So it’s now about two and a half years later.  If you’ve followed my writing, you can see I’ve gone from as many as two to three blogs a week to basically once a month on average … if that.  Part of the decline is likely the same as other bloggers … I just ran out of gas.  I certainly don’t consider myself to be like other bloggers who write daily (or sometimes hourly) based on what’s happening around them in the world.  There’s nothing wrong with that … in fact, it is the more successful blogging model … but it was just never how I intended to blog.  Initially, I’d pick up on a news story and expand on it with my opinions and connected the dots with the world of beta oriented instruments.  Now the world is far more complicated for many reasons which can take up so much time/effort so let’s just agree to accept that.  In addition, the world of beta instruments (ETFs and their related siblings of ETNs, ETCs, etc. as well as the wide array of derivative contracts) has expanded in a way no one would have predicted ten years ago.

Now near the end of 2008, after at least a year of strong market declines, we should be seeing what I’ve called “the next wave”.  As with the market declines of 2000-2002, we should see a new wave of exchange traded products.  Everyone can see the massive outflows from mutual funds and other traditional products.  Hedge funds are seeing the same.  But we also find significant new monies going into ETFs.  Whether it be a focus on costs, the realization of tax benefits, the frustration with active managers … all of the above … the result is this new wave.  After the rebound in 2003 we saw the arrival of PowerShares, ProShares, Van Eck and several other providers who now manage billions of dollars in assets.  This third wave will introduce many new entrants some sticking to the basics of indexing and other moving towards more actively managed mandates.  Theirs is all a case study in timing.  This wave of new arrivals hasn’t really started yet but had these new entrants come to market with their products 12 months ago, they’d now likely be dead; or like many smaller ETF providers today, barely breathing.  But it’s not just a case study in terms of timing the overall market direction and attempting to launch ETFs at the beginning of a major uptrend.  It’s about timing the tastes and values of investors.

Will actively managed ETFs gain favor of investors who are running for the exits (from mutual funds and hedge funds)?  Or with an eventual rising equity market, will it just be a matter of time before risk aversion turns to risk acceptance and thus realize flows back into actively managed funds?

My sense is that it will take a very long time before actively managed ETFs get any sort of momentum.  I would be very surprised if aggregate assets under management within US domiciled actively managed ETFs totals a quarter billion by the end of 2010 (two years from now).  If it’s in that vicinity or more at that time, I’d further speculate that the more successful products will be “ETFs of ETFs” marketed by the biggies … like iShares.  Unfortunately, I believe it will be the smaller independent providers with their own EoE that likely provide something special … meaning, an underlying portfolio of ETFs consisting of those from a wide variety of providers and no constraint in terms of who can or can’t be included.  Somehow, I would think that a large “brand name” provider would only use their own ETFs as underlying constituents in their EoE.  Can’t blame them really.

I am also a student of timing.  My first job in the industry was with a company that actually had the word “Timing” in its name.  Working in a conservative country like Canada (never mind legalized marijuana use for now) for what was essentially a hedge fund - and a proponent of market timing on top of that - makes me a student of timing in many different ways.  I don’t know if there even was a hedge fund industry in Canada back in the mid 90’s but I remember how hard it was to be a market timer when the markets were only going in one direction.  Fast forward over ten years and for precisely the entire calendar years of 2007 and 2008 I have not managed money.  Instead, I have done some consulting which I really enjoyed, on top of the occasional blogging and conference speaking … loved that too.  In highsight, not a bad career move as I’ve sidestepped the scariest and most volatile market activity that anyone can remember.

Lucky more than anything else.  Actually, being away from the market as a professional participant looks even better when you look at this chart:

Some smartass might call me a chicken for bailing out during this challenging time.  I’m up for a challenge, but I’m not stupid.  If I know there’s a freight train about to run me down, I’ll get off the track.  I’ve been bearish on the US market since early 2006 (way too early a call) but I never thought it would be like this:  Maybe one investment bank gone but not three.  The world now looking to do a photocopy of Japan’s ZIRP.  Problems with the auto sector yes, but not nationalization.  This last one really has me thinking … China is ever so slowly transitioning from socialism to a market economy with something that looks more like “trial and error” than anything from an economic policy textbook.  Can’t bad mouth them for trying their own thing with the Russian model and past help from the IMF/World Bank not looking like safer bets.  But with recent attempts from the US government to resuscitate the banking, insurance and auto industries, is the US moving in the other direction and possibly looking a lot more like the Chinese model?  Maybe it’s too early to say this and so it’s a bit of an exaggeration since the US is clearly not moving from a market economy to socialism.  However, if this is the beginning of a trend of China and the US merging to some form of “controlled capitalism model”, who would have thought?  What a world.
Frankly, this past year should have been the time for hedge funds to shine but no one thought about the fact that panic can go to extremes … especially after such a long period of time with no panic.  Just look again at that VIX chart.  Was there anyone speculating for a VIX at 80?  I’d like to talk to that person. As you can see, we entered a whole new world in the 4th quarter of 2008.

Despite this, I think what’s happening to the hedge fund industry is not all bad.  The closing of some funds (including recently exposed frauds) is necessary just as it is for the closure of some ETFs this year.  The hedge fund industry will have to evolve somewhat as both regulators and investors demand greater transparency and liquidity.  To many, this will be more than “evolving” but a massive transformation.  Will the active manager lose their information edge due to added constraints?  Possibly and that’s sad.  But I think there are markets where the information edge is still significant.  Emerging markets, for example, will always be just that … emerging.  The Poland of today could be the Germany of tomorrow just like the Vietnam of today might be the future South Korea.  As emerging markets of today move up to developed status, like Korea recently, new countries will plug into the modern global financial complex, and investors will slowly enter these markets and seek information.  Hedge funds should hopefully be the early entrants if the regulatory world allows them access.  I generally don’t think it’s the more traditional investor (mutual fund, etc.) that will have the inkling or ability to make it happen.

Overall I believe there is a strong future for both ETFs and hedge funds and I’m keenly interested in how these two worlds interact.  Furthermore, my interest is intensified when I intersect these areas with the emerging markets.  Any reader of this blog should know that I have little interest in the active versus passive debate.  Rather, my interest is in seeing how active strategies and passive instruments can work together, not just for the heck of it but because it makes sense.  I honestly believe that emerging markets are the realm for active investors.  The volatililty inherent in these markets turn a long-term oriented buy-hold investor into a short-term trader at the worst possible time.  A hedge fund-like mentality is more likely needed for investors’ non-core positions which may or may not include emerging markets.  I say “may not” for those who consider emerging markets to be an essential part of their core portfolio.  Debate this point if you wish but let’s face it: with the needs on the liability side of the equation and interest rates where they are, there’s a lot of pressure for investors to get anything in at least the low double digits for returns.  Although it comes with volatility, I can’t think of many other places like emerging markets where the long term potential for double digit returns exists.  But it’s just that damn volatility.  It requires supervision and at times tactical rebalancing.

This leads me to my final point on timing.  I’m getting back in.  Not in a portfolio context but professionally.  IndexUniverse.com put a comment in one of their latest “ETF Watch” articles under the subheading “EGA Makes First Filings” about this new venture which we hope will be considered THE emerging market ETF provider and research firm.  There’s a link at the end of the commentary to the registration statement filed with the SEC.  Those in the industry will note I’m working with Bob Holderith (formerly of ProShares) on this and if you know what ProShares ETFs are about, you’ll understand the common thinking Bob and I have.  We view ETFs as tools for any type of portfolio manager whether it’s the hedge fund or the couch potato at home.  Although emerging markets may not be perceived as appropriate for everyone, investors realize the challenges that come with gaining exposure to these markets.  We believe that the inherent benefits of ETFs (liquidity, transparency, ability to short, etc.) are just what are needed in emerging markets investing.  They are not a solution on their own nor are they only for the ultimate buy-hold investor or day trader.  They are just a piece in a bigger puzzle.  Our lineup happens to focus on providing sector based exposure … a first to the market which is key.  Because of where we are in the regulatory process, I am limited in what I can say about these new products.  This blog post is not meant to be a form of product solicitation but to outline my transition away from blogging (at least for now) and back into the investment management industry.

I hope my timing’s good.

Thanks to those who have followed my work here at Beta Brief.  I’ll still be writing and you’ll find most of it online on our company’s future website and possibly on one of the now many ETF related websites.  I wrote a piece recently for Institutional Investors’ annual Guide to ETFs and Index Innovations and I plan on having a series of articles with my friends at IndexUniverse.com to keep me plugged in.  So I’ll be busy, but not too busy to reply so note my future business email address:  rkang [at] egshares [dot] com.

Best to you all in this challenging environment.

Just read something from a TD Asset Management letter where one of their US based fund managers said the following:

“A major step towards resolution occurred with the formal insolvency of Lehman Brothers and the potential of Merrill Lynch. While being rumoured for some time, these events are still sad and shocking for anyone in the investment business. But in relation to the markets, despair is a healthier phase than denial. For much of the past 18 months, we had been concerned that most financial companies and federal officials were acting as if the problem of too much debt could be solved with more debt which meant that loans just needed to be restructured so everyone could hold onto the assets they could not afford or accurately value. While we do not believe the credit crisis is over – given that there may be more global write-offs – we do believe the process of capitulation and healing has begun..”  Paul Ehrlichman, Chairman & CIO, Global Currents Investment Management

So that got me thinking about the stages of dealing with tragedy.  According to Wikipedia:

The stages are:

1. Denial:
• Example - “I feel fine.”; “This can’t be happening.”‘Not to me!”
2. Anger:
• Example - “Why me? It’s not fair!” “NO! NO! How can you accept this!”
3. Bargaining:
• Example - “Just let me live to see my children graduate.”; “I’ll do anything, can’t you stretch it out? A few more years.”
4. Depression:
• Example - “I’m so sad, why bother with anything?”; “I’m going to die . . . What’s the point?”
5. Acceptance:
• Example - “It’s going to be OK.”; “I can’t fight it, I may as well prepare for it.”

If the illness - it isn’t dead - of the global financial system, I think we’re still somewhere between stages 2 and 3.  I say global financial system but mostly we’re talking about the US - investment banks, PBGC which insures pensions as well as ESGs and other entities - but which have an obvious effect globally.  Denial was the bull market and perhaps even up to just a few months ago (say, the peak in May).  Thain saying everything was OK at Merrill Lynch and that they were getting into yet another round of financing (once it was discovered that they were in deeper crap) is a good example of the denial stage.

The stages of “Anger” and “Bargaining” can be represented as both investors bailing from the markets and the authorities trying to “band aid” things.  I hope we don’t lead to point #4 which ironically is not just a medical term but also an economic term.  But if capital can’t move around the planet well then that surely is a quick road to economic depression.  What else is happening but the major central banks of the world in a concerted effort trying to re-establish some form of normal liquidity?

I don’t mean to be a pessimist but it’s hard not to be one when watching the news and reading the latest coming online.  I think step #5 will not come for quite a while … certainly not this year but likely not in 2009.  These will be very volatile markets for some time.  It will interesting to see how the adamant buy-hold advisors/investors common to the traditional ETF industry stomach events.  Will the new alternative exposure ETFs (timber, intl real estate, real return bonds, gold/oil) and other altenative positions (hedge funds, private equity, etc.) do their job and provide the diversification needed to survive the storm?  Will they deviate somewhat from buy-hold to allow for some tactical asset allocation or … market timing?  If there’s ever been a time when investors of all types will be tested - this is it.

The world today looks like we’re heading towards another two super-power situation.  Consider economic and political influence, voting on the UN security council, acquisition of oil, the space race, and even the medal count at the coming Olympics … there are a lot of themes that demonstrate the power of China, even relative to the US, and perhaps that’s one of several reasons why China is attracting plenty of foreign investment.

Before I get into a rant that leans in a fairly anti-US bias, I first want to preface this with the fact that I honestly believe that Zakaria’s comments on “the rise of the others” versus the decline of the US seems spot on.  The creativity and innovation of the US, and of course the developed world, will slowly have to compete with those from the emerging world.  But it will be some time coming in my opinion.  Since I focus on China in this post, I’ll give one example care of my cousin Grace who’s doing her grad work in that region.  So on her blog (runs in the family), she has a post showing this visual instruction for spectators to the upcoming Olympic games:

I should be like Jeff Matthews of famed “I Am Not Making This Up”. So Grace gives props to the BBC for sourcing this and here’s the accompanying text for the genius graphic:

Beijing Olympic chiefs are introducing an official cheer for patriotic spectators to spur on Team China at the Games, Chinese media reports.

The authoritative, four-part Olympic cheer, accompanied by detailed instructions, will be promoted on TV, in schools and with a poster campaign.

It involves clapping twice, giving the thumbs-up, clapping twice more and then punching the air with both arms.

The cheer is accompanied by chants of “Olympics”, “Let’s go” and “China”.

The Beijing Olympic Organising Committee has hired 30 cheering squads who will show spectators how it is done at Games stadia, reports Xinhua state media.

Say wha?  First, China is so NOT totalitarian since they won’t even have the masses practice before hand with drills.  Why not go full North Korean and have 25,000 people do that fully orchestrated “all in unison” song and dance that’s likely choreographed by the same person who gets 25,000 soldiers to march in unison each lifting their foot to the exact same height.  Scary in that “Brave New World” kind of way and all joking aside we can only hope some type of reform similar to what we’ve seen in China happens one day for North Korea.  Sadly there’s little to no chance they’ll do it on their own and given what’s happened to them over time (even before the Korean War) it will be a real challenge for them to move towards a world of partnership as opposed to isolated self-reliance.

But clearly, going back to the China graphic above, China still has a bit of North Korea old school in it and is still about hardcore conformity … it’s only a relative few who are taking hold of the new world and taking advantage of opportunities that result in tangible benefits for themselves.  It’s the creative/innovative class of the younger generation in the emerging world that will be the ones to watch.  Take a look at elite grad schools and note the demographics compared to ten and twenty years ago and you’ll get an idea of the growth of this new group.  Books are written about the billions in China and India and the demographic weight they impose is undeniable.  But it’s the future Gates, Jobs, Page/Brin to watch out for.

If the US is to really lose its place as the economic power, the rest of the world will have to compete in a manner where people try to copy their software, gadgets, and certain lifestyle attributes.  We’re nowhere close to a world where automakers try to copy the latest vehicles out of India.  They’re probably copying German not US auto designs but it’s still about the domination of the West.  How long will it be until China is designing the latest “iPhone of 2007″ Jesus Phone with the US leeching on with a fake?  I’m thinking not in my lifetime.  Maybe not.  Perhaps the blockbuster will be some YouTube, FaceBook, high intensity website that catches on fire like no other before it.

Well, long journeys begin with one step and clearly China is on an ambitious to its road to dominance.  They may not be the significant innovators until much later but in so many ways, they will be influential.  Of course, the trick for investors will be dealing with the bumps along the way and in today’s world the reality is that it’s all about a rather indirect manner to gain exposure into China.  For now, the easiest path is indirect investment via a closed end fund, mutual fund, ETF or hedge fund.

But I can’t help recalling one of many (MANY!) presentations on China I’ve attended in the past year where this gentleman (honestly, I can’t remember his name) was concerned about investing in the iShares FTSE/Xinhua China 25 Index ETF (FXI) since the underlying firms were controlled by a few people.  I’m paraphrasing but his point was clear and simple:  the Politburo controls virtually all the companies in this ETF.
Before the commentary, here’s a 1-year chart:

That’s about an 85% climb to nirvana over a two and a half month period last autumn.  Unfortunately, that’s about a 40% ulcer for the period thereafter that has dragged on for what must feel like years for anyone long FXI.  No wonder ProShares is having the time of their life with FXP and many of their other inverse ETFs.

So back to the Politburo which I still recall was the term used in the speech.  I’m no political scientist so I have no idea if the term applies for China as it did with the old USSR.  For now, I’ll assume that the situation described may still be true but given the latest helping hand from the Fed/Treasury Department/White House, you have to wonder.  The writers at Barron’s definitely have in this article with the sub-title “Socialism takes hold in US finance.  Get over it.”

We all know what’s happening and after Bear Stearns, this looks like chapter 2 of what could be a long story revolving around US policymakers adding band aid after band aid on a body that needs to bleed and perhaps follow up with a transfusion.  I thought I was decent in the art of metaphor but Randall Forsyth sets thing out clearly:

Even so, the descent down the slippery slope of socialization of the financial system is gathering speed.

“Capitalism without failure is like religion without sin,” Allan Meltzer, the distinguished economic theorist and historian once wrote.

Yet, like it or not, we don’t want to deal with such harsh verities, either in religion or the marketplace. Traditional churches are losing out to TV evangelists who promise material rewards now rather than later.

Forsyth concludes that we’ll see the pendulum swing back to increased regulation which shouldn’t be a surprise especially if the Democrats take over.

But the irony will be the trends taking place in both China and the US.   I seem to observe that they’re moving in opposite directions.  China is wanting to move into a dominant two-power global paradigm with the US as a capitalist powerhouse.  The US is on the defensive trying not to lose ground (influence).

It’s always funny when the US government comment on how bad the Chinese do things.  In the past, comments on the manner in which certain areas are treated or marginalized are retorted with Chinese counterarguments as to the manner native Americans or various other visible minorities are discriminated against.  It’s the same as the nitpicking both sides have with the other related to votes on the UN security council.

But today’s scenario is a juicy one for China.  The US government has often criticized the Chinese over various economic policies (currency, trade, commodity deals with foreign despots) and keeping a too-firm-hand on the wheel.  It’s almost too easy to respond with Bear Stearns, Fannie and Freddie.  It’s down right silly when Wall Street takes their show on the road to ask SWFs “Can you spare a billion?” and I wonder if they’ve come knocking on China Investment Corp?  Oh, wait a second … Morgan Stanley.  It’s so hard to keep track these days of all the SWFs and commentary regarding their dealings with Wall Street I-banks and the sense now is that the second wave of deals should be starting soon.

I leave you with this final chart showing the two most popular ETFs for the US and China since October 5, 2004 (inception date of FXI):

Quick note on FXI:  Don’t be fooled.  Of any asset category, it’s the China ETFs that differ from each other the most so selection criteria is critical in this niche area.

I state earlier that these two nations seem to be moving in opposite directions.  One is on the offensive while the other is on the defensive.  It’s a tough call to simplify things to the point of “buy FXI and short SPY” but in the longer term, how many investors are thinking about this?  From the SWFs point of view, it looks like it’s buy their buddies in the emerging markets but also buy the US … or at least financials at fire sale prices and with preferrential treatment in terms of yields.  The diversification story may be boring but owning some of both countries would make a ton of sense … the only difference among investors based on volatility and personal beliefs is what proportions.

1.  I’m not as excited as I once was to post something about me on TV or video.

2.  I could say it’s simply lost its appeal but frankly I feel like whatever I say is surely going to be irrelevant by the next day.

3.  If you’re reading this post and today’s date is past July 16th, 2008, the video I refer to below is no longer available for viewing.  Sucks to be you cause you would have made a mint no matter what I said in point 2 above.  I know you trade on what you just heard from the Boo-Yaa guy on CNBC.  You think I don’t know?  Joke stops here but when you consider the amount of trading software commercials on that channel, you have to stop and wonder.

So anyway I was invited to speak on BNN on Wednesday.  BNN’s our version of CNBC in the great white north and BNN stands for “Business News Network” … yeah … I know … “Business News Network” … classic.  Don’t know why but for some reason I didn’t think about posting it until now.  Well, to be perfectly honest, for anyone with even the most basic self-education on VIX, there will be little new in this clip (after the short ad, scroll forward to just past the 29 minute mark and I’m on for about 7 minutes).  So again, if you’re reading this post a few days after I’ve posted it, you’re really not missing much from the video.

Funny that BNN called me on Tuesday to talk about VIX but due to a busy schedule I couldn’t make it that day … luckily we were both good for the next day. Tuesday’s close for VIX was somewhere around 23, a low for the past few weeks.  And they wanted to know why it wasn’t up over 30 given the market declines in those same past few weeks.

Bottom line: Should VIX be somewhere closer to 30?  Probably.  But being down where it was on Tuesday/Wednesday and given how volatile VIX is (volatility of volatility?!), well geez Louise, where are we now?  Here’s the one week chart:

So VIX came pretty darn close to 30 and if it does in the next day or two, does that mean all’s well with the planet again?  Come on … rules of thumb rarely apply and if there’s one place they basically never apply, it’s in VIX land.  Positive or negative correlations (like the kind I mention in the clip) exist for many relationships but can’t be construed as solid rules of thumb that necessarily can be relied on with a great level of confidence.  If you want to trade on generalizations, that’s fine but when things don’t go as expected (i.e. when you switch from paper trading to real trading), investors shouldn’t be surprised when things go astray.  That’s the beauty of life and the real art and science of trial and error.

Makes me think about middle school algebra when we first were introduced to variables.  Like “VIP”, VIX should mean “Very Important X” or variable.  It’s important, VIX is, because it can give clues to other important things just like the unknown variable in high school math.  But it’s not much later in our young academic careers when we realize that sometimes we can’t solve for X.  I don’t know about you, but a lot of the math courses I took didn’t end with X=3.  It was more like an equation where X equals some formula.  And that was even before calculus and statistics.

Thus, you have to wonder if VIX as a trading instrument is something for the masses.  Perhaps it’s best to be used as a signal for trading SPY or its inverse ETFs (or S&P futures or some other derivation of this strategy).  Trading VIX, whether via existing options or futures, or perhaps one day by way of an ETF, could be an area of exploration for hedge funds, day traders and various short-term active managers.  But with all the rules of thumb I hear and [false] expectations that “VIX should be at whatever”, if it were really that easy, why don’t we have an actively managed fund (mutual fund or hedge fund) that focuses entirely on trading the VIX?  Maybe there is one and if so please let me know.  I’d be interested in seeing its performance record.

At that time, my thinking was that any exposure to uranium would best be accomplished with a combination of U plus Cameco.  Here’s the chart for Cameco over the past three years:

Very different performance patterns between the commodity and one of its major producers.  But it wasn’t until mid-August of last year that Van Eck came out with the first nuclear energy related ETF, the Market Vectors Nuclear Energy ETF (NLR).

For some reason, BGI with its newly listed iShares Global Nuclear Energy ETF (NUCL), must feel like being “second to market” ain’t half bad if the longer term outlook is strong.  I’m posting this blog after having seen this article in Canada’s Financial Post which gives some bullish views given the recently depressed price and a demand situation here in Ontario.  My interest is more related to significant energy policy shifts in the US (regardless of who wins the White House) and even more importantly, the choices made in the emerging world.  The developed world (well, mainly the US) complains about the relative lack of participation of the developing world in environmental policies such as Kyoto.  However, evidence from the annual reports of major uranium producers suggest that the market for them is the emerging world and that’s where they see the future growth.  Who would call that surprising?  Aside from foreign policy roadblocks for concerns that perceived unfriendly regimes would produce weapons grade materials, the necessity for the developing world to access nuclear energy is clear.  How can they compete with the US, China and larger (& more powerful) nations for oil?  I think they need alternative energy sources even more than the big guys.  I’m still a longer term bull for uranium.  The question is whether the exposure should be to uranium prices, the producers or a combination.

Well, aside from Uranium Participation Corp traded in Toronto, there are also uranium futures traded on the NYMEX.  The futures contracted started trading about the same time as my blog from May 2007 … as usual product development seems to be a decent market top provider.  And yes, it’s cash settled … no jokes about delivering 250 pounds of uranium.  That’s about it.  I’m kind of surprised that firms like ETF Securities in London or PowerShares (with their association to Deutsche Bank) haven’t created a uranium price tracker given their expertise in ETFs with futures based underlyings.  It’s just a matter of time.  I’m thinking that it would be nice to have this now and NOT near the next intermediate term top.

To go after the producers, like I said before, we now have two ETFs.  From a year ago, my simplified approach was to put it all in Cameco but for the passive fan, the ETFs would be the way to go.  Since NUCL only came out only about two weeks ago, we can’t do much comparison shopping.

Both have global exposures.  The newer NUCL is about 20bps cheaper in fees but with less holdings at 25 versus 38 for NLR.  The list of holdings for NUCL and NLR show some clear differences in the top 10’s in each as well as proportional weightings.  But what seals the deal for NLR over NUCL is the sector allocations.  Take note that for NLR, the breakdown of the top three sectors is 31% nuclear generation, 29.5% plant infrastructure, 28.8% uranium mining, with the remainder in uranium storage, nuclear conglomerates, uranium enrichment and nuclear fuel transport.  NUCL’s top exposure is in utilities (54.2%).  Their remaining catergory names are relatively generic like “energy”, “industrials” and “financials” (in that order, actually) and so part of their flaw is not doing a better job educating investors on the real uranium sub-sector breakdowns.  Hey, isn’t BGI the experts in ETF education?  You know I just like pickin’ on the big guy.

So, bottom line, this might be a decent time to get in to nuclear/uranium as an alternative energy and emerging market play.  The holdings list does not give enough information on its own so a bit of homework is required to see how much of each name is actually going out to places where energy infrastructure for the longer term is a concern.  Because the uranium producer space is limited to a few big names and many microcaps, it’s a tough call.  Pick a few of the big producers and you’ll do fine but if you’re from the industry or are a commodity freak, hopefully you’ve got some talent in picking the future successful producer (who will likely get acquired by one of the big guys).  Since that’s a tough sport, I think the focus should be on the uranium price for the longer term.  With limited instruments available, the challenge now is to decide between Uranium Participation Corp and uranium futures.  Until, that is, an ETF or ETN for this commodity gets launched.

Via an EDHEC-Risk email, I received a complimentary copy of Investment Management Review and found an interesting article on beta.  After receiving permission I now provide the text in its entirety.  No comments from me … just the content as it is.

Ok, just one comment.  Note Anson’s introduction of a continuum from classic beta to pure alpha.  Very similar to my alpha/beta spectrum but with well defined zones along the line.  I can spend a lot of time thinking about this and how it will apply to future product/service offerings in the changing investment industry.

BETA CONFUSION

Editor’s introduction

What does ‘beta’ stand for? The terms ‘alpha’ and ‘beta’, once the province of academics, quants and risk managers, are now familiar to every professional in fund management. Unfortunately, they do not mean the same thing to everybody and there is considerable looseness in the current jargon. ‘Beta’ as it was in the old-fashioned sense represented the bet one took against a market, a beta of more than and less than 1 meaning riskier or safer than the market respectively (see ‘What is beta?’ box).

A current widespread interpretation of beta is different. In the simplest sense, it is used as the proxy for matching the market risk and, in a wider sense, it is used to represent all sorts of risks which can be easily replicated, perhaps with a computer.

The two papers below highlight the different ways, the old and the new, in which the word ‘beta’ is interpreted. Markowitz’s conclusion in the first paper rests on the old idea of beta (see above box)

Anson’s paper for the most part implicitly refers to the newer idea.

As widely referred to now, beta is no longer a number as it used to be, defining leveraging or de-leveraging relative to the index. It is now a concept reflecting the matching of the market performance, as opposed to alpha, representing the excess return. Undoubtedly, many still adhere to the previously prevalent rigour, including academics and quants, but the newer use of beta conflicting with the old is now widespread throughout the industry and among commentators.

Markowitz back on the warpath

‘CAPM investors do not get paid for bearing risk: a linear relation does not imply payment for risk’, Harry M. Markowitz, The Journal of Portfolio Management, Winter 2008, p91

‘Markowitz attacks beta’, Investment Management Review, Winter 2005/06, p46

Prof. Harry Markowitz, the founder of modern portfolio theory, has returned to attacking the use of the capital asset pricing model (CAPM).

In the above paper, Markowitz focuses on the outperformance by a security over its benchmark going up and down proportionately with its beta. He attacks the fact that the proportionality between the excess return and beta is wrongly interpreted as investors being paid for bearing systematic risk.

He uses high-level mathematics in showing that this is not so, because two securities with two identical risk structures in terms of the way they are correlated with other securities in the market place can have different excess returns.

Different types of beta

‘The beta continuum: from classic beta to bulk beta’, Mark Anson, The Journal of Portfolio Management, Winter 2008, p53

Mark Anson provides some insights into the different ways the term ‘beta’ is referred to by investment practitioners, which as mentioned above is different from the sense in which it was formulated in the capital asset pricing model.

He starts by defining beta as the efficient capture of risk exposures tied to broad asset classes such as equity markets, bonds and commodities. Beta should be acquired cheaply, because active asset management is not necessary for exposure to an entire asset class. For instance, equity market exposure can be achieved by investing passively in an index. Beta represents passive management and alpha refers to active portfolio management. Along with many others, Anson refers to the excess return as alpha, though, as the box above shows, beta also can be a source of excess return in the old-fashioned meaning of the word.

Anson argues otherwise. But he does not revert to the old meaning of beta. He disputes the notion of a sharp demarcation between alpha and beta, and argues that in fact that there is a continuum from classic beta at one end to pure alpha at the other, with various types of beta in between.

In elaborating, he outlines the following different types of beta.

1. Classic beta – This is related to the ‘beta’ as referred to in past decades, though now corrupted to mean precisely matching the market. In the new parlance the word beta is equivalent to a beta of 1 under the older definition. It effectively means just matching the market, whether the market is the US stock market, the UK FTSE 100 or the global MSCI-EAFA. Standard index funds come under this category.    

2. Bespoke beta – This refers to the same as 1 above except that the index no longer represents the broad market but particular sectors or other asset classes. For instance, the banking sector or a basket of commodities.

3. Alternative beta – Anson describes this by example. The rationale is that there are systematic risk exposures which were previously not available to investors but which can be now accessed through ETFs. As an example, he cites a currency ETF linked to the price of the euro in terms of the dollar.

4. Fundamental beta – There is now a raging debate as to whether indices constructed by weighting the constituent stocks by market capitalisation are the best proxies for the market. A strongly supported school has sprung up which claims that fundamental indices, in which the constituents are weighted by fundamental factors such as revenue or dividends, are much better. Anson refers to matching these fundamental indices as fundamental beta.

5. Cheap beta – This refers to a situation where beta cannot be produced by investing in an index or ETF, but where beta is embedded in a complex basket of risks within one security. An example is a convertible bond. This has the following elements of risk embedded in it: interest rate risk, stock market risk, credit risk, and volatility risk. Players in convertible bonds are effectively getting indirect exposure to all these different betas. Interestingly, here Anson thinks of beta as numbers rather than as the concept of matching the market.

6. Active beta – Here Anson refers to long-short funds such as 130/30, where the overall exposure of the portfolio matches the market but additionally there is 30% additional long exposure in favour of stocks, counterbalanced by short exposures in unattractive stocks.

7. Bulk beta – This refers to traditional equity portfolio management of the standard type, where portfolios consist of a large element of beta, i.e. market exposure, as well as the ability to generate alpha through stock selection.  

Editor’s comments

This is not the first time that Markowitz has gone for the CAPM and the use of beta. In late 2005, he attacked the concept of beta and the CAPM as not relevant to the real world, though he did describe the CAPM as a thing of beauty. In particular, he criticised beta being used for risk-adjusted performance (see Investment Management Review, vol.1, issue 4, p46).

What is particularly fascinating is that, when Sharpe was awarded the Nobel Prize for Economics for his CAPM, in 1990, Markowitz received the same accolade alongside him for his seminal work in the early 1950s. Markowitz’s seminal research was not regarded as very practical at that time, given the lack of computer power. It was the simplification introduced through Sharpe’s model that allowed modern portfolio theory to take off. It is ironic that it is now Sharpe’s model that is more suspect, whereas Markowitz’s techniques of correlation have more widespread uses across other asset classes, because of advances in computing.

On a different note, having done his path-breaking work in the early 1950s, Harry Markowitz cannot exactly be described as young today. What this paper perhaps demonstrates is that his intellectual vigour remains intact, which must be encouraging to baby boomers who want to carry on being productive.

Anson has embarked on an unenviable task of trying to introduce order and clarity into the use of the word ‘beta’, which has been highly corrupted since its inception during the 1960s.

There are some logical deficiencies in Anson’s classification. His classic beta (1), bespoke beta (2) and fundamental beta (4) are all essentially the same type of beta, but with the market defined differently. There is no conceptual difference, whether one talks about the global Morgan Stanley index, the national S&P, the sector-based banking index, or the fundamental index. It is the same type of beta, with just the index being defined differently.

With his ‘alternative beta’ (3), calling a euro-versus-dollar currency bet a beta is stretching the applicability of the concept too far. It is open to even the poorest individual to go into a bank and buy a fistful of foreign currencies. Of course the spreads he has to pay might be different, but it is difficult to justify the use of the word ‘beta’ merely because there is an ETF alternative.

Overall, Anson plays a useful role in highlighting the looseness of the term. Previously, beta has been also defined as any process or investment that can be easily replicated.

There is possible reason why this looseness in the use of the word beta might have arisen. A beta of 1 is easy to understand and accept as matching the market index, whatever that is.

When, however, beta values significantly differ from 1, their validity and reliability have always been regarded with considerable scepticism by many investment practitioners, even those well versed in the theory. Equally it is difficult to explain the concept to many non-technically minded players. Many academics, including even Markowitz, as referred to above, have joined the band of disbelievers in beta in the CAPM sense.

Against this background, perhaps it is understandable why so much looseness surrounds the idea, and why many people when referring to beta merely think of beta having the value of 1 in terms of the theory.

This is not just an academic debate. It is now common for asset allocators to talk about splitting their fund into two separate portfolios of alphas and betas. Industry-wide uniformity in the use of the word ‘beta’ would be welcome, though perhaps not achievable. Anson has contributed strongly to this topic, the deficiencies of his classification notwithstanding.

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Speaking of hot, this event was in Dubai. I’ve experienced some hot and humid conditions in my life in places like Manila, Seoul, Singapore and Hong Kong. But this was by far the hottest climate I’ve ever experienced. It was a dry, baking heat. When outdoors, finding shade helped and certainly the buildings had great air conditioning. But, for example, I had my cousin who lives in the city take me around the gold (souk) market. Getting out of the car into the sun was incredible. It felt just like a dry sauna. And they say it’s just the beginning of the hot season! Luckily, the hotels, office buildings and shopping centres are all so luxurious that climate does not have to be a concern. With most taxis I rode in being a Lexus, you get a sense of what this city is about. Never mind the Burj Al Arab hotel, indoor skiing and other obvious signs of excess.

A quick comment on the souk. It’s all about gold there. Prices are quoted daily and there are people buying. I wish I was in Dubai six months ago and a year ago to get a handle on the number of people transacting. A good sign was at the retail section of the Dubai airport (departure section). They had a gold merchant right at the centre when you pass through the last security checkpoint (I think my carry on luggage was scanned only twice which is hopefully enough). Unlike the real souk market which was not empty but certainly not busy, this place was packed! And people were really buying. They didn’t look like momentum traders nor supermodels but everyday travelers. Maybe they know that gold is back to where it was near the beginning of the year:

Or more likely, maybe they new better than me than to take the heat and walk the outdoor souk.

From the moment you cruise into Dubai International or drive into downtown, you can’t help but notice the construction. It beats Las Vegas, Miami and other real estate bubble regions of the US. It kind of reminds me of Seoul when I first went there as a youngster in 1979. My bet is that Dubai will want to host an Olympics … but they’re held in August and if that’s still the hot season I just don’t know who could survive the marathons, triathlons and other outdoor events. Still, you can’t help but sense the feeling of ambition in Dubai. For some reason, a lot of the new buildings going up have the number of floors in the triple digits. Excess is a relative term when you’re in Dubai. The sense on the ground is that the construction boom is in full throttle but not anywhere close to the bubbly stage. But I can’t get my mind off the fact that a lot of the construction is done at night when the temperatures are simply cooler. It’s the endurance of the migrant workers who have the day shift that I find quite astonishing. Think of the pyramids in Egypt and the Yucatan, the Taj Mahal and other larger-than-life structures and the same can be said for the city of Dubai. The super-skyscraper “Burj Dubai” was front and centre from my hotel room window. I can’t remember and certainly could not even count the number of cranes working throughout the day and night when viewing the skyline. Part of the view is filled with very unique and certainly luxurious looking buildings, but among them were cranes working on competing structures. The success story that is the UAE is of course based on the decision of its leaders to diversify beyond oil. But the structures we see being built today, like the pyramids of the past are built from the labors of a massive force that are too often left forgotten. I think that in today’s world when we think about gold and oil, the supply/demand imbalances are often cited as being driven based on what’s happening in the emerging world. That’s certainly true, but the commodity that is labor is certainly a key factor as well and you can see that when driving by any construction site in Dubai. Of course, think of the factories in coastal China and the low cost IT worker in Bangalore and you quickly get the story of the emerging markets.

An important point to make on this is the importance of the success of the emerging markets in aggregate. It simply has to happen. Jeremy Siegel at Wharton wrote a paper in the September 2007 Financial Analysts Journal titled “Impact of an Aging Population on the Global Economy”. To summarize one of its key conclusions I begin with a simple fact: The western world is aging and it can’t eat its financial assets during its retirement stage. Much has been said of an equity market depression should the boomers sell their equity investments as a whole even if it’s spread out over several decades. Siegel’s paper articulates the fact that the growing middle class of the emerging world can be a very significant group that buys these financial assets. As individuals, they may not have much residual assets left for savings and investment, but in aggregate the numbers can and likely will be in their favor. This logic makes sense and our only hope is that the typical worker from the emerging markets does not go berserk with their discretionary spending and adopt a savings rate similar to many in the west. Furthermore, we have to hope that the western world does not adopt a protectionist stand. We see the beginning of potential trouble already. How do most Americans (never mind their government) feel about some sovereign wealth funds buying significant parts of major Wall Street financial conglomerates? What about if the same happens to media firms, utility companies and certain defence/high tech firms? Much of Western Europe isn’t happy with the rising growth of mosques versus churches across the continent. Will religious as well as racial discrimination hamper the transfer of wealth, and as important, capital investment? I think that the factors driven by demographics are so strong that any reasonable person or society will figure out what measures are required in order to survive. Unfortunately, the short-term horizon of politicians often conflict with this simple assumption.

Getting back to this commodities conference, the overall turnout was a bit of a disappointment but what was especially poor was the level of institutional investors in attendance. I couldn’t find one. Luckily I had meetings set up for me prior to traveling or this would have been a rather uneventful trip. One observation that I made was the fact that despite this being a commodities event in a growing part of the emerging markets, on day one of this conference all sessions except for one made some reference to indexing, passive investing or the use of ETFs. I did not attend day two and so I can only wonder if this fact remained true. Now I know that most of the discussion revolved around the active use of ETFs and/or derivatives but this still strengthens my case that the ETF story is not only strong but expanding globally. I think that the saturation we see today in the US will grow to many other regions. However, it’s still early. Today, there are no ETFs domiciled in Dubai. Great fanfare has been made about Dubai as the financial centre bridging the time gaps between the financial centres of Europe and East Asia. It will only be a matter of time before Dubai becomes a hub for derivatives and ETFs. From my travels, I see a parallel between ETFs (or financial services products in general) and airports. The US and Europe are full of busy yet aging airports. The emerging world is now making waves about their fancy new and relative large airports, albeit in much smaller numbers. I think the ETF industry will expand to these same regions with a few but relatively large (by asset levels) offerings in the not too distant future. Who knows what the expansion will be like thereafter. I don’t see a duplication of what has happened in the US but perhaps something fairly close in a few markets. We’ll see how the BGI’s, SSGA’s and other ETF providers do in entering these markets to compete with the local providers.

By the way, I’ve mentioned that the ETF industry within the region is still sparse. However, we’re not much better here in North America. The SPDR S&P Emerging Middle East & Africa ETF (GAF) is all we have now.

Not exactly the greatest diversifier but the high correlation story is one you’ve heard from me enough times I’m sure.

An interesting tone I sensed at this conference and confirmed at my meetings was some urgency in terms of dealing with the commodity complex. The need for active management was clear. Most would agree that a “buy-hold” mentality just doesn’t make sense for this highly volatile asset class. This would be true not just for a diversified (index-like) exposure but also positions in specific sub-indices (agriculture, metals, energy) or direct single commodity exposures. Despite the fact that so many commodity tracker funds have been launched in recent months and years, it looks like the need for them is very high indeed.

If you were to ask an investor what was their main reason for commodities exposure, you’d get a variety of answers. This may be true for any stock, hedge fund or asset class but I’m very interested in those given for commodities: inflation hedge, low correlation to other major asset classes, macroeconomic rationale given growth of emerging markets and relative dormancy in 1980’s and 90’s, demise of US dollar. These are all risk based rationale but for whatever reason, it seems like there’s a vast array of investors jumping on the Jim Rogers bandwagon. This includes the many ETFs, ETCs and ETNs that have hit the market over the past few years with exponential growth both in terms of numbers and assets. Should there be cause for concern that these new assets are helping fuel the fire? I think so as it will likely lead to greater volatility both up and down. Don’t get me wrong, even without all these new commodity tracker funds, I’m still in the camp that we’re in a long secular bull market albeit with the strong possibility of down markets (drops of 20% easily) with the possibly of not regaining new highs until at least six to twelve months if not longer. The question is whether the magnitude of drops and time to recovery are magnified due to ETFs and related instruments. I can’t help but think so.

And the main reason why I think this is so is just from considering who would be using these commodity trackers. The big user has to be the hedge funds which for me includes managed futures/CTAs. Don’t have anything against them. My first job in the industry was basically in this space although the focus was squarely on equity indices. Just like quant funds that were quite synchronous (unfortunately to the down side) in the late summer of 2007, I could see CTAs herding in and out of the broad commodities complex to capture the major up and down markets … I’m not saying they’ll all move in line to day-to-day volatility.

This excess momentum due to mass herding is what angers the emerging countries when they consider the foreign “speculators” (not “investors”) getting in and out of their market. That’s one of the prices of capitalism. The key, like we see in Dubai, is to find the long-term story. Dubai and other countries in the GCC region and beyond will not only survive but evolve into a longer term success story based on their ability to reap the rewards of this high oil price period (or “era” depending on how long this lasts). My hope is, just as South Korea copied the Japanese model through a well educated workforce and strongly industrialized infrastructure, the neighboring countries in the gulf and the broader MENA region can duplicate some of the success of Dubai. We can see some of this already in Bahrain and Qatar but there needs to be more.

Final thought on Dubai. I had dinner with a gentleman in the industry and asked what model Dubai used for its success to diversify beyond its core asset. My guess was Hong Kong but he said it was Singapore. Makes sense since Singapore is a bit more diversified in terms of having had greater labor requirements in the past (not so much today) from abroad to help build its infrastructure whether it be engineering, financial or otherwise. Singapore definitely has a more culturally diverse population than Hong Kong or any other Asian city I can think of. In this regard, I can’t help but think that the commodity that is often left unconsidered or, at best, overlooked is labor. Where will the migrant worker move to next? Where can one find skilled or at least partially skilled labor? I heard of the incredible housing and food inflation in the UAE and I wonder how that effects the laborer at the very bottom of the ladder. Probably not well but it’s certainly better than their prospects at home. Still, on one of my comfortable taxi rides, I saw a bus packed full of workers … something I’ve seen in countless other cities but I could see that conditions for them were not good. Not to pick on Dubai, but I wonder how fair their labor laws are for immigrant workers. This question is easily applicable to other booming economies that have significant immigrant populations and the debate in the US on this subject is an appropriate example even though their economy, nor its outlook in my opinion, could not be described as booming. This trip was certainly an eye opener for me. The chance to see and feel the luxury was nice but I’m glad I was able to observe a bit of the other side although from far away. Cliche as it it may be, I think it’s Pierre Trudeau who first said something to the effect that you really don’t appreciate the value of Canada until you’ve traveled the world. It’s certainly not meant to be an insult to Dubai - clearly one of the great success stories of the emerging world and especially within a volatile region - but I find it interesting that after this trip I realized just how great Canada is. Maybe it’s also the fact that we get roughly ten days at most of 40 degrees Celsius heat or worse a year.

I spent some time today with my wife and daughters at the park with warm sun and a cool breeze. Perfect weather.

To no surprise, there was a lot of content revolving around the use of alternative investments of all sorts but especially hedge funds. I was most interested in discussions related to emerging markets as, to me at least, it seems like this is an area where in the longer term there would be a fair assumption for double digit returns unlike other broad asset classes and strategies. The downside of course is the volatility but for long-term oriented institutions, that shouldn’t be a problem given appropriate diversification and risk budgets. However, the overall sense I had from this and other events in recent months was that emerging market investing is still in the early “toe dipping” stage. Never a good time to get in like when it’s nearly too late! I think it’s far from too late … in fact I think it’s still relatively early. But it’s this herd mentality that I believe is hampering the performance of many institutions. Perhaps the people working at conservative institutional funds just aren’t compensated in a way that would allow them to deviate from what would be perceived as “industry norms”.

Of course, the same could be said of the herd mentality of all investors including retail individuals and their financial advisors. What once was about picking stocks has now moved well past chasing managers with mutual funds to chasing markets via ETFs. Is Kang bashing ETFs?!!! Well, yeah in a way but everyone knows that the gold market and other peaky, speculative (pick an adjective) market has likely had its volatility juiced up due to the level of increased participation of everyday investors thanks to ETFs. Whether it’s good or bad is not for me or anyone to say … in any market that sees more speculators come in versus long-term investors it’s common to find more instruments to feed the frenzy. Remember all the tech and Nasdaq funds in 2000?

The whole concept of alternative investments is a bit of a conundrum to me. At the one end, it’s a reality that has to happen given the limitations of traditional investments. Having a vanilla portfolio of stocks, bonds and cash can only get you so far. So called “couch potato” portfolios sound good but when the markets are going against you, the tendency will be to take action at the very worst time. I didn’t even say that the action would be right or wrong; I’m just saying that the timing will likely be off. If the decisions of what to sell, what to buy, what to hold, whatever, are also off … well, no one does well in college or at their job by being a couch potato.

Correlations among asset classes and strategies remain high. The search for low correlated alternatives will evolve in time but this search for the next new market will persist. The frontier markets of today will be the emerging markets and then developed markets of the near future. Technology, high educational standards internationally and the globalization of economies and capital markets will see this transformation process increase pace exponentially.

The low yield environment of today is another reason alternatives are hot. The traditional fixed income market just isn’t enough. And that includes inflation adjusted bonds where we’ve recently seen the TIPS market hit some interesting numbers (zero).

If we’ve now entered something similar to the beginning of the decade (negative returns with low interest rates), then we’re back to the deadliest of combinations for pension plans and their asset/liability mismatch predicament. With low interest rates, the present value of their liabilities increase so that, on paper … well let’s just say, GULP. Not good. The honest knee jerk reaction from some along with, of course, thoughtful debate and consideration by many others will be to increase allocations to all sorts of alternative investments. It would surprise me immensely if hedge funds and real estate did not get the biggest chucks of these new allocations. My hope is that these alternatives, no matter what they are, provide a true “risk reduction” function for portfolios as opposed to simply a “return enhancement” function. I believe the period of early 2003 to mid 2007 was the time for thinking about return enhancement.

With regard to thinking about risk, I now refer you to three videos that were made immediately after an appearance I made in Las Vegas earlier in April. I was speaking on global investing at the 5th Annual Las Vegas Financial Advisor Symposium thanks to the organizers at InterShow and an invitation from the panel moderator and fellow blogger, Tom Lydon. FYI: Equally cool and insightful blogger, Roger Nusbaum, was also a panelist with me on stage. It’s clear that moving from a US-centric portfolio to one that is more international (with a significant dash of emerging market exposure) is key to improving risk adjusted returns for long-term investors. The concern is implementation and keeping intelligent diversification a key directive. Anyway, the evolution of ETF industry to active management, emerging markets exposure and risk management are the main topics from the three videos. Clicking on the still shots below will lead you to InterShow’s site and the videos [Sorry for having to make you leave this site and come back for each video but there was no allowance for me to embed the videos on my site … traffic matters].

Evolution in ETF Industry:

Emerging Markets:

Risk Versus Return:

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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.

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.

Let’s think about the ETF industry for a minute (I am aggregating ETNs and any other derivative of this type of instrument … no not that derivative … into the term “ETF”). Are we moving more and more towards alternative asset classes? Are we adding sexier functionality to products? Are actively managed ETFs on the horizon? The answer to these questions is not just “yes” but we’re basically there. If the ETF industry is less about beta and more towards something else … some alternative or exotic or “non-standard” beta and even possibly (wow!) alpha then watch out. Investment banks are going to jump in and then some.

Why wouldn’t they? Once you move away from the more traditional views of passive management, you’re moving closer to the I-banks sweet spot. The higher fees (margins) don’t hurt either.

One of the Opta ETNs covers commodities in general with a fantastic ticker symbol (”RAW”). Another covers the hot topic of the day, agriculture. And the last one brings some competition to PSP in the private equity space. Note how Lehman uses the word “Beta” in the commodity ETNs but not the private equity ETN. I agree … private equity is no asset class.

Regardless of classification, Lehman is entering the ETF/ETN space focused on alternative investments. It would not surprise me one bit if other I-banks enter in a similar fashion. Many, like Merrill Lynch have publicly spoken on their hedge fund replication products … they could be turned to ETFs. There are many ETFs that are in the middle of regulatory approval manufactured by existing ETF providers both large and small (firms that is) that, when launched in the market, would have no competition. These would be rather esoteric asset classes or strategies such as carbon credits or 130/30. Again, I-banks live and breath these markets and strategies and unlike startup ETF providers have the cash (some, thanks to their new friends, the Sovereign Wealth Funds) to make a real go at it.

If the I-banks do jump in to the ETF marketplace in a big way, there could be significant fallout. More products and more competition would make it harder for the many new entrants in the field (that are not I-banks or backed by them) to not only establish themselves but grow in a significant manner. Like mutual funds, hedge funds and other financial products, ETFs are sold not bought … just find out who makes the big money at these firms. I don’t see how the little guys could go up against a marketing machine heavyweight like a Lehman, Goldman, Merrill or Bear.

Worse still, I wouldn’t want to be a mutual fund right about now. Not only do they have to keep up with their lobby against the favorable tax treatment of ETNs but they must also be thinking about how to stop this whole active management ETF train from leaving the station. Too late … I think that was the whistle and last call.

Well, if you welcome competition (and you should), hopefully the average ETF management fee will at least go down … wait, we’re talking Wall Street I-bank heavyweights right? Check that. Don’t hold your breath.

More importantly, I strongly believe that writing down the thoughts in my head about a particular new ETF, derivative contract or interesting industry development is, in my opinion, a fairly novel way to “keep the knife sharp”. Portfolio construction is tough enough as it is but with new products and services continually popping up, filtering the good from the not-so-good is a worthy exercise. Interestingly, I found that the ETF assembly line slowed down enough last summer for me to go on hiatus (thus, the nearly zero posts in the past eight months). There have been quite a few new arrivals, some actually a bit interesting but somehow, not enough to get me excited and write about them. Or maybe I’ve just been lazy. Perhaps some laziness but also a bit of consulting work thanks to the blog and even more due to the conference speaking.

Thus, the conference speaking has not only been an additional forum for me to assert opinions/ideas and discuss/debate them but also to see where that sort of dialogue takes me. And along with this blog, these conferences have taken me in many interesting directions. Funny, but that could be taken in many ways. For example, here’s my speaking calendar as of now for 2008:

Inside ETFs Conference, Florida
o January 10-11, 2008
o http://www.insideetfsconference.com/index.php?Itemid=295&option=com_content

Indexing & ETF Investments Asia 2008, Singapore
o February 27-29, 2008
o http://www.terrapinn.com/2008/iia/

DICE Emerging Markets 2008, London
o March 11-13, 2008
o http://www.terrapinn.com/2008/DICE/index.stm

8th Annual US World Series of ETFs “East” Conference, Florida
o March 26-27, 2008
o http://secure.imn.org/~conference/im/index2.cfm?sys_code=20080331_IM_0036&header=on

Base Metals Investment Summit 2008, New York
o April 1-2, 2008
o http://www.iqpcevents.com/ShowEvent.aspx?id=49544&details=69950

Financial Advisor Symposium, Las Vegas
o April 16-18, 2008
o http://www.financialadvisorsymposium.com/lasvegas/main.asp

Commodities Investment World MENA 2008, Dubai
o May 26-27, 2008
o http://www.terrapinn.com/2008/ciwae/

ETF & Indexing Investments Europe 2008, London
o June 24-27, 2008
o http://www.terrapinn.com/2008/etf/

Quite a bit in terms of market coverage as well location (so as I said above, “… in many interesting directions.”)

The last event listed above is still tentative (in terms of my involvement, that is) as are a few more I am in discussions with at this time. This list was a lot shorter only one month ago. I’ll bet that in another month or two, I’ll be set for the year. My aim is to limit myself to no more than two events per month with likely a quiet July/August. Clearly, most of the events are focused on ETFs/indexing but, perhaps not surprisingly there are other conferences covering specific areas of the capital markets or investor types that have sections dedicated to beta and in most cases that means ETFs.

I’m not entirely certain, but my guess is that only three years ago there may have only been, at most, a half dozen conferences entirely dedicated to ETFs/indexing with all but perhaps one in the US. Today, not only would I say that there are, on average, at least two ETF/indexing events per month globally but from the above you can see that the interest in passive instruments and beta has expanded beyond the US albeit ever so slowly and in a very limited manner. Internationally, the interest has always been there of course, but now we’re seeing greater product development and overall acceptance of ETFs beyond the rather saturated US marketplace.

Still, as explicitly stated at an ETF/indexing conference I recently attended in Hong Kong, ETFs have a long way to go globally. Aside from the fact that that was the first mainstream ETF/indexing conference I had ever come across in the region (there have likely been a few in the recent past) another strong indicator for me was the fact that the event had a rather small group in attendance. From the discussions I had with many at the event, it was not surprising. In general, the consensus is that East Asia still wants to search for alpha (via hedge funds) rather than focus on low cost beta exposures (via ETFs). Who can blame them with all the market volatility especially in the region? But the stats don’t lie and one can see that the ETF growth internationally both in the number of funds and in “assets under management” is similar to the US perhaps as far back as ten years ago. A slow and steady climb will continue for a few more years and regardless of bull or bear markets, there will be an explosion in the ETF marketplace as investors realize that the beta/alpha combination (ETFs plus hedge funds/private equity/other alpha generators) makes sense for them. We have already seen major indexing and ETF providers build operations internationally including the Pacific rim … the speaker list for the upcoming event in Singapore confirms this.

Speaking of Singapore (the first event listed above), it’s the next ETF/indexing conference in the East Asian region and my first time as an event chairman. We’ll see if the turnout is better than what I saw in Hong Kong only three months ago. While I’m sure the size and scope will be nothing like, say, the Superbowl of Indexing I will be interested to see if there’s some growth at least in the turnout. The attendance at a conference might seem trivial but I’ve been at quite a few over the past decade or so and the one thing I’m certain of is that the number of people attending conferences is proportional to the market interest in its area of focus which usually is at its peak near the same time as that of the market.

Aside for one event (Las Vegas) the conferences shown in my list above are generally for professionals although I don’t suppose there’s anything stopping a keen private investor of any sort to attend. Gauging the market situation with industry conferences is one thing but it may be even better to consider conferences geared towards the private, self-directed investor as they’re often the last to join the party.

Now how about all those conferences to “teach” you how to go about buying and flipping real estate … you know the ones on TV shown late at night along with food processors and exercise equipment? Where’d they all go? Almost too easy as a long-term market signal. But as with many sell signals, I’ll bet those commercials came off the air too late.

But once in a while, another story pops up on the derivative side that’s too big to dismiss. I wish it were some new exposure (like carbon credits) but unfortunately, like hedge funds, the derivatives markets provides a spectacular blowup/debacle once in a while and like a collision on the freeway, everyone pauses to take a look. This time, it’s SocGen’s (Société Générale SA) turn. Facetious as that may sound, this graph from the WSJ gives a quick snapshot of past blowups back to the days of Nick Leeson and slightly beyond.

It seems that in time, we often see the latest blowup being outdone again and again.

For anyone who has taken a risk management course, these “rogue traders” and their blowup events are part of the curriculum. But are they truly rogue? To me, that implies that they were on their own. That may not fit the definition of “rogue” but my point is that in all cases, the focus is so finely tuned towards the individual and not the environment he was in (hey, who no female rogue traders?!)

Out there are people studying for their FRM or PRM designations (from GARP and PRMIA respectively) and I wonder what they’re thinking when they read today’s news. Same old story. Somehow, this guy knew how the back office worked. Somehow, despite all the debacles of the past, they’re still able to circumvent the safeguards that are in place. Just how “safe” these “guards” are … that might just be the key question. You simply have to wonder if this SocGen incident will make a difference in the way such institutions monitor and manage operational risks. Here’s an article from GARP that discusses this topic. Somehow, I feel like there will be minimal change in the way things operate at financial institutions.

My previous post discussed risk from the point of view of the financial advisor who services the individual investor. Here I want to think about risk from a more micro point of view. This “micro” view would apply to the internals of a bank, hedge fund or any big pile of money. Just as in my previous post, I think that the more things become complex (adding hedge funds to a portfolio, for example) the more things are susceptible to trouble. The derivatives markets are relatively complex and the mechanisms in the back office operations of seemingly sophisticated institutions allow for an individual with the right technical skill set to determine where is the weakest link and, if given the opportunity, take advantage of that knowledge should it be required. Clearly, to take away the ability for an individual to exploit an opportunity is the objective of this exercise.

This is not a call to tell financial advisors to stay away from hedge funds. My argument there has always been for financial advisors to realize that the resources required to adequately determine which (if any) hedge funds belong in client portfolios is quite onerous. Nor is this posting meant to be a purely negative assessment of the derivatives industry. In fact, my point in this blog is that derivatives are not bad themselves but, as everyone knows, are like dynamite … things can get out of hand quite quickly. I believe we can’t simply ask why the banks and hedge funds haven’t tightened up their operations so that such blowups can’t happen or are at least minimized in terms of magnitude via some set of protocols. Surely, the risk managers, the top officers and board of directors would want and have placed such risk policies and procedures in place. Shouldn’t they have? The question is simply implementation.

Perhaps it’s just not possible to make a fool-proof security system. I’m thinking of a cornered cat. It’ll come out fighting if required. Now think of Nick Leeson or this new guy Jerome Kerviel. You’ve been allowed to trade, things might be going well (you’ve had that feeling at the craps tables in Vegas, right?) and you’re on top of the world. Nothing different there. Nothing wrong. That’s just human nature. But nothing goes up forever and sometimes things go bad. Hey, crap happens but every so often things really get out of hand. Sometimes, we hold onto losses no matter how bad they get. Normally, one would eventually accept the situation and simply exit the position.

For some, that might simply mean taking a big loss. For some, that might mean shutting down their hedge fund and starting up a new one under a new name. But for some, there’s something else that’s entirely sinister. A common theme in the financial blowup is the hiding of losses. In some cases (I’m thinking of some hedge fund blowups but not Amaranth as far as I know) the trader tries to siphon some money away. I think the idea is “Damn, I’ve lost a ton of money. My career is over. If I’m going to go run and hide, I better take some cash with me.” I don’t think that was the case with Leeson and now Kerviel. There’s was simply trading gone bad and a futile attempt to hide the losses. In both situations, the inevitable story is one of a world slowly closing in around them with the noose tightening ever so slightly until the eventual day when they’re on the front page/screen of every media outlet on the planet. I suppose that’s the ultimate risk of any institution (note how I’ve just flipped this to not focus on the individual - they’re not thinking about this risk because no one ever plans to participate in a blowup). Congrats Socgen, you’ve just gained a new perspective on risk. Welcome to the world of “front page risk”. That’s a toughy to measure and is not like VaR and standard deviation covered in most textbooks.

The perception of risk is really not that difficult a subject. I think it’s amazing how a significant event like this can crystallize what risk management is all about. I think it’s less about risk management and more about thinking of all the steps in the process and what can go wrong at each step. Like many things in life, I suppose it all comes down to the details.

Anyway, on the afternoon of day one, I was a panelist on a discussion focused on investment risk. I ended up getting into a bit of an “anti hedge fund rant” which was not my intention and part of this blog entry is to clarify some points which could not be made simply due to the limited time allotted to our session.

So, what follows is what I would have hoped to cover that day, either did cover in a relatively light matter or not at all, or have considered now that a few days have passed.

First, because this event was targeted towards financial advisors, my perception is skewed to what I know of this type of intermediary. From our session and confirmed on many other session, it seemed clear that the financial advisor’s role within the portfolio building function focuses more on asset allocation than anything else. The comments from my fellow panelists (all financial advisors with strong acumen based on the discussions we had in preparation for the event) further confirmed this. Manager selection may be in integral part of the process but it seemed like rebalancing issues and related matters revolving around portfolio maintenance were of paramount importance. And this makes sense if they’re participating at an ETF focused event.

Now let’s focus on the subject of this post: risk. With a discussion on risk, an important point of differentiation is that between risk measurement and risk management. Over the years, I’ve seen many investment professionals increase their proficiency with risk measures such as standard deviation and correlation. Even more, some measures from college level math like higher moments and rather sophisticated downside measures like VaR are creeping into the more common industry dialogue. More than one of my fellow panelists mentioned the use of sensitivity analysis as well as Monte Carlo simulations. This is the power of the desktop computer and the internet. But it is also a point which must be clearly understood when we shift our thought from measurement to risk management.

Risk measurement attempts to provide some increased certainty in what is an uncertain endeavor. Certainty about what we saw in the past … that’s for sure. Certainty about what will come in the future? Well, statistical inference is a whole 2^nd year math course so I won’t go there in this post. There’s a reason why legal disclosures in investment related marketing materials include the phrase “Past performance is not indicative of future performance.” That’s because it’s true. The best I think we can say is that some investment methodologies may have greater certainty of behaving in some sort of way in the future. Note some uncertainty still exists. For example, with backtested results based on an index, we can say that, as opposed to backtests from an active manager, there is less concern of active management risk which can include the risk of style drift, among others

This leads to my next point of clarification. I think that the investment industry uses the idea of “more risk” or “less risk” too freely. What may actually be happening is not an increase or decrease in overall risk but simply a transfer of the type of risk.

One simple example is the “active-passive spectrum” which I have referred to in the past several times. For the sake of simplicity, let’s just keep this in the realm of stocks and the stock market. At one end of the spectrum is the pure passive world. Think beta. Think super low costs beta exposures like S&P 500 index futures contracts or the S&P 500 Spyder, SPY. This is where believers in market efficiency reside and they believe that exposure to market risk will pay off in the long term via the equity risk premium. The other end of the spectrum is the pure active world. Think alpha. Think much higher costs paid in an attempt to beat the market. This is best exemplified by hedge funds. Since there are multiple definitions of hedge funds, this end of the spectrum should really include only those that are market neutral, or perhaps more precise “beta neutral”. Essentially, at this end you should not be taking on any market risk as the manager has promised to outperform in both good and bad markets. If true (practically speaking, you will need that grain of salt if you accept this assumption), then you are not exposed to market risk but manager risk.

If you accept this paradigm of a see-saw of market risk versus manager risk, then for a financial advisor or any investor who decides to put some of their money within a particular asset class in ETFs versus an active manager, they are simply transferring risk. Anyone who says that by investing in an ETF over an active manager is taking the “lower risk approach” I believe is mistaken. As much as I like ETFs, I believe this choice is one of taking on market risk over manager risk. Again, not necessarily less risk.

Another investor who shifts between money in a bank account and a broad market ETF is also transferring risk. Actually, there are various risks which one is exposed to no matter which of these two paths one takes. The bank account clearly has the risk of not having enough funds for future spending as its growth is reduced due to unfavorable tax treatment and the future purchasing power is dependent on returns after inflation.

So let’s review. First, I’ve said that risk measurement is not the same as risk management. I didn’t say this before, but one of my concerns is that a process of risk measurement, no matter how thorough or robust, may lead to a false sense of security. That would, in fact, mean that risk measurement, if used inappropriately, could be counter-productive to the overall risk management function. This subject has been covered well in the best selling books of Nassim Taleb and I think both “Fooled By Randomness” and “The Black Swan” are required reading.

Second, I have differentiated between increased/decreased risk taking and risk transfer. Again, thinking this way may lead investors away from getting caught in the false sense of security that makes one think of various natural and man-made disasters. The Titanic is a good example. My first boss in the industry called it “banana peel risk”. These are more philosophical exercises which are not meant to cause higher blood pressure or an anal-retentive complex with the readers of this blog. This is just my opinion and I’m just trying to tell it like it is from my eyes.

Although I did not cover the above in great detail at the conference, what I did discuss was pretty close to this. However, what I did get a lot of feedback on after our session was my views on the fund space, both inside and outside ETFs.

One of my key points was that the evolution in the ETF industry was allowing investors to gain exposure to new asset classes and strategies. This would have the potential for investors to add further diversification to their portfolios and hopefully weather any sideways or downwards market, should that be the environment we now find ourselves in. Another point I stressed was that the new niche ETFs coming into the marketplace are certainly not meant for everyone. This also applies to many alternative investments including hedge funds which I’ll get to in a minute.

The simply beauty of ETFs is that they are the ultimate Swiss army knife. For everyone who has or ever used a similar multi-tool, we all have our favorite of its built in tools. I happen to use the corkscrew more than anything else. I think the blade is pretty useless. Actually, over the Swiss army knife I prefer my 12-year old Leatherman multi-tool which resembles this. Note that it has no corkscrew but is unique with its main set of pliers which is handy when fishing. What’s my point here? I have two multi-tools and I find certain things of value with each of them. You probably have one or both of these in your toolbox and likely others but only you know what works best for you in the common situations you find yourself in. I’m not big on brand loyalty and I just care about the quality/value proposition of a product and can only hope that it delivers as promised. Similarly, I don’t have any brand loyalty with ETFs … I’d be surprised if many investors do. The worst an ETF can do is not delivering as promised. Anyone who says that an ETF is “bad” because it’s not diversified enough, covers an esoteric asset class or is too narrow by sector is closed minded and frankly arrogant. Who are you to tell me or anyone else what to put in my portfolio unless you know my income needs, feelings on loss/volatility, time horizon or other parameters which determine my portfolio’s overall financial objective(s)? Now, if you’re my financial advisor and I’m paying for your advice, that’s a different story. Deep breath in … and now we continue.

Getting back to investing, after the 5 year bull run, investors likely need holdings to augment their core holdings. I’m not saying replace their SPY or EFA positions with a nanotechnology ETF or Chile fund. But there’s nothing to say that these types of holdings could provide improved risk-return characteristics in the future.

Now, some of the more controversial points I made last week were those around the use of hedge funds and even comments regarding hedge fund replication products. Well, as an extension to what I just said earlier, who am I or anyone to simply say “No” to the use of hedge funds? However, when an attendee asked me during the Q&A session my thoughts on the use of hedge funds, I started with a simple one word answer of “No”. Furthermore, when another listener asked my opinion on option-based strategies, my response was leaning more towards caution rather than a simple stamp of approval. Yikes. Looks like I’ve just painted myself in a corner. Time to explain myself.

Hopefully what I say now does not bring into disrepute the financial advisory profession. But I believe that the vast majority of financial advisors do not have the adequate resources necessary to adequately process hedge funds into their program. Frankly, the same could be said for many if not most investors. I won’t get into this into too much detail because I’ve said it so many times before on this blog but it takes a lot of specialized skills conduct the necessary qualitative and quantitative due diligence that goes into the vetting process of weeding out the many hedge funds that come knocking down one’s door. And there are a lot of them … again, too many participants trying to get that alpha … there’s just not enough to share. This leads to too many losers and not enough winners. Worse still, many of the “winners” are closed to new investors. And with hedge fund managers wanting to keep up with past performance in an ever changing and tougher world, leverage is often used in an attempt to juice returns. It all makes a lot of sense and you can’t knock them for doing what they do. The system allows them to get paid based on performance so if they’re able to try, they will.

However, if financial advisors are shifting from mutual funds to ETFs because of lower fees and the folly of “closet indexing” among many mutual funds, one has to wonder if the appeal for hedge funds is worthy. Many financial advisors find themselves accepting the fact that selecting hedge funds is as tough, if not tougher than with mutual funds. Hence,.the fund-of-funds is a common avenue. The unfortunate reality with FOFs is that their added layer of fees adds further necessary returns just to be breakeven and their tendency to perform closer to common benchmark equity indices is even greater than with single strategy hedge funds.

Buy quality? Goldman Sach’s Global Alpha hedge fund is a commonly cited example of where this line of thinking may not apply. In fact, many large institutional investors, backed by academic studies, have realized that emerging (read smaller) managers have the greatest potential due to their nimble operations to extract true alpha from global markets. Whether there is consistent alpha from these managers is questionable which leads to the idea of rotating managers more frequently than one may deem reasonable. But philosophically, it makes sense to me that small managers with knowledge “ahead of the pack” can outwit other participants who are relatively late to the game within a particular and likely newer/esoteric segment of the capital markets.

All of this led me to my answer of “No” to financial advisors getting into hedge funds. I was also not very accommodative to the new world of hedge fund replication products. One new entrant in the ETF industry has been cited in the press several times in regard to its product development in this area. Whether it’s a good product for the ETF marketplace, I can’t say right now and without full details, it’s hard to say yea or nay at this point. The only thing that can be said for now about HF replication is that it brings a new benchmark for hedge funds to go after. I mean, any financial advisor might be able to say in the near future “Um, Mr. Hedge Fund Manager, I can go to a replication ETF with much lower costs to get something that might likely perform very similarly to your fund’s strategy without many of the risks that keep me up at night.” This argument would be very similar to the idea of investors shifting from actively managed mutual funds to index funds or ETFs because of the closet indexing prevalent in many mutual funds. Clearly, the fact that so much beta is embedded in hedge funds in aggregate (a very important point to stress is “in aggregate”), is a telling sign and flaw of hedge funds that makes this new world of replication both insightful and alarming.

Of course, there’s no absolute “black and white” answer to the use of hedge funds or HF replicators and like other market participants, financial advisors must differentiate themselves from their peers. So, my “No” is in general but will find exceptions from those firms willing and able to allocate the necessary resources to a dedicated “hedge fund due diligence team”. Same goes for building an option overlay program.

Above is a chart showing the performance of some common equity benchmark indices with a broad hedge fund index. The main point I want to make here is that during the strong bull markets of 1993-2000 and 2003-2007, the hedge fund index was basically similar in scope and trend to an index fund. However, during the bear market of 2000-2003 it behaved like a high-yielding cash/bond position. In other words, the hedge fund index seemed to have a built in put option in play that paid off well during the bear market. The conference attendee who asked about options may have had a chart like this in mind. My response to the gentlemen and my comment here is that an option overlay program makes sense depending on the confidence you have in your own market timing abilities. For many, market timing abilities are about as reliable as one’s knack for coin flipping.

One insightful friend of mine thinks of option overlays in this way: If you’ve made a lot of return during an extended bull market (think 2000 or 2007), why not spend some of that return on an insurance policy. You’d do the same with your life insurance policy if your income increases dramatically. You’d to similarly again if you move into a bigger house. Why not protect another important asset that has grown dramatically? Makes a ton of sense to me. Just too bad that insurance is very expensive … pretty much true for any type of insurance including premiums in the options markets.

And there’s the rub. No matter if we’re talking about adding higher fee ETF diversifiers, even higher costing hedge funds or insurance policies like a put option, it won’t come cheap and the process won’t be easy. But that’s pretty much the definition of alpha ain’t it.

Mine is not the place to tell any financial advisor or investor what to do. It’s all about choice. If now is the time to think defensively for one’s portfolio, there are multiple levels of protection that can be applied:

• Diversify further into developing markets and alternative asset classes/strategies
• Diversify beyond market cap weighted indexing to dividend weighted or other forms of fundamental weighted or even equal weighted indexing
• Shift asset allocation to decrease enlarged positions and build cash
• Perhaps even make a tactical call to hold excess cash
• Apply the use of options in various ways to provide non-linear payoff characteristics
• Apply the use of inverse ETFs or outright shorting.

Financial advisors, like investors, come in different types with various degrees of proficiency and complexity. If the above are some of the various steps to increased complexity, one’s own personal philosophy on investing will likely determine where they fit. One thing’s for sure: The trend in the ETF industry towards niche exposures and specialized strategies such as inverse exposures lead most, including myself, to believe that the core positions like SPY and EFA have been done if not overdone. Investors are looking for the next step to finer tuned portfolios and this just makes sense. You can survive on meat and potatoes but multi-vitamins help just in case you’re missing something. This makes me think of the folic acid pills my wife took while she was pregnant. You just never know, and that’s the point of insurance.

To conclude, my comments at the conference were clearly tilted against hedge funds and more complex strategies for the majority of financial advisors. It’s just my opinion and of course that stance is entirely debatable. But I make my final argument here: Perhaps in the overlying concern of uncertainty (not simply risk), one must ask themselves if it’s even worth the exercise. I mean, for most financial advisors, I can see the benefits of ETF-based investing or at least, biasing their clients’ portfolios with the use of ETFs. I can even understand the benefits of using ETFs, among certain other instruments to gain exposures to developing markets, alternative asset classes and certain strategies. But adding hedge funds and somewhat complex derivative strategies … does it provide their clients greater certainty of success? Or perhaps a more succinct question: Does it provide clients a greater level of comfort to apply these strategies on top of the ETF based portfolio? Or does it not. For the financial advisor, there’s the real risk to consider in my opinion.

ProShares Launches First Short International ETFs

BETHESDA, Md.–(BUSINESS WIRE)–ProShares, the fastest-growing ETF provider this year, announced today the launch of the first-ever short international ETFs, designed to go up when a foreign market goes down. ProShares, the nation’s only short and magnified-exposure ETFs, recently crossed $9 billion in assets under management.

The six new ProShares, each to be listed on the American Stock Exchange, are:

The Short and UltraShort MSCI EAFE ProShares launched today; the remaining four are slated for release in November. After these launches, the Short ProShares lineup—providing short exposure to a wide range of domestic and international markets, capitalization sizes and investment styles—will number 35.

These launches follow ProShares breaking though $9 billion in assets under management after a significant market drop on Friday October 19. Initially launched in June 2006, ProShares had the most successful first year of any ETF company in history.¹

“The dramatic acceptance of ProShares has been fueled by investors looking to go beyond the basics and expand the strategies they employ in their portfolios. Shorting strategies have been used by serious investors such as institutions and hedge funds for years,” said ProShares Chairman and CEO Michael Sapir. “By introducing short ETFs to the marketplace—first on domestic market indexes and now on international—we have opened up opportunities for more investors to use short strategies to manage risk or to seek to benefit from market declines.”

Short and UltraShort ProShares offer many advantages over shorting baskets of stocks, individual stocks or ETFs. Investors can achieve short exposure without opening a margin account—buying short exposure is as convenient and simple as purchasing an individual stock. In addition, investors can lose only the amount that they invest, whereas when they short stocks, stock baskets or ETFs, their losses are theoretically unlimited. Moreover, these ETFs can be employed in vehicles that do not permit margin accounts—IRAs for instance. And finally, these ETFs can easily be tracked throughout the day.

Investors seeking to hedge gains should understand that they may need to make adjustments to their holdings to maintain a specific level of short exposure over time. Also, the funds have fees, expense and tax consequences of their own. These short ETFs are structured to provide the inverse of the daily performance of the market indexes that they track; that is, if MSCI EAFE declines by 1% in a day, the Short MSCI EAFE ProShares should gain 1%; if the index goes up by 1% in a day, the ETF should lose an equal amount. The UltraShort ProShares are designed to deliver twice the inverse of daily performance; in the above instance, where MSCI EAFE declined by 1% in a day, the UltraShort MSCI EAFE ProShares should appreciate by 2% and if the benchmark rose by 1%, the ETF should decline by 2%.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

• HSBC Climate Change Index

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Since the bottom in late ‘02/early ‘03, we have seen dips followed by relatively quick erasing of the drawdown. Something as fundamental as poor credit practices looks now to be rather minimal in terms of market effect although 1) we’ll see just how accommodative the monetary authorities remains for the rest of 2007 and 2) we’ll see how the remainder of the year turns out as we’re yet to get the full reporting (latest quarterly earnings from the financial sector, inflation numbers, hedge fund performance numbers).

You’ll note that the dips are getting deeper but the time to recovery seems to be constant. We have V shapes that are only being stretched vertically. I’m a bit surprised that VIX hasn’t dropped back below 15. No forecasts from me now. After hurricanes, subway bombings and credit crunches, this global market has shown resilience that makes me think we’re well into the area where behavioral finance takes over. Kind of has that late 90’s feel (I’ll comment again on this below).

I have not submitted a blog entry since June 21st, nearly three and a half months ago. Is it me, or has it been relatively quiet in ETF land? Not to say that there haven’t been new products launched, there have been … some good and some not so good. But my feeling is that the conveyor belt has not only eased up on its acceleration rate but may have actually decelerated. If this is not true, someone please let me know. But if I’m right, then let’s all give a collective sigh. This pause in product launches should give investors of all types the time to reconfigure their processes to determine their investable universe and even tighten up their actual potential short list.

But don’t be mistaken. This pause is temporary. Although I may have been silent online, I have been in contact with many in the industry. We are going to see more from the big 3 (BGI, SSGA, Vanguard) although I’m thinking that PowerShares should be included in this group soon. However, the more interesting developments will come from the new entrants … some of them you have already heard of and others you likely haven’t. Some will provide exposures “with a twist” to asset classes already covered. Some will provide exposure to new areas of the capital markets.

It is the arrival of many smaller new entrants into this space that will provide what some will call innovation or differentiation while others might simply call (in aggregate) crap. I mentioned before about the feeling of the 90’s. If the new ETFs coming out focus on new ideas … there’s way too many to list so I might go over them one-by-one in future postings … then wouldn’t this new chapter in the ETF story be similar to the dot-coms? It’s simply the transfer of capital to new ideas, some that will work and some that won’t. Most of these new entrants have the backing of VC firms. You have to make your way to them to understand why they think their story is unique (i.e. why they have skin in the game). It’s pretty much the same idea on the hedge fund side. Except the manager doesn’t usually have the backing of a VC firm although they may be involved in some way (distribution). But the hedge fund is also about an idea. Unlike the ETF that provides (hopefully) a new or significantly meaningful market exposure, the hedge fund’s idea is about some new actively managed opportunity. I personally don’t see that significant a comparison with the dot com craze. The anti-ETF crowd surely sees it differently.

In this tough environment where getting paid for risk premium is suspect, it’s no surprise that we continue to hear about the growth of both ETFs and hedge funds. Hat tip to AllAboutAlpha for the latest commentary on this subject from InvestmentNews. Having now passed the half trillion dollar mark, you just have to wonder if the real asset growth of ETFs will be in the tried/true SPY-type behemoths or will the smaller players and new entrants be able to gain significant market share.

An interesting development is the cross border (or in most cases cross-ocean) movement of firms and operations. For example, SPA who is based in Europe have recently set up operations in the US. For those interested in the fundamental indexing approach from the likes of WisdomTree and PowerShares (via Research Affiliates), you’ll want to check out SPA and their fundamentally driven ETFs which are advised by MarketGrader who are based out of the US. I’d like to see this type of development (international operations) continue and the trend lead to more fluid trading of instruments. A good start would be to have NYSE-Euronext allow for a full ETF menu for US and European domiciled funds to be easily traded on a convenient online platform. We must be already headed that way.

I’ll find out additional information on these little tidbits and more in a few weeks at the “World Series of Exchange Traded Funds -West” conference in Scottsdale Arizona. From what I can tell, this should have a similar feel and scale as IMN’s similar event in Miami back in March. However, it won’t be as big as the upcoming “Superbowl of Indexing” which is also in Scottsdale and has more of an institutional investor bent.

For those of you who know me or have communicated with me in the past few months, you’ll know that I focused my attention on finding a new role for myself. My consulting work from earlier this year was meant to be a transition for me as was the blogging. One of the potential avenues open to me is writing. I have been given suggestions by several people about starting up a paid newsletter focused on ETFs. I remain cautious on this as there are a lot of these types of newsletters and there will surely be many more. In New York, I have spoken with a group that is interested in institutional level research of course with an ETF focus. Think I-bank but with an adamant spotlight on independence. One individual suggested that I have a 3-tiered service: free blog; low fee newsletter and top shelf institutional service. I just don’t know if I see myself in the online media business as all I’ve focused on in the past 12 years or so is the management of portfolios. It would be nice to do both (hence the blog), but you can only spread yourself so thin.

So, I have been speaking with a small number regarding possibly joining their organization. Some small, some large. This is where I have focused myself over the past couple of months. The upcoming busy conference schedule over the next few months helps in the networking so we’ll see how it goes. Like Yasser Anwar and various other bloggers who have spent far more resources than I have on their site (with surely more impressive results such as number of visits … mine is certainly a bare bones blog), I have found that as much as I enjoy blogging, the opportunity to turn this into a business is possible but likely not my path. The 3-tiered online service is something I have been thinking about for a while and I now have some potential partners to work on this with. But deep inside, I feel like that that would be a nice place for me to be AFTER I decide to stop managing money.

Let’s face it: This has got to be one of the most interesting times ever to manage portfolios. It’s a low yield world where it’s also harder to find alpha. This has forced sophisticated investors to explore new asset classes and strategies. This kind of thinking is making many market participants attempt to emulate others who are ahead of the pack … have you noticed how so many people online and in the mainstream press are talking about Yale’s endowment? We could certainly be in a point right now where the next ten years will have negative annual average returns.

For me, despite my focus on ETFs on this blog, I’m interested in the broader asset allocation problem. Writing about this just isn’t as much fun to me as compared to actually managing the money. So for now, I’ll put up the occasional blog posting here but hopefully I’ll be notifying you soon about where my career path takes me.