There’s got to be something to be said about the timing of fund offerings. We all saw the incredible push of Nasdaq linked products around the peak of 1999-2000. I remember Guaranteed Investment Certificate [GIC] linked notes offered at my local bank, and many of the other Canadian banks, that were linked to the Nasdaq 100 Index being launched near the end of our Canadian RRSP season - this is synonymous to the IRA in the US. The deadline for yearly contributions is the end of February (for the previous tax year). No need to remind you of how the Nasdaq moved after February 2000 but just in case, here’s a chart:

So I wonder now about real estate. It’s a topic that has been discussed at great length by many market observers. Like high-tech, investors can’t say later that they didn’t see it coming. I know many people in the Far East who have everything in real estate. After what happened in Japan, I wonder if they expect it to happen in their home country at some point in time … but just not now. Maybe, but there continue to be new fund offerings allowing global investors to add more fuel to the fire (Note that after each fund’s name below, I include both their ticker symbol as well as its inception date.) They include:1. US domiciled real estate ETFs: Many of these are a fund of REITs such as:

a. iShares Cohen & Steers Realty Majors Index Fund (ICF) 1/29/2001

b. iShares Dow Jones U.S. Real Estate Index Fund (IYR) 6/12/2000

c. streetTracks Wilshire REIT (RWR) 4/23/2001

d. Vanguard REIT (VNQ) 9/23/2004

For group #1, the ETFs with REIT exposure, the growth has obviously been great. Here’s the 2 year chart:

Like the equity markets, you basically have a nice rate of growth since early 2003. Since these ETFs have been around for well over five years (except for Vanguard which was late into ETFs anyway), investors have had a good chance to participate in the rise.2. US domiciled real estate ETFs not focused on REITs but on home builders:

a. SPDR Homebuilders (XHB) 1/31/2006

b. PowerShares Dynamic Building (PKB) 10/26/2005

c. iShares Dow Jones US Home Construction Index Fund (ITB) 5/1/2006

Group 2 is a different story. Homebuilding was the second wave of real estate investing via ETFs with fund launches in late 2005 and early 2006. How have they done this year?

3. European domiciled real estate ETFs: I’ve seen recent news that a European ETF provider called Indexchange Investments has just launched three new real estate equities based ETFs on the Frankfurt and Stuttgart exchanges. They cover three geographic regions with these specific indices:

a. The Dow Jones Stoxx 600 Real Estate index – this index tracks 22 European real estate equities

b. The DJ Stoxx Americas 600 Real Estate index – this index holds Canadian and American real estate equities

c. The DJ Stoxx Asia/Pacific 600 Real Estate index. This index is composed of real estate stocks in Japan, Hong Kong, Singapore, Australia and New Zealand

Group #3 represents recent fund offerings in the real estate space geared for European investors. I’m sure similar funds either exist or are in the works for Asian and other international investors. I think about the timing of these and wonder.

There are other means for investors to get into real estate investing via capital markets (on top of your primary home, winter cottage, investment property for rental income, timeshare in the warmer regions, etc.) and these include:

Housing futures and options traded on the Chicago Mercantile Exchange. Based on S&P/Case-Shiller Home Price Indices, these cash-settled derivative contracts cover 10 major US cities individually as well as in aggregate through a weighted composite index. These actually look like a great hedging vehicle for residents in any of these large metropolitan areas with significant and highly appreciated home values. Of course, someone has to be on the other side to speculate. Goldman Sachs has recently entered into a licensing agreement with S&P for the development of financial products based on the S&P/ Case-Shiller Home Price Indices. Perhaps investors will soon be able to participate in this specialty market without direct involvement in derivative instruments.

Property derivatives have been in existence for about a decade in the UK albeit in limited use. The market for this type of instrument has grown in the past few years however these are instruments, often custom made, for real estate developers and perhaps institutional investors (pension funds) who are building hedging programs to overlay on top of their real estate portfolio. Again, speculators (hedge funds and others) would likely be on the other side.

I wouldn’t be surprised to see increased derivative and ETF development for real estate, just like we have seen recently for commodities (GLD, SLV, USO, DBC) the other asset class with plenty of press regarding its recent climb in prices. These are two of the most common alternative investment asset classes but I wonder if investors today have weightings in these two asset classes that are as large, or larger, than their holdings in traditional stock and bond positions.

Bottom line: Be aware of new investment products in the real estate space. Perhaps some areas (emerging markets, east Asia) may be worthwhile for further analysis, but I’d be careful. No one can know if it will be as bad as the Japanese real estate market in the 1990’s or the Nasdaq crash but it’s the timing of new product development that’s the issue.

Roger Nusbaum has an interesting look at the Amaranth story on his site. As usual, good commentary. With a $5 billion loss in a week, this will certainly become a case study to add to any FRM or PRM curriculum along with LTCM, Baring (Nick Leeson), and Metallgesellschaft. By the way, those interested in risk management (industry pro or not) should look at these sites: Global Association of Risk Professionals and Professional Risk Managers’ International Association. During the bull market of the 1990’s we certainly saw enough risk taking as tech buying was like taking daily vitamin supplements. Supposedly good for you, so just keep on doing it. The problem was that there was not enough focus on the general balanced diet (asset allocation). After the bust, we saw some risk aversion. “Risk management” has been the big buzzword with Sarbanes-Oxley and other measures put in place to deal with problems, albeit in a rather reactive measure. We can only hope that ongoing risk management becomes ever more pro-active than reactive.

But what I wanted to comment on was Roger’s comment on materials being roughly 3% of the S&P 500. Americans don’t have the same issues as Canadians, Australians or other commodity heavy countries have. The S&P/TSX Composite (the broad Canadian equity index) had 16.7% in materials as of June 30th, 2006. 30.4% was in energy. No surprise but a challenge for investors.

Perhaps Canadians have been a bit spoiled watching the main equity indices here double over the past 3 years with the commodity bull market. Furthermore, the Canadian dollar has meant that foreign investments have generally seen performance degraded due to the foreign exchange.

So with the strong gains, you would think that diversification would be the way to go, possibly with the Canadian dollar being strong and a possible reversion to the mean in order. The problem is that the benefits of international diversification have been reduced with the increased globalization of world economies and markets. You would think that EAFE exposure would provide good benefit but even emerging markets are in question for Canadian investors (and anyone else with heavy commodity exposure). Take a look at this chart that plots the Canadian broad market index and iShares Emerging Market Index (EEM).

The black line is the S&P/TSX Composite. EEM looks like a leveraged position in the Canadian index! Thus, for any investor with heavy broad Canadian equity exposure, implementing a broad emerging market position provides little in diversification (the correlation does not seem to be low), but in fact you get the opposite. For those that may have bought emerging markets earlier this year to diversify their risk, it would have been synonymous to doubling down your bet at the poker table.Thus, adjusting cash allocations and/or implementing put options are an absolute requirement for those who have made nice gains in the nice bull market we’ve had in the past 3 years.If we see down markets like we had in May and June, then it will be too late for proactive measures. Reactive measures in the form of shorting futures will be required. For those who do not require a specific percentage hedge can apply the use of ProShares’s inverse ETFs.

For those who think I have put too much of a focus on the issue of the Canadian equity investor, take a look at how the emerging markets compare with the Goldman Sachs Natural Resources Index (IGE):

There’s again a strong correlation between the two except for the past month. If they continue to deviate, then that would be nice. If they continue to track, then investors need to consider what diversification benefits they provide to the rest of their portfolio.Roger’s right. You have to be aware of how much you have in the commodity space. But you also have to be aware of other positions in your portfolio that may behave similarly with commodities. Emerging markets is just one example. There may be more. Part of risk management is finding the weakest link.Like Barings and Nick Leeson, it’s hard to say that Brian Hunter, the trader at the center of this latest blowup, was the weak link. Sure, he did it. But who was watching the trades in the back office? Was their a compliance department monitoring things? There had to be a risk management employee at this hedge fund shop whose job was to measure the risks. We hear that other participants in the natural gas market knew of what Amaranth was doing and suggested that this blowup was of no surprise to them. Someone at Amaranth higher up the chain also had to know what was going on. If they knew, they’re in trouble. If they didn’t know, I actually think that’s worse.

The upcoming ETF focused on private equity was a short bullet point from my entry on August 24th. We now have some more info — here’s what we know from these:

• ETF Eyes Private Equity
• Private Equity Comes to the Masses

· Roughly 30 positions in publicly traded companies so liquidity is not the same concern as is usual in private equity investing. Although “While the index will hold about 30 companies, Red Rocks says these 30 in turn will have investments in more than 1,000 private businesses.”

· “The new index is a benchmark of about 30 publicly traded companies that invest in businesses that participate in private equity, including private equity firms, business development companies and banks that put the lion’s share of their capital into private companies.” I’m interested to know how much of the fund will be invested in the business development companies and banks.

· The composition of the positions is based on the Listed Private Equity Index, created by Denver investment advisor Red Rocks Capital Partners.

· Minimum $50 million market cap for underlying positions. The Street’s article suggests domestic and foreign exposure but nothing more precise than that.

· There will be diversification by sector. “It will include publishing, leisure, retail, biopharma, aerospace, materials and health care, though it will change as the portfolio is rebalanced.”

· Quarterly rebalancing.

· Maximum 10% allocation for single position

· Since it’s an ETF, transparency is another benefit not often associated with private equity investing.

· Expense ratio of 0.7%. This is high in the ETF space but considering how the uniqueness of this product, I would call this reasonable.

For those who follow institutional investors, the Yale Endowment is a name commonly given as a leader in the field. I think that David Swensen’s (Yale’s Chief Investment Officer) books are required reading. His first book, Pioneering Portfolio Management, has a significant focus on the benefits of alternative investing, including private equity.

Take a look at their latest annual report on their website (.pdf).

According to the table on page 8, they have roughly 15% in private equity as of June 2005 with a target allocation of 17%. More detailed description on their private equity work is on pages 20-21. Well worth reading as a first step to those considering the addition of private equity into their portfolio.

The question thereafter is whether an ETF linked to an index is the appropriate vehicle for private equity exposure, or something more like a fund-of-funds. This would be a similar process for an investor in any alternative investment such as commodities or hedge funds.

Back on June 12th I discussed PowerShares WilderHill Clean Energy ETF (PBW), and how it behaved relative to traditional energy exposures like iShares Goldman Sachs Natural Resource ETF (IGE), iShares S&P Global Energy Sector ETF (IXC), iShares Dow Jones US Energy Sector ETF (IYE), Vanguard Consumer Staples ETF (VDC) and Energy Select Sector SPDR ETF (XLE). I tried to make a case for buying PBW. The drop since then has proven me wrong, but I still think it’s an important holding, and my clients have held it throughout the year (we haven’t touched it), as it’s only about 3-5% of the total portfolio depending on the client.Well, it hit a low of around 16.50 on August 14th. It popped up about 10.5% thereafter, but had a 4% drop yesterday. This thing’s volatile.

As discussed on June 12th, what interests me about PBW is its correlation to the traditional energy ETFs. Take a look at this chart below comparing PBW and XLE over the past 12 months. I use XLE, but any of the other energy ETFs mentioned above could be used as well, since they are very similar in nature and performance. I care more about the trend when looking at these charts for this particular bit of analysis.

Note the relatively strong correlation prior to June 2006. The key difference prior to June 2006 was PBW’s stronger climb relative to XLE during the first half of 2006.

Again from my earlier piece, it’s important to note how important IT is in terms of PBW’s sector allocations. With a 30% IT weighting, it’s fairly significant. Energy has less than a 3% weighting in PBW. So why does PBW not have a chart more similar to the Nasdaq than to XLE?

There are some months with great similarity (November and December 2005), and they generally both decline, as did most markets this summer. But you don’t have the same strong similarity like you have between PBW and XLE prior to June 2006.

Although too simplistic in its discounting of underlying fundamentals for the component positions, PBW seems to be a vehicle traded as an energy proxy. The important question now is: What’s going on post June ‘06 that has lead to what seems like an “out of sync” relationship between PBW and XLE? Is it simply that traditional energy rose in July and August due to the war in Israel/Lebanon? That’s fairly obvious. But clearly we see a divergence after the first week of June 2006. This is the same chart as the first but only showing the past six months:

By eyeballing the lines closely, you see that the general weekly trends remain intact between the two ETFs in July and August. The only difference is the strong drive up by XLE in the latter half of June due to geopolitical concerns in the Middle East. But otherwise, we still see the same week-to-week trend matching.

PBW still seems to be an energy play, but acts as a more volatile proxy to oil producers. Sometimes we invest to diversify, sometimes it’s for the story, whether it’s macroeconomic or otherwise. PBW can be considered a “high volatility” energy play. I think similarly of Canada and emerging markets. Buying iShares MSCI Emerging Markets Index ETF (EEM) for a Canadian investor provides no diversification, but is more like having a levered position.

iShares MSCI Emerging Markets Indx ETF (EEM) vs. iShares MSCI Canada Index ETF (EWC) 2-yr Daily Chart

Lastly, I compare PBW and oil itself over the past three months, which is the period I initially commented as one of divergence. It seems more clear here:

Now for the first time we see true divergence, and very little week-to-week trend-matching. My feeling is that this is not the moment many have been waiting for. That is, the moment where alternative energy and traditional energy completely de-couple as oil drops down to $30 or less and the massive acceptance of alternative energy pushes something like PBW up astronomically. New oil find in the Gulf of not, I still think we’re many years away from that “paradigm shift.” But I still hold 3-5% in PowerShares WilderHill Clean Energy ETF (PBW) because it behaves like traditional energy, and you just never know. A 9/11 type plan except aimed at several mideast refineries could do it. I think the limited resources of what’s left of El-Qaeda would likely aim for a western target, perhaps American energy infrastructure.

Moving from speculation back to investing and focusing again on diversification (especially for Canadian investors with heavy energy exposure), I’m still waiting to find out more on the new PowerShares ETFs, specifically the PowerShares Cleantech Portfolio and the PowerShares WilderHill Progressive Energy Portfolio. I wonder how they will behave compared to PBW and other energy ETFs.