On Monday of this week I received the latest reports from Deb Fuhr at Morgan Stanley [UK], who was probably the first of what is still a small number of sell-side analysts covering the ETF space.The reports are big on stats and various data tables. One of the tables that always interests me is the one titled “Announced Plans for New ETFs” (for those of you who have the report, it’s ‘Exhibit 68′ on page 35 of 83 in the report titled “Exchange Traded Funds – First Half 2006 Global Review”).

There are about 40 listed for Europe, about half of them being European sector ETFs from Lyxor.

For the US, there’s a list of 97. The slicing and dicing of the health care industry by HealthShares with 12 ETFs is part of the list. Another dozen or so “dynamic” sector ETFs from PowerShares. Despite this, PowerShares seems set to completely master the slicing and dicing by sector with yet another 8 sector funds based on Rob Arnott’s RAFI (fundamental indexation) methodology. You’ve got to give attention to PowerShares considering the full list of offerings they have in the pipeline. The sector funds may not appeal to the vast majority who have similar existing positions, but here are some others from this list that look really interesting from PowerShares:

• PowerShares Autonomic Allocation Research Affiliates Portfolio. I just met with Rob Arnott last week here in Toronto so I wish I knew of this fund to ask him first, what’s it all about, and second, who thought of the name. Sounds like some kind of asset allocation fund but I’m eager to understand what autonomic means. I see on Wikipedia that “The autonomic nervous system [ANS] is the part of the nervous system of the higher life forms that is not consciously controlled.” I might suggest they find another word that doesn’t make my spidey sense tingle.

• PowerShares Listed Private Equity Portfolio. I’m interested to understand the logistics of this fund. Certainly, it’s intriguing and I am all for expanding into new asset classes/strategies. However, the list of questions regarding a private equity based ETF requires a whole new blog site.

• PowerShares Financial Preferred Portfolio and PowerShares REIT Preferred Portfolio. In this yield-hungry, expected low return environment, it’s not surprising to see this as well as all the dividend oriented ETFs.

• PowerShares Cleantech Portfolio. I’ve mentioned this before and I think the high tech space applied to alternative energy, clean air/water and other closely similar areas is a worthy consideration for any portfolio. I see it as something that fits well with those who have PBW and PHO. Speaking of PBW, another new ETF mentioned is the PowerShares WilderHill Progressive Energy Portfolio. I hope to find more and report on this later.

• PowerShares India Tiger Portfolio. For the truly long-term oriented investor, I believe that emerging markets are an important area to consider. Although a BRIC ETF is on this list, I wonder about the composition formula and the relatively underweighting in India. I’ve reported here earlier that the breakdown will be something like: 50% Brazil, 30% China, 15% India, and 5% Russia. Since we already have ETFs for Brazil and China, why not for India? The concept of BRIC is interesting but I think for most investors having EMM or VWO plus some single country exposure like India or China should be enough for EM exposure. Here’s a short online presentation by Goldman Sachs on the BRIC story.

Not to be outdone, both the SPDR family as well as WisdomTree are coming out with their own line of sector funds (ten each). Someone has to invent a word for saturation within the fund industry. I understand everyone thinks they’re doing something unique but after the launch of all these funds, if it actually happens, be prepared for even more commentary about the mass proliferation of ETFs!

streetTracks is coming out with something called the streetTracks KBW Mortgage Finance ETF. We see a lot more mortgage investment funds here in Toronto. I’m interested to see what this ETF is about.

Of course there are some commodity based ETFs (GSCI tracker from BGI and at least two oil ETFs). With all the new stuff from PowerShares, it’s funny that BGI only has a list of five: Aside from the GSCI tracker, the rest are rather boring fixed income ETFs. I say boring, but likely required in this current market environment.

Lastly, I’ll mention the First Trust Value Line & Ibbotson Equity Allocation Fund. Ibbotson & Associates are rather well known for asset allocation software. I’m thinking this could be like the autonomic ETF mentioned earlier. Burton and Malkiel may not like it, but the ETF industry is trying to move away from pure low cost indexing. I say, innovate away!

I have a copy of Morningstar’s “ETFs 100” on my desk as it’s a decent source of info on US domiciled ETFs. It basically has a nice 1-page fact sheet for each ETF as of December 31, 2005. Each page has (thankfully) no assessment for the ETF in terms of number of stars although there is some commentary/opinions given in a few short paragraphs. Yesterday I came across this from the IndexUniverse.com website (sub. req.):

Is Simple Better?

Morningstar bestowed its highest possible mutual fund honor on the Rydex S&P Equal Weight ETF (RSP), awarding it five stars for the three years ending June 30, 2006. The Morningstar rankings are based on risk-adjusted performance, with funds measured against other funds in the same category – large cap growth funds against large cap growth funds, small cap value against small cap value, etc. RSP was evaluated in the “large blend” category, and apparently, it compared well.

Before we celebrate (and evaluate) RSP’s performance, however, let’s take a moment to pity the poor active fund managers in RSP’s category. Imagine their fate: They’ve been staying up late, pouring over company filings; they’ve logged 100,000 air miles shuttling to and from conferences and corporate headquarters; their hair is turning gray, there are bags under their eyes, and they haven’t seen the sun in weeks. Maybe they are doing well … maybe their performance is up, and they’re looking at three or even four stars … when along comes RSP, flouncing by with its simple equal-weighting methodology, and it earns five stars without breaking a sweat. It is the idiot savant of strong performance. If I were an active fund manager, it’d drive me crazy.

I mean, let’s be serious: The strategy winning these accolades could not be simpler – you hold all the stocks in the S&P 500 at equal (0.20 percent) weightings, and rebalance quarterly. That’s it. No comparative analyses or complicated quant-driven programming. Instead, it’s like a kid in a candy store: I’ll take one of those, and one of those, and one of those…

I don’t mean to criticize the fund. RSP has delivered 16.27 percent annualized returns to shareholders over the past three years, compared to just 11.22 percent for the traditional S&P 500. And there’s a good body of evidence that suggests that both mid/small tilts and regular rebalancings are associated with improved performance – both of which RSP provides in one fairly inexpensive packet.

But the utility of the rating – like the utility of all Morningstar ETF ratings – is suspect. We know that RSP’s portfolio sits on the very edge between mid- and large cap exposure (57 percent large cap vs. 43 percent mid-cap exposure, according to Morningstar). With that in mind, the rating tells us … what, exactly? That small/mid caps have outperformed large caps over the past few years? Well, yeah…

And if small/mid caps fall out of favor for a while???

I do think there is some utility in the Morningstar ratings for ETFs when applied to the fancy, quantitative strategies, of the kind introduced by PowerShares and its various followers. After all, those funds are trying specifically to “beat the market,” not to simply provide exposure to a given slice of the market. (Note: The PowerShares Dynamic Portfolio (PWC) – one of PowerShares’ flagship “enhanced index ETFs” - has also received a five star rating from Morningstar, and has outperformed RSP over the past three years.)

But for most ETFs, I’m not convinced. So, congrats to RSP – they have an interesting fund that incorporates some basic good ideas for shareholders, such as rebalancing on a regular basis, and they’ve delivered strong returns. But my advice? Don’’t let it go to your head.

So, we now have Morningstar providing ratings for ETFs. Intuitively, I wouldn’t think that those in the investing world would find much value in Morningstar ETF ratings. Certainly, for the truly passive ETF based on the traditional, market cap weighted indexation, what would be the point? I suppose it would be similar to the S&P SPIVA reports which determine how well active managers beat their relative index. In the case of the Morningstar report, instead of comparing active managers within a certain asset class or subclass, they’d be making the comparison to the more appropriate, after fees/costs equivalent, ETF.

More importantly, the writer discusses the value of ratings on enhanced index ETFs with specific mention of PowerShares’ ETFs based on their Intellidex methodology. I would agree that Morningstar has a case to provide ratings to the new batch of ETFs based on quasi-active management. In addition to the ETF mentioned, this would also include those from PowerShares (based on RAFI methodology) and WisdomTree. Although DFA is not in the ETF space, it would be interesting to see Morningstar’s commentary on the fundamental indexation based ETFs versus the Fama-French based mutual funds from DFA. However, I’d be quite doubtful if their examination would be anything close to the highly quantitative analysis I’ve seen (William Bernstein, Burton Malkiel) seen recently surrounding the introduction of fundamental indexation funds from PowerShares and WisdomTree.

For me, as someone whose company tilts more against the role of manager selection, I have never been a fan of Morningstar ratings. I will only expand briefly on this by saying that if an investor can use some form of inexpensive means to gain broad market exposure (index derivatives or ETFs), that should be the focus. Manager selection should be limited to areas where these products just don’t make sense for various logical or logistical reasons such as private equity, hedge funds, infrastructure, etc.

Despite this, I suppose there’s nothing wrong with someone out there who has built a name - some would say good, some would disagree - based on rating funds (OEF or otherwise). What I don’t understand is how an investor can consider the Morningstar rating system anything more than a rough guide. Certainly I hope it isn’t used even partially to build an investment process.

Last thought: There’s been a lot of commentary online about the fundamental indexation ETFs. There has also been some analysis and follow-up commentary comparing FI methodologies and results to the Fama-French models. There has not been much discussion comparing any of this to RSP. Similar results in terms of dialing down the large cap in favor of small cap. RSP also has a longer track record, albeit entirely in a strong bull market. Morningstar ratings aside, the concept of equal cap weighting is so simple, it’s silly. Other indexes also have ETFs with equal weights. Of course they have their downside of greater trading costs and the related performance drags such as taxation. I’d be interested to know if the performance of equal cap weighting is inferior to fundamental indexation (whoevers version you use) for, let’s say the broad US equity market. Also, if so, by roughly how much?

I saw this piece over at Indexuniverse.com:

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

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

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

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

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

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

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

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

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

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

CPMKTS 1-yr chart:

There has been so much discussion about US real estate as an overvalued asset class. I’ll keep this simple. There is an interesting article on Contrary Investor that shows how out of hand things have become. (The site requires you to sign up as a subscriber but at no cost.)The argument given is that real estate is a good leading indicator of the national economy in general. Nothing new there but it’s the charts that give a good indication of the extreme situation investors need to be aware of. Here are some charts from the article:

The conclusion you can draw from the above is of a hard landing. Same with this chart: According to the writer, “we’re looking at the number of US homes for sale multiplied by the median US home price as of now. Without sounding melodramatic, price and volume is telling us one large and very important story here. We’ve never seen anything like this.” What I have put above hardly comes close to analysis so I strongly suggest reading this report and do some further digging. But when you look at the ETF space, you have further evidence of the same. Take a look at the barcharts.com’s ETF site. Here’s the list of top ten ETFs sorted by YTD returns:

Numbers 6, 7 and 9 (ICF, RWR, VNQ) show about 18% to 19% returns YTD. If you’ve been holding them, you’re looking good. The 3-year charts look nice with a few downward bumps along the way.

The only question now is if there is risk of a more substantial drawdown (high Fed uncertainty is making this a very interesting time) and if so, whether shorting should be considered.