There was a lot of press coverage this past week on City University London’s Professor of Risk Management and Director of the Alternative Investment Research Centre at the Cass Business School Harry Kat and his recently published papers on replicating hedge fund performance by way of trading futures contracts.I first mentioned this new area of hedge fund replication programs, referring to Kat’s site, from which you can download all his papers, on Seeking Alpha earlier this month. Although there are not very many participants in this area, we are seeing quite a bit of scholarly research, and, like with Kat, we should be seeing the evolution from academic papers to actual investment products/services based on this research. MIT professor Andrew Lo, another researcher in this field, is covered in a separate article, and the concept has even gained broad media exposure from The Economist.

So what is this all about? We are in a world where there are many hedge fund products managed by many hedge fund managers. It’s possible that the hedge fund universe is getting so crowded that there is just not enough good performance to go around. With relatively low barriers to enter into the hedge fund industry, just how much “alpha” is out there, on average, considering the large number of participants? And will the trend of more assets going into a larger number of hedge funds continue? Consider Hedge Funds For Dummies, now online, available to any soon-to-be hedge fund investor. I’m just happy to see that How to Create and Manage a Hedge Fund: A Professional’s Guide is not ranking as high.

Playing the piano, mastering a martial art, starting and running a hedge fund … clearly there are many activities where a book may be helpful, but is not the way to go. In such cases proficiency is nice, but what you really value is an expert.

Getting back to replication strategies. Like I said, you can’t just rely on what’s written on paper. Kat’s papers, as well as those from other researchers [Lo, Jaeger, etc.], provide various statistics as part of the argument to validate their work. But the proof is in the pudding so what we’ll need to see is some form of real, live performance. In the case of Kat and his associate, Helder Palaro, they have developed a software program called “FundCreator” which, according to the recent articles, is now being used by a small number of institutional investors. It is with this program that investors have the means to build portfolios based on Kat’s research. According to Kat:

“In most cases, managers aren’t good enough to make up for the massive fees that they charge. The combination of excessive fees and minimal opportunity in the market makes alternative investments really doubtful in terms of their value for portfolios.”

Kat might not be expecting many greeting cards from the hedge fund community in December. His FundCreator program costs 3 basis points per month for what he calls “the ideal diversifier”. Essentially, through broad beta exposures chosen from a list of 78 different futures contracts managed on a highly active basis, the program makes any number of allocation decisions so as to achieve the desired amount of statistical characteristics [correlation, volatility, etc.]. Clearly, hedge fund managers and especially fund-of-funds will argue that their methods are more proven to provide truly exceptional return characteristics. Like mutual funds, however, the argument always leads to the effect on performance due to high fees. Will replication strategies provide significantly improved performance numbers versus actual hedge fund investing because of its actual investment process or its lower fees or a combination of both?

Reading the various articles above gives you the broadest ideas of what these replication strategies are all about and what I have written here is too short and broad. The academic papers on the internet are generally full of math, except for those from Kat. However, to get a better and more complete understanding of this new concept and how it can be implemented in a real portfolio, I think you need to hear it straight from the source. For those able to get to London on February 12-14, 2007, this HF conference may be of interest. Harry Kat, as well as pretty much everyone [it’s a very small, very niche field at its very earliest stages] in this space, will be speaking at this event.

I have referred to the following blog in the past but I highly recommend, again, AllAboutAlpha, where AlphaMale covers a lot of this new research on replication strategies.

State Street Global Advisors yesterday declared that the SEC has given all its ETFs exemptive relief from constraints imposed under the Investment Company Act of 1940, thus allowing mutual funds greater flexibility in terms of holding these ETFs. Without this allowance, mutual funds are governed by the Act’s various fixed restrictions, specifically the following limits listed in Section 12[d][1][A]:

· A fund can not hold more than 3% of the total outstanding voting shares of another investment company

· A fund can not invest more than 5% of its total assets in a single investment company

· A fund can not invest more than 10% of its total assets in two or more investment companies

For those whose interests lean toward self-torment, they may wish to peruse the full text of the Act.

Although the exemptive relief allows for the above constraints to be surpassed, the order does specify certain terms and conditions specific to investments made in ETFs. This type of exemptive relief is nothing new as SSGA had a similar order for its SPDR (SPY) and DIAMONDS (DIA) ETFs from the SEC in May 2004.

Despite this, I question if the exemptive relief is a good thing. On the one hand, if the growth of ETFs [in terms of numbers and asset size] is due to their general acceptance by the ordinary investor as well as institutions, why shouldn’t mutual funds be allowed to hold them in significant amounts?

However, I wonder for what purpose mutual funds would want to have significant ETF holdings, or at least so much so that this exemptive order from the SEC was required. This is not an issue for index mutual funds as they can position their portfolio in a highly cost effective manner through derivatives and direct security positions. The issue is then with active managers: Why would they want to hold significant ETF holdings? Perhaps they are global tactical asset allocators who hold positions in various asset classes and see ETFs as the most effective means to implement truly tactical decision. That’s a good example.

What I fear is the potential other case where ETFs are simply used to gain broad market exposures instead of the manager implementing security selection decisions which is the norm in traditional mutual funds. As an ETF user myself [and for our clients’ portfolios], I understand the appeal of ETFs. But if actively managed mutual funds hold significant ETF positions, does this dilute the active role of the manager? I suppose it all depends on what the mandate of the manager is, but if there is “dilution”, what value is the manager providing relative to the fees charged.

Bottom line: The generally accepted flaw of mutual funds is that so many of them provide nothing more than index-like returns. Depending on what the new increased allowance for ETF holdings will do to the mutual fund industry in aggregate, the phenomenon of “closet indexing” could become worse. On the other hand, if mutual funds take a more tactical approach to the use of ETFs, including the use of shorting, then we could see the increasing blurred/merged world of mutual funds and hedge funds. We are already seeing investment companies who are involved in the management of both types of funds and this has brought forth concerns regarding conflicts that benefit HF investors to the detriment of MF investors.

Again, I bring up the focus on the two poles of the portfolio spectrum [ETFs and hedge funds] and how the investment industry is now going through a incredible period of change.

There was an interesting article from Bloomberg News on Monday about the strength of international equity indices. The story focuses on emerging markets and in particular, the iShares MSCI Emerg Mkts Index (EEM), but investors should also consider Vanguard Emerging Markets Stock VIPERs (VWO) as the lower cost alternative. As everyone knows, emerging markets have been simply hot even with a serious drawdown earlier this summer.(Performance note: from the peak on May 8th to the bottom on June 13th, EEM fell nearly 27%. From current prices, if EEM gains 4% it will break through the previous high of May 8th. Sounds like the Dow and a lot of other indices I’m watching.)

EEM’s Strong Performance
What I find interesting here is the comment on how the EEM has generally outperformed comparable actively managed funds:

The iShares fund has returned 30.6 percent, while 645 actively managed funds investing in emerging markets returned an average 29 percent before fees. In the United States, the trend is reversed: stock pickers have beaten the Standard & Poor’s 500 index during the past 12 months, although they underperformed in the 1990s bull market.

This result is confirmed from the latest quarterly “Standard and Poor’s Indices Versus Active Funds Scorecard” from October 13th, also known as the SPIVA scorecard. The report does not use the same benchmark index that tracked by the EEM (from one of S&P’s competitors, MSCI). The report states that “the S&P/IFCI Composite also outperformed 77.9% of emerging markets funds over three years and 89.6% over five years.”

A table near the back of the report shows that for Q3 2006, a choppy but overall sideways market environment for emerging markets in aggregate, the index outperformed roughly 53% of emerging market funds. It’s hard to beat the passive strategy long term and especially in long bull markets but there’s certainly a case for active managers in times of distress. The problem is how you time the passive/active call and whether your manager selection process is also correct. I think the likelihood of getting both calls right is tough.

By the way, on the bond side, the same SPIVA report states that “year-to-date, 52.4% of emerging market bond funds surpassed the Lehman Brothers Emerging Markets Index.”

Call that one a tie.

Emerging Markets Exposure: Hedge Funds or ETFs?
Whether or not the case for passive investing in emerging market equities will remain strong, clearly with hot performance in absolute terms, we should soon see a long list of new ETFs that spotlight emerging markets and focused on certain regions, specific countries and possibly even sectors.

As these markets continue to allow greater allowances for foreign investors, this is an area where we could see extreme divergences in investment strategy. In other words, investors will decide to go full passive [ETF] or full active (hedge funds). What we will need to see, however, is greater allowances for investors to make truly directional calls.

It’s just not realistic for a hedge fund manager to implement significant short positions in a diversified manner such as in a multi-country emerging market long-short mandate. At least, not anywhere close to a similar long-short portfolio of US equities, for example. In addition to this, measuring and managing the various risks in an emerging market hedge fund strategy is difficult to say the least. I’m not saying that it’s impossible to manage an emerging market portfolio in a hedge fund type mandate versus a long-only mutual fund type mandate because the classification does exist and the results are decent.

Here’s a table from Credit Suisse/Tremont:

The index had a 13.58% YTD return as of the end of October. This underperforms a buy-hold strategy on EEM by about 4%. Although I don’t have the statistics, I would guess that the emerging market classification of hedge fund strategies has one of the most wide range of performance results. I just add that comment here since the return for a hedge fund index or subclass is almost meaningless unless you have an idea of the dispersion of the underlying managers’ performance. And here’s a chart for the CS/T Emerging Market Hedge Fund Index:
I know I’m being repetitive here with my recent blog entries but again we find a case where it’s getting harder to be a mutual fund. I think most investors will make the shift to ETFs, possibly in combination with hedge funds, for emerging market exposure.

Wow. Not to soon after I write about the potential for hedge fund investing to morph into an exchange traded instrument, the Financial Times now reports that Dow Jones Indices is working on investable indices that are engineered to mimic the performance attributes of various hedge fund strategies.For those of you who follow hedge fund investing, you have to wonder if these new “replication strategies” will not only aim for return and volatility targets but also attempt to provide some control over skew and kurtosis.

These new “investable indices” sound a lot like hedge fund index investing, which has been around for quite a few years with limited success. The only difference now is that instead of having various underlying hedge fund managers (and the costs of managing them in addition to their inherent fees), we have a strategy based on implementation using direct investment into capital markets including derivatives.

Theoretically, this should lower costs dramatically. However, if new products based on these strategies actually do provide the expected performance results (high alpha, low beta) then I have a funny feeling that the fee structure will not be too far from existing fund-of-hedge fund products currently in the marketplace. We’ll see.

Professor Harry Kat, of London’s Cass Business School, has written some commentary on this subject. The concept of replicating hedge fund strategies using derivatives is one of Kat’s areas of specialty. I highly recommend his papers which, although not as technical as most academic papers are still, well, technical.

There’s a bonanza of fund offerings in the alternative energy, clean water/air, environmental services and related industries for those who are either a) worried that humankind is devastating planet earth beyond the point of no return or b) see the “green revolution” as a worthy investment theme for a globally diversified portfolio. Count me as someone highly interested in both arguments.

Cleantech: The New Biotech
I think we’re now at a point where we all have to become, at the very least, better educated on this global, multi-generational crisis. However, I’m not an environmentalist (by education or training). Thus, I’ve kept and will keep my comments to the second point: the investment theme.There are many diverse arguments for green-based investing. For example, the Powershares Cleantech ETF (PZD) can be viewed as one of the new emerging tech plays, similar to biotech or nanotech. I have commented in the past on the volatility of highly specialized sectors like clean tech. As good a diversifier as they may be (but this should not be assumed; calculations are required), significant inherent volatility can still cause stomach aches. If you’re risk averse, use caution in asset allocations and the allowable risk budget for these very focused investments.

So, the industry has determined that there’s a market for funds specifically focused in this new space. Here’s a quick review of green ETFs that have been launched, many in the past month:

First there was the Powershares Wilderhill Clean Energy (PBW) which was actually launched in March 2005. PowerShares followed this up with two more ETFs in the alternative energy space less than a month ago: PowerShares Cleantech Portfolio (PZD) and PowerShares Progressive Energy Portfolio (PUW).

In a recent article I’ve also covered the Market Vectors Environmental Services ETF (EVX). In addition, there is the Claymore LGA Green ETF which tracks the “Light Green Eco Index” Finally, indices tracking carbon emissions could lead to ETFs allowing more investors access to the emerging area of carbon trading.

The latest related offering is an ETF from First Trust Advisors linked to the NASDAQ(r) Clean Edge(r) U.S. Liquid Series Index (CELS) that is to be launched in January 2007.

Here’s a description of the tracked index from the press release:

The NASDAQ Clean Edge U.S. Liquid Series Index (CELS), developed jointly by NASDAQ and Clean Edge, is designed to track the performance of clean-energy companies that are publicly traded in the U.S. The NASDAQ Clean Edge U.S. Liquid Series Index includes companies engaged in the manufacturing, development, distribution, and installation of emerging clean-energy technologies such as solar photovoltaics, biofuels, and advanced batteries. The four major sub-sectors the index covers are Renewable Fuels and Electricity Generation, Energy Storage & Conversion, Energy Intelligence, and Advanced Energy-Related Materials.

ETF Bubble?
Clearly, we’re beginning to see some overlap among ETFs in this space. Very quickly, it seems as if the alternative energy ETF market is becoming more like the traditional energy ETF market. I’m talking about a sudden increase in competing offerings in the same industry sector. Previously I thought that energy related ETFs were a concern, but with the recent increased pace of ETF offerings in alternative energy, I foresee this being the new crowded market.

I would be concerned if I were a product developer planning to launch a similar product in the next quarter, never mind the individual who may be working to submit a preliminary prospectus to the regulators. Look for more offerings in this area, likely with even greater degrees of specialization (carbon trading, uranium/nuclear plant management, variety of service providers in all of the above sub-sectors).

You have to wonder: At what point do we have so many ETF offerings that we call this an “ETF bubble”? I don’t think we’re there. I think we’re seeing a significant shift in assets from the mutual fund industry to the ETF industry. With this shift, Wall Street is trying to keep up on the “supply side” to satisfy the “demand side”. There is a similar shift, again away from mutual funds and into hedge funds.

Investors are reaching for the extremes to get low cost beta (market risk exposure) and higher cost alpha (manager-based return exposure). The problem is that the beta side is beginning to shift further away from the low cost model. We can only hope that competition and continued technological innovations in the financial services industry drive costs down in the ETF marketplace.

PZD vs. PBW vs. EVX vs. PUW 1 month chart:

Claymore is a firm that actually started an ETF business in Canada near the beginning of this year. Their first offering was a Canadian fundamental index ETF launched in February of this year based on the FTSE-RAFI methodology first discussed here. Currently, Claymore Investments (Canada) has five ETFs, with their US operations a bit behind in terms of fund launches but they now also have five ETFs available. Here is a thorough review of these funds.

(CVY): Claymore/Zacks Yield Hog ETF

(EEB): Claymore/BNY BRIC ETF

(NFO): Claymore/Sabrient Insider ETF

(STH): Claymore/Sabrient Stealth ETF

(XRO): Claymore/Zacks Sector Rotation ETF

IndexUniverse.com (registration required) reports about the next set of ETFs from Claymore USA. The prospectus can be found here.

The new offerings include the following:

Claymore/Clear Spin-Off ETF: This ETF “holds the stocks of companies that have been spun-off from larger corporations”.

Claymore LGA Green ETF: Tracks the “Light Green Eco Index” which is based on “data from public agencies that monitor environmental performance, and then selects stocks that rank in the top 50 percent for environmental performance in each industry.” Again, there’s an added quantitative screen overlaid on top.

Claymore/Ocean Tomo Patent ETF: Tracks an index that according to the site “includes 300 companies with the highest intellectual-property-to-book-value ratio on the market; in other words, companies that hold patents and not smokestacks.”

Claymore/Sabrient Defender ETF: Tracks an index whose constituents are biased based on having fundamentals that have “a history of out-performance during bearish market periods”.

Again, we have some ETF offerings showing the continued divergence away from the extreme low cost, broad asset class, market cap weighted index fund. They all sound interesting, however some (the green ETF and defender ETF) likely are covered by other existing ETFs, or at possibly overlap a significant amount. From a portfolio construction point-of-view, I’m not entirely sure how these would be fit. The spin-off and patent ETFs would not fit your traditional or even alternative asset classifications.

In many cases, I wonder if investors would look at ETFs in these new “exotic” spaces as simply a punt. I’ve made arguments in the past for alternative energy (maybe this green ETF could apply) as a counterpart to energy sector positions, especially for investors like us Canadians with significant weights in this area.

However, I think it’s becoming harder and harder to build arguments as to why I would need some of these new, highly focused ETFs. Portfolios differ just as much as investors. However, what would be your argument for holding, for example, a gastrointestinal/genitourinary/gender health index ETF, a private equity index ETF, a steel index ETF or a patent index ETF in your portfolio? I’m not saying you shouldn’t hold these. I only hope investors have a fundamental, portfolio based reason for adding such a holding within their mix.

A lot of news on the web on regarding Rydex Investments’ filing last week for 96 ETFs. Plans are for three ETFs to track each of the 32 benchmark U.S. indices. Like the ProShares line of ETFs managed by ProShare Advisors, there will be:

· An ETF that seeks to track double the return of the index

· An ETF that seeks to track the inverse return of the index

· An ETF that seeks to track double the inverse return of the index

Essentially, with the first ETF you have a long position in the index and would hope to get double the return of the underlying index. With the other two, you essentially have short exposure to the index through a long position in the ETF.

You would think that Rydex will have to be competitive on price as ProFunds has had several months of edge in terms of being “first to market”. No news on fees but according to the various sources on the web, the ETFs will be linked to various S&P and Russell US equity indices with the usual style tilts (growth/value, small/mid/large cap and combinations thereof).

Rydex was actually first in the market of leveraged long and short index funds. These mutual funds still exist today and I recall in a previous life managing accounts that was based on their Rydex (long 150% S&P 500) and Ursa (short 100% S&P 500) funds. ProFunds was built from some Rydex defectors and they are the two main providers in this unique space. Rydex is clearly playing catch up now.

I suppose there’s a market out there for the inverse ETFs, although I would have hoped for more international exposure. Luckily, there’s word of State Street Global Advisors bringing on some new ETFs and in this case the focus is on various international equity indices as well as a global REIT index. However, these ETFs don’t have the leverage and shorting available with Rydex and ProShares.

On top of this, there’s news on new ETFs as well from:

· WisdomTree: An additional 31 ETFs that like previous launched funds are based on fundamental weights rather than market cap weights.

· PowerShares: An additional 35 ETFs focused on international equities including country based funds.

· Barclays Global Investors: No word on the number of ETFs but a spread among bonds, commodities, and currencies.

More fuel for those saying that there are too many ETFs. According to Deb Fuhr of Morgan Stanley in her latest ETF Global Quarterly Review, there are 669 ETFs worldwide with 926 listings all totaling US$504.5 billion. For the US, the numbers are 303 ETFs at US$362.9 billion (all numbers as of the end of Q3 2006).

I think these numbers are fine, with assets under management well below mutual fund and hedge fund numbers. It’s the growth rate in the number of product offerings in the past couple of years that is of concern — and whether this is the beginning of a significant growth trend that could lead to similar problems found in both the mutual fund and hedge fund industries.

More ETF innovation coming out of Europe. This one is from Societe Generale Asset Management and it’s an ETF traded on the Euronext Paris that is linked to the Dow Jones EURO STOXX 50. What’s new is capital protection (albeit only partially) on the long position.So, there’s some downside protection but the first thing that I’m thinking is how much? Not just how much downside protection, but how much is this added benefit going to cost me?

Here’s the press release (.pdf).

According to this site, “In the case of a market decline, exposure to the index is adjusted to less than 100%, the difference being transferred into a money market placement until the markets rebound. The portfolio insurance method guarantees a partial capital protection of 80% of the net asset value of the ETF on 31st of December of the preceding year.”

At first, the wording might seem to suggest a form of constant proportion portfolio insurance [CPPI] is used; a commonly found mechanism used in structured products with a principal guarantee wrapped in. Societe Generale, and their subsidiary Lyxor, are not only well known (at least in Europe) for their ETF business but for their hedge fund and structured product business which actually preceded their ETF work. Many hedge fund products all over the world are built with this type of guarantee (specifically CPPI) with SG as the guarantor.

However, CPPI includes the use of leverage which is not mentioned here. In fact, there is mention of a maximum of 100% exposure to the index. This could be a simple vanilla structure where in the case the market continually goes down, there is an increasing proportion put into money market instruments. At some point, a threshold is hit and the portfolio is completely in cash equivalents such that at the end of the calendar year the return will be enough to provide the required 80% capital guarantee.

What comes up next in the same press release is nothing more than a description of pure active management in this ETF: “Every quarter, SGAM Alternative Investments’ analysts and fund managers examine the market in detail and anticipate future trends in order to determine the optimal participation in the index performance. Thus, during stable or bullish up markets, the exposure to the index can reach its maximum of 100%. If the market declines, investors will be under-exposed to the market with the aim of maximizing the partial capital protection.”

So not only is there a mathematical formula which measures the allocation between the index and cash so as to properly provide the required 80% guarantee at year-end, but there is also a quarterly reset mechanism where managers determine what starting proportion — I suppose anywhere between 0 and 100% — of the portfolio’s assets are to be invested in the index.

I’ve written recently quite a bit about the merging of the two extremes in investment management:

* Passive: with discussions on ETFs, and
* Active: with particular attention to hedge funds and private equity investing).

This new ETF is another example of this. On the one sense, it’s an ETF meant to track an index. But on the other hand, they’re also talking about managers who “examine the market” and “anticipate future trends” to basically decide if the ETF should have full exposure in the index it’s tracking or not. If I’m not mistaken, this will be the first ETF to not be fully invested in an index (albeit for minimal cash positions as a logistic reality).

Just as significant, the active management process does not seem to be built on some form of “rules based” methodology but something more subjective. I thought fundamental indexation was mixing things up in the ETF industry. Now this!

You might have noticed a pattern in my past few blog entries with my attempt to further explore the new ways that the concept of passive and active investment management are being blended together. Question: Although ETFs have always been about exposure to beta (market risk), is this ETF all about seeking alpha (manager skill)?

Furthermore, are we to see a major divergence in the ETF marketplace where one group tries to follow Vanguard to the low-cost model where others add unique properties to take fees in the other direction? This new capital protected ETF can’t be cheap and I would be surprised if it had an MER under 100bps.

Bottom line: Will sophisticated investors pay the increased fee over the comparable plain vanilla ETF for the active management and guarantee structure when other simpler and cheaper strategies (moving to cash, option strategies) are available?

Maybe there’s something to be said about the fact that there are too many ETFs. According to this column from HedgeWorld:

In the past 12 months 252 new exchange-traded funds were launched worldwide and ETF assets increased globally by 46%, according to research by Merrill Lynch. There now are more than 665 equity, bond, commodity, and currency ETFs, with combined assets of $525 billion.

We’re still far from comparable mutual fund numbers, but the growth is quite staggering. A fairly synchronized global bull market since late 2002 provided nice fuel. A similar pattern in growth can be found at the other end of the investment spectrum: hedge funds. Wikipedia may not be a suitable authority on the hedge fund industry, but the site is quite up-to-date on statistics in general and in this case provides data from a good source of industry information, Hedge Fund Research Inc. From the Wikipedia entry on ‘hedge funds’:

Assets under management of the hedge fund industry totaled $1.225 trillion at the end of the second quarter of 2006 according to the recently released data by Hedge Fund Research Inc. [HFR]. This was up 19% on the previous year and nearly twice the total three years earlier. Because hedge funds typically use leverage/gearing or debt to invest, the positions they can take in the financial markets are larger than their assets under management. The number of hedge funds increased 10% during the past year to reach around 9,000 according to HFR.

Hedge fund data is notoriously opaque in nature so don’t consider the data above as “hard numbers”, but you get an idea of the scale involved in terms of size and growth. On the one hand, you would think that the strong bull market over the past 4 years would explain the ETF boom — but not the hedge fund boom. However, perhaps with such great returns (aside for the hiccup this summer), comes increased risk taking. Thus, the assertion by many that hedge funds are not so much a “defensive” instrument meant to truly hedge certain risks from a portfolio but are “offensive” to enhance overall returns.

Hedge funds are extremely diverse. Some are meant to provide low volatility. Others are the opposite. So it’s critical to know what you’re buying. In a way, there’s nothing different in this one aspect from knowing the differing characteristics of a bond ETF versus an emerging market ETF.

I can’t say yet that I am overly concerned about the growth in these two areas, although there has been some talk in recent years of a bubble in the hedge fund industry. Despite my lack of overall concern, I would say that having too many funds in a particular area does cause me some unease. For example, how many energy sector ETFs or large cap US equity ETFs do we really need? Similarly, there are a lot of US equity long-short hedge funds competing against each other with surprisingly (or maybe not so surprising) high amount of overlap. What I do like however, is the idea of new ETFs and new hedge funds finding new areas to explore. These new areas may even overlap amongst the ETF and hedge fund entities. For example, the area of carbon trading (a recent article of mine covered this) could be structured in the form of an ETF even as a growing number of hedge funds begin trading them in an opportunistic fashion.

Further to the above, what follows are some further observations with many references to the terms “beta” and “alpha”. Risk and return go hand in hand. Think of beta as the risk/return associated with the movement of the market. Think of alpha as the risk/return associated with deviating away from the market (i.e. active management):

1. Having too many ETFs in the same space is not a very big concern. Those that are not accepted by the market simply get shut down voluntarily. This has happened here in Canada as well as in the US. I’m sure it has happened in most countries with a substantial ETF market.

Too many hedge funds in the same space - a whole other story. In the best scenario, competing hedge funds in the same or very similar underlying strategy simply realize that their efforts in a saturated market are not worth it in an economic sense and shut their fund down. Nothing different here than in the similar ETF case. In a more dangerous scenario, hedge fund managers strive to push on and beat the competition. This can include the application of leverage to “supercharge” returns. Of course, this also brings the potential for “supercharged” risks and is the reason why leverage is almost always the main factor in sizable front-page blowups. As well as hubris. Let’s face it: The hedge fund industry is considered to be the elite of the industry. Top tier education. Track record of performance from sandbox to current YTD returns. Massive bling as proof of past success… and hopefully not as a result of fraud as in a few scary cases. If performance fees are not enough of an incentive, then simply a long history of success provides the drive or arrogance to continue on. It makes the fall just that much greater and some Nobel prize winners (awarded in 1997) from the LTCM blowup (of 1998!) are probably the best example of this.

2. It should be of little surprise that the concept of beta/alpha separation is being accepted by ALL investor types, both individual and institutional, as demonstrated by the increased use of both ETFs (exposure to beta) and hedge funds (exposure to alpha — and I’ll get back to this point in a minute).

With investors becoming more knowledgeable, one area of concern has been the costs embedded in mutual funds. Management fees are fine, but not when the vast majority of a fund’s return is dependent more on beta than alpha – recall my definition of alpha as ‘the risk/return associated with deviating away from the market’ and then think about your mutual fund holdings. Hopefully, they’re not closet indexers.

Getting back to management fees, they are often considered a form of “negative alpha” since it is a factor determined by the fund manager/sponsor that negatively affects returns. So, instead of holding mutual funds, a well accepted alternative is to hold a combination of ETFs and hedge funds. For example, if you have a variety of mutual funds for US equity exposure, this could be replaced by a broad and inexpensive US ETF like VV, VTI or SPY. Overlaid on this would be a portfolio of hedge funds that would presumably be beta-neutral, in other words provide only alpha with no beta. This last assumption is rather unrealistic, but even if close to beta-neutral would at least align the portfolio better in terms of performance attribution and aligning fee structures (low for beta, higher for alpha) in a more appropriate manner.

3. Point #2 above generalizes ETFs as a means to beta exposure and hedge fund as the means to capture alpha. A third area of massive growth is in the use of derivatives. This is subject of a whole other blog entry, but it’s key to note that derivatives are a key component to both beta and alpha. Large institutions use swaps and futures instead of comparable ETFs for various broad market exposures/hedges due to the even lower costs. But of course, the use of ETFs is still an integral part of the process. In the past, I’ve mentioned the Yale Endowment (as have many others) and their significant use of alternative investments but there’s very little discussion of them in regard to beta exposures and specifically the use of ETFs. I recently discovered a site via the Kirk Report that lists some holdings from various “Pro Portfolios”. You’ll note some familiar ETFs in the list of Yale’s holdings. Hedge funds implement macro decisions and often apply the use of leverage through the use of various derivative strategies. In this case, the main selling point is not the low costs of derivatives but the massive liquidity available 24/7.

4. Although the concept of beta/alpha separation is relatively new to individual investors, but not so in the institutional investment industry, the concept can become quite blurred. The previous discussion on derivatives is one example. In my recent posting Can Retail Investors Profit From Hedge Fund Access?, I described how the ETF world is starting to evolve as greater levels of active management creep into this space. First we moved away from classic market cap weighted indexation to various alternative forms of indexing. Now we see ETFs allowing for private equity exposure.

Hedge funds traded on an exchange are the next step - although not technically an ETF these really are funds that trades on an exchange so the term does make sense… semantics really. If this trend continues, ETFs will no longer be an instrument for broad market exposure more associated with the concept of beta.

5. (Still with me?) Point 4 ends with ETFs moving from the beta world to the alpha world. I’ll confuse things further by letting you know that a new area of increased research in the academic world surrounds the replication of hedge fund returns using various passive exposures. The removal of active management from hedge funds?! First ETFs moving to alpha … now hedge funds built from beta! What is this world coming to? The end of bling? Relax, this is mainly in the research stage with very limited application in the real world as far as I’ve seen. Rest assured, there will always be a search for alpha. An industry built on fees based on competition and success within that competition revolves around a scarce commodity. That’s alpha.

6. In another previous posting, I discussed how the use of ETFs in a variety of creative ways, and especially through the use of inverse ETFs, allow investors to turn their portfolio into more of a “hedge fund”-like vehicle. As noted in my top-most link, the author from HedgeWorld.com notes that “Hedge funds are heavy users of ETFs, whether for the purpose of hedging positions or as a way to get easy exposure to a market.” Again, some blurring here of the beta and alpha worlds. However, in reality there’s nothing new here. Hedge funds have been trading beta exposures for the exact same purposes by way of derivatives for decades. All I’m saying in my post from earlier this summer is that the ordinary investor can trade beta in the hopes of capturing alpha.

I want to return back to point #1 above, where I mentioned briefly investor concerns of how mutual fund returns are dependent more on market returns versus the skills of the fund manager. Investors seem to be turning to ETFs as the low cost alternative where returns are very similar to the vast majority of comparable mutual funds. I also commented on hedge funds providing investors exposure to alpha, this being returns not associated to the oscillations in the capital markets but as a result of actions taken by a fund manager. But I said “hopefully”. This comment was made because greater evidence has been found, especially in more recent measurement periods, that hedge fund returns also have significant levels of beta. This is an even worse predicament as that found in mutual funds. Paying 1% (or whatever is the management fee for your typical mutual fund) for beta when you can get a comparable ETF for a fraction of the cost is bad. Paying 1% + 10% or 2% + 20% (management fee based on assets under management plus performance bonus based on returns over a certain hurdle or benchmark) for beta just plain sucks.

It’s important to note that the level of beta in the vast majority of hedge funds is nowhere close to that of mutual funds. What is of concern is the level of beta exposure in certain hedge fund strategies as well as the trend (potentially increasing). With a relatively low barrier to entry into the hedge fund industry, the amount of available alpha needs to be divided between an ever growing number of market participants. Thus, alpha becomes ever harder to find. For many practitioners, including myself, the exercise of “seeking alpha” is found through the strategic and sometimes tactical allocation of beta. In other words, I put greater emphasis on a certain type of timing (beta timing) versus stock or bond selection.

Truthfully, there is an aspect of securities selection in terms of finding exposure to new areas not covered in existing holdings in my portfolios. As mentioned numerous times in my previous entries, the addition of new positions (ETF or not) is to add a further bit of risk management to the overall program. An example would be my repeated emphasis on alternative energy considering the significant exposure to commodities, especially oil, found in broad Canadian indices. Of course, we adjust allocations when required as the effects of diversification has its limits. But this brings me back to the top and the proliferation of ETFs: A good thing whether you are a conservative buy-hold simpleton; an asset allocator seeking out new corners of the investment space whether it be country, sector or even strategy; or the next hedge fund manager opportunistically seeking true alpha.

The main theme of this piece is the separation and re-combining of beta and alpha. One common term for this is “portable alpha”. It just so happens that a great site, in fact one of the only sites, for more information on this area is from a fellow Torontonian, whose online alias is boldly “Alpha Male”. Here’s his site.

There’s an interesting new development in the alternative energy space that may soon apply to ETFs. The following is from Hedgeworld.com:

UBS today [Nov. 2] announced the launch of the first index to track emissions allowances. The UBS World Emissions Index will initially track two of the European Emissions Trading Scheme platforms and will potentially expand to include other emissions programs. The EU-ETS is the largest carbon dioxide trading scheme, and covers about 46% of European carbon dioxide emissions. The new index will be published in U.S. dollars, euro and Swiss francs.

This is an interesting play on what looks to be the big issue of this century: global warming. Further from this press release:

The timing for the launch of the new index couldn’t have been much better. Carbon dioxide emissions are seen as one of the main factors in climate change and global warming, and the index has been presented in the same week that Sir Nicholas Stern, head of the Government Economics Service [United Kingdom] and adviser to the U.K. government on the economics of climate change and development, presented his influential report, The Stern Review on the Economics of Climate Change.

Here is a short executive summary on this report (.pdf). And here’s the main page for further information.

Lastly, this section from the same press release gives an indication of current product development efforts as well as constraints:

UBS has already structured products on the new index, available in the index’s three denominations. “Open End PERLES on UBS World Emissions Excess Return Index” products were launched today, and the subscription period will remain open until Nov. 24, which will be the pricing date. The pre-announced bid-offer spreads—1.75% when markets are open and 3% when markets are closed under normal market conditions—are an indication of the currently limited liquidity in the underlying markets.

We could potentially see some form of fund structure providing exposure to this important new market in the not too distant future. Certainly, this would be a good compliment to PBW and uranium related holdings as diversifiers to long energy holdings.