is nearly over, or that we’re about halfway through (or even more bearish than that), hopefully you have built some cash reserves and hopefully this was done prior to the May selloff. If so, it’s time to build a shopping list. Here are some positions to consider:1) First, a look at an area that has been hurt badly and is probably the best area for constructive debate: emerging markets. The iShares emerging market ETF (EEM) has gone from a high of about 111.25 to 89.80 (always using yesterday’s close), down about 19.1%. Vanguard Emerging Markets VIPERs (VWO) has gone from a high of about 76.51 to 61.63, down about 19.4%.

Coincidentally, according to the charts, we’re right back where we were at the beginning of 2006. Roughly 0% return YTD. Now, there’s been a lot of talk about potential slowing of trade in the EM region as a consequence to bearish views on the US economy and rightly so, but what percentage of future EM trade will be dependent on North America? Separately, looking at a long-term chart of EEM/VWO, you have to think that some steam had to be released from the pressure cooker.

Also important to note are the big holdings in EEM/VWO like Samsung Electronics. It is the largest holding in both of these ETFs with roughly 5% weighting in each. That’s actually not bad compared to Samsung’s roughly 20% weight in the South Korean ETF (EWY). South Korea is down just over 16% since its peak in early May and so it isn’t surprising that EEM/VWO are both down similar amounts considering that there are some large holdings from this one country (Of note, South Korea raised rates unexpectedly today which could further the bleeding … in fact South Korea was down 3.5% Thursday with the rest of east Asia performing similarly).

Of course, there are significant holdings in other EM regions like Latin America which have been even worse. The Latin America ETF (ILF) is down about 22.6% since its peak on May 10th. Again coincidentally, ILF is very close to where it was at the beginning of the year. The numbers may sound scary, but I think there’s plenty of room for prices to go down further. How far and for how long no one can know. I haven’t even commented on views regarding the BRIC countries and news of possible upcoming BRIC ETFs. But as a long-term investor, I think it would be prudent to at least have a 5-10% allocation to EM equities such as EEM or VWO. The trick will be avoiding major drawdowns like we’ve seen in the past month.

2. Bond ETFs. Inflation and the debate if there is or isn’t any, or if there will be or won’t be any in the near future has almost made my mind numb on the subject. It seems like it’s an unending debate on CNBC but luckily the World Cup will occupy a lot of my upcoming screen time. We’re still not fully in on our bond exposures (relatively overweight cash in lieu of bond ETFs). We’ve held certain index bond mutual funds and a few bond ETFs (including TIP) but are currently working on this area of the shopping list. I’d like to see a US domiciled international bond ETF. Let me know if there is one. For now, I’m watching TLT. I’ll update our progress on this area in a later entry.

3. Commodities. We’ve held all our commodity based ETFs during this market downturn as we have only about a 5% weight in materials (gold related ETFs) and energy (IGE, PBW). Of note to Canadian investors, we hold the TSX gold subindex ETF [XGD] and the TSX energy subindex ETF [XEG], both traded on the TSX.

We may rebalance these by topping up at some point but expect both gold and oil related ETFs do drive up sharply over the summer months. For those that have been tactically inclined and gotten out of these positions recently, I can only bet that you are contemplating new points of entry. But, like the EM positions from point #1, these are obviously volatile so from a risk budgeting framework, I would not consider putting more than 10-15% in the commodity complex.

We, up here in Canada, are not immune to the “home bias” phenomenon so have greater than global market cap weighted allocation to Canadian equities. Thus, since a broad Canadian ETF has nearly 50% allocation to materials/energy, an investor with a 10-15% allocation to the commodity complex plus a 20% allocation to Canadian equities may actually have close to a 25% commodity sensitive portfolio.

Thursday’s opening bell is about to go off. Despite some news from Iraq, the mood is not good at all after market action from Europe and Asia. A lot of uncertainty. Wouldn’t be surprised if VIX finally breaks above 20.