Sometimes I kind of look at what I do as similar to a sell side analyst at a big I-bank. The only difference is instead of looking at stocks in a particular industry sector, I study ETFs. So consider this when reading below, as the first half is news regarding a revamping of index constitution and the second half is my speculation on changes to Canadian ETFs as a result.Thanks to Credit Suisse’s Quantitative Trading and Derivatives Strategy group for their “Index Analysis” report last week on some changes that will occur to S&P/TSX Canadian equity indices:

**************************************************************************

- S&P has announced that the S&P/TSX SmallCap index methodology has been revised and the index will now be independent from (and may include overlaps with) the S&P/TSX 60 and Composite indices.

- The S&P/TSX MidCap index will be renamed the S&P/TSX Completion index - containing the stocks in the Composite index that are not in the S&P/TSX 60.

- These changes will become effective at the March quarterly review on March 16th, 2007.

- There are relatively few assets indexed to the current MidCap or SmallCap indices, so there should not be much index trading resulting from the changes.

Structurally, the new SmallCap index will have significant overlaps with the S&P/TSX Completion index (and by association the S&P/TSX Composite as well). Best guess, roughly 67% of the SmallCap index cap will be in the Completion/Composite indices (conversely, about 25% of the Completion index cap will be made up of SmallCap constituents). Therefore, this means that funds indexed to the Composite index would be “double-counting” a sizable portion of stocks if they decided to track the SmallCap index as well.

S&P decided to make this change after consulting with the Canadian investment community and feeling that this was what they wanted. In many ways, it is similar to Russell’s introduction of their MicroCap index in the U.S., which overlaps with the Russell 2000 SmallCap index. So far, it doesn’t seem as if the Russell MicroCap index has gained much traction, with many investors questioning the logic of having two indices that overlap so much.

At the same time, MSCI decided recently to do the opposite with their global index products. MSCI is moving from an independent small cap index, which also had overlaps with their standard indices, to a modular set of indices that fit together by cap.

It will be interesting to see who makes the most headway in the small cap space, and if the modularity of the MSCI indices entices any index funds away from S&P in Canada.

**************************************************************************

In the Canadian ETF space, specifically in traditional market cap weighted equity index ETFs, Barclays has the dominant, if not exclusive market. I don’t know what MSCI can do in Canada within the ETF market since BGI basically has all its ETFs aligned with S&P indices.

As S&P makes the above changes, I see little doubt that BGI will make adjustments to the mandates of its ETFs. The problem is that there will likely be some confusion as the small cap and “completion” index have underlying positions that overlap. This double counting will make both indices partial small/mid cap indices or or the commonly termed “SMid”. It will be interesting to see how BGI deals with these changes by S&P. Changes to mandates is not new as BGI’s bond ETF changed from a fixed government bond ETF to one linked to the Scotia Capital Bond Universe Index. In addition, BGI recent revised its gold company ETF from Canadian miners only to a global mandate.

With all the potential changes described above, after all is said and done, we could see (although I can not guarantee this as it will of course be dependent on BGI Canada):

1. XIC to cover the broad market

2. XIU for the large caps

3. XMD for the mid caps with some small cap exposure, or as they call it the “completion” index

4. X?? for small caps with some mid cap exposure

From this link bringing you to the following Standard and Poor’s website (http://www2.standardandpoors.com/portal/site/sp/en/ca/page.topic/indices_ts xsml/2,3,2,3,0,0,0,0,0,5,2,0,0,0,0,0.html) I have found the following information on their existing Canadian small cap index as of November 30, 2006:

Probably not surprising that there is a heavy (60%) weighting to commodities.

Bottom line: We could be seeing a new small cap ETF from BGI in the 2nd quarter of 2007. There has been considerable ETF development in the small cap scope globally especially from WisdomTree, but I don’t know of anything specific in terms of Canadian equities.

For interested investors, the idea of the existing mid cap ETF (ticker: XMD on the TSX) becoming more of a Smid ETF may sound interesting for some resource tilted exposure on the lower end of the capitalization scale.

For those familiar with the US ETF industry, you’ll know that the US equity market has been overly sliced and diced by market cap, style, industry, etc. For investors interested in exposure to the Canadian equity markets, the choices have been relatively limited. Although the potential addition of a small cap ETF provides only a small, incremental addition for investors, it could be a sign of future growth potential in the industry. We could see more slicing and dicing of other geographic regions in a similar manner, although likely not to the same extent as the US market. Although good in terms of choice, this could increase the average costs of ETFs.

Take the Canadian ETF space as an example: With XMD, the Canadian mid-cap equity ETF currently at 55bps MER (same as BGI’s sector ETFs), I would guess that a small cap ETF would be at best 55bps but wouldn’t be surprised if it were a bit more expensive.

This push to relatively expensive niche ETFs will hopefully be offset in kind by relatively large and broad ETFs with sub-10bps MERs. The ETF industry clearly appears to be moving in this direction of polarized product development.

Further to my posting from two months ago we now have details on SSgA’s new streetTRACKS DJ Wilshire International Real Estate ETF (RWX). Although there are closed end funds covering international real estate, this is the first ETF to cover this fairly broad [although neglected] asset class. In the case of RWX, it tracks the Dow Jones Wilshire ex-US Real Estate Securities Index. Here’s a chart for this index from the DJ Wilshire Index website which seems to show something close to a 30% return since mid July:

click to enlarge

Clearly, a strong trend up since the summer. Very similar to the Northern Global Real Estate Index Fund [NGREX] which I mentioned in my article from October. Here’s its latest chart:

The recent 2% drop is rather modest compared to the 17% run up since the fund’s inception in early August. Still, we’re talking about time series data that’s far too short for proper analysis. Luckily, Dow Jones provides data for its indices and you can find data specific to its DJ-Wilshire real estate indices on its site.

Some further information on the The DJ-Wilshire ex-US Real Estate Securities Index and the DJ-Wilshire ex-US Real Estate Investment Trust Index can be found in a handy fact sheet [PDF].

More detailed explanations regarding the composition rules in general for the DJ-Wilshire Real Estate Indices can also be found.

After digging through all this, I suppose a good question is how much of a diversifier international real estate really is. Here’s the chart comparing NGREX, SPY and iShare MSCI EAFE Index (EFA):

Again, it’s a short time period and we’ve seen relatively high correlations among most asset classes [both in up and down markets] over the past few years. But this picture really does not provide much comfort of international real estate as a diversifier to broad equity market exposures.

So, now we roll up our sleeves are dig a bit deeper. Using the data from the Dow Jones website for their ex-US Real Estate Securities Index, I show here a simple/crude Excel-built line chart for its price alongside the S&P 500 Index going back about 8 years:

Perhaps not a fair comparison as one index is for the US and the other is for everything outside of the US. So I redid the chart to include EFA which only allows for data going back to August 2001:

We can see that in the international space, real estate has been an outstanding performer, greatly outperforming the broader MSCI EAFE Index, albeit the ETF’s performance is net of some fees but the scope of the difference remains the same. In terms of a diversifier, we can see that real estate securities appear to go down hard [if not harder] than the broader equity markets in times of distress [2002, spring 2004 and summer 2006]. As strong as the S&P 500 and MSCI EAFE have been since this past summer’s correction, the DJ-Wilshire ex-US Real Estate Securities Index has shown even more spectacular growth.

For anyone who is weary of recent highs attained by many broad market indices [US, Canada, various other regions and sectors], you have to wonder how much more gas is in the tank for international real estate.

According to Reuters, Standard and Poor’s were to launch Shariah-compliant versions of some of its equity indices yesterday. [Shariah forbids Muslims from receiving interest payments and from investing in companies involved in the production or sale of pork, alcohol, tobacco, pornography, gambling and non-Islamically structured finance or life insurance.] The indices - the S&P 500 Shariah, S&P Europe 350 Shariah and S&P Japan 500 Shariah – are very similar in nature to Socially Responsible Investing [SRI] indices such as those by KLD.This is not a new index in this space, by any means, as it comes out to compete with a similar index from Dow Jones which was launched back in 1999.

No details yet on how the S&P index is constructed, but the Dow Jones site gives the following description of the composition guidelines for its DJ Islamic Market Index:

The selection universe for the DJIM Index is the Dow Jones World Index, which covers approximately 95% of the float-adjusted market capitalization of 44 countries that are open to foreign investors. For the complete methodology of the Dow Jones World Index see Guide to the Dow Jones Global Indexes.

The DJIM Index includes all securities in the Dow Jones World Index that pass the following screens for Islamic compliance:

Industry Type: Excluded are companies that represent the following lines of business: alcohol, tobacco, pork-related products, financial services, defense/weapons and entertainment.

Financial Ratios: Excluded are companies whose:

* Total debt divided by trailing 12-month average market capitalization is 33% or more.
* Cash plus interest-bearing securities divided by trailing 12-month average market capitalization is 33% or more.
* Accounts receivables divided by 12-month average market capitalization is 33% or more.

Since 2000, there has been a fund traded on the NASDAQ which, although has the term “Index” in its name, could be classified as only a “partial index fund”. This is the Dow Jones Islamic Index K (IMANX).

According to Google Finance:

The fund normally invests at least 80% of net assets in domestic and foreign securities included in the Dow Jones Islamic Market indexes, as well as up to 20% of net assets in securities chosen by the fund’s investment advisor that meet Islamic principles.

So the fund is 80-100% passive, 0-20% active. More on the fund, its mandates and the managers who run it can be found on its website.

Performance wise, there’s not much difference to the S&P 500 as shown in this 3-year chart:

There’s also another Shariah-compliant index from FTSE and its site also gives details on its composition rules.

In terms of investable instruments and specifically ETFs, I don’t think there’s much out there. Here’s something I found information regarding an Islamic Index ETF but it’s traded in Kuwait.

Thus, for anyone interested in this type of mandate in a quasi-index form, the choices are pretty much limited to IMANX.

For those of you who have shown interest and may even be invested in the water ETF, PowerShares Water Resources (PHO), here’s some good news to bring water investing into a broader global perspective. According to AMEX:

The American Stock Exchange [Amex] [has begun] publishing Palisades Global Water Index [PIIWI] over the Consolidated Tape. The index will be published daily every 15 seconds between approximately 9:30 AM and 4:15 PM starting on Monday, December 11, 2006.

Palisades Global Water Index - PIIWI

The Palisades Global Water Index [PIIWI] is a modified equal-dollar weighted index comprised of companies worldwide that are engaged in the water industry. The benchmark Index includes international companies traded on major stock exchanges around the world. The component companies are positioned to benefit from the rapidly accelerating water resource challenges associated with the demands of growing world economies in conjunction with human health and ecological sustainability. The Index was established with a base value of 1,000.00 at the close on December 31, 2003.

Palisades Indexes expects the introduction of an ETF to track the Palisades Global Water Index as soon as Q1 2007.

The latest PHO related article from Alligator Investor provides some pretty strong material for the marketing team at PowerShares, who I would speculate is working on the global ETF version to go alongside PHO. With the heavy “home bias” seen in many US domiciled ETFs, it would not be surprising to see further product development in terms of global versions of existing ETFs.

Case in point, the news of upcoming leveraged and inverse ETFs from Rydex to go up against those from ProShares which have reached the $2 billion mark after launching only in June of this year. According to the prospectus there are 96 ETFs. Amazingly, they’re all focused on the US market. They’ve sliced and diced the market thinner than any Ginsu knife could. And so the opportunity arises. What ProShares has started, Rydex has saturated. I’ll again state the obvious - the market will decide which of these funds are worthwhile. As an ETF user, I’d like to have seen Rydex go that extra mile and provide some international exposure. I have a strong feeling that a new Canadian based ETF manager may provide these globally oriented mandates. More on that if and when it happens.

I read a most interesting article submitted last week from Matt Hougan, of IndexUniverse.com, regarding the “Superbowl of Indexing” conference in Arizona. Here are some of my thoughts on Matt’s observations:

• “The Indexing Swagger”: This is an interesting paradox. The irony is that the ETF industry, and those who are proponents of the implementation of ETFs within an investment portfolio, have based their arguments on the fact that active management is filled with many flaws that, in aggregate, form a drag on investment returns. The main factor is costs [trading costs, management fees, tax implications, etc.]. But another factor is simply that it’s difficult for an active manager within a particular asset class to beat his or her relative benchmark, after costs. Furthermore, for the relatively small number of managers who do beat the index in a relatively consistent manner, it is very difficult for investors to select them in the appropriate time.

This leads to the fact that many investors have returns worse than the appropriate index, as well as a buy-hold strategy of the median fund [both for the appropriate asset class]… the exercise of getting in and out of mutual funds is actually detrimental to their portfolio’s performance. So, to me at least, the indexing industry is one built on a philosophy of humility. “It’s difficult to beat the index, so why not just match it” is a common phrase used by some index providers. This mentality does not come with a swagger. But I suppose times are changing. I can’t quite imagine a bunch of dark suits in Arizona doing a John Travolta strut at last week’s event. Furthermore, based on where the industry has come from, I am a bit disconcerted about the shift away from the traditional view of indexing as a means of truly passive investing.

• This last sentence I’ve written above is rather hypocritical of me to write. I come from the hedge fund industry, where I started in the industry tactically trading financial futures as well as ETFs [back when they were called WEBs]. At that time there was only a small number of instruments like SPY and QQQ that had significant liquidity. It would be naive of me to think that there are not many other market participants who have been trading ETFs [and other instruments for cheap and broad beta exposures] in a highly active manner. Thus, it is not at all surprising to me that tactical asset allocation [TAA] is a big buzzword in the ETF industry. With the number of geographical regions, industry sectors, and investment styles now available through ETFs, what would you expect but for investors and managers to build TAA programs.

In reality, anyone can be a hedge fund manager and applying a global macro mandate is the logical next step beyond TAA. My disconcerted feelings stem from the fact that, even with my background in trading beta, I honestly believe that a core portfolio of well diversified market exposures managed more in a “strategic asset allocation” context, rather than a “tactical asset allocation” context, is most prudent. This certainly would make sense for one’s tax deferred investment account. I suppose there’s a balance to have a conservative core portfolio built with a low cost, broadly diversified “Boglesque”-type mandate and superimpose on this a more ambitious TAA-type mandate. This leads to a portable alpha approach to portfolio management, which is gaining significant acceptance in the institutional world. Only with ETFs is portable alpha a realistic possibility for retail investors and next year’s EDHEC Asset Management conference in Geneva is a good example of this.

• I read with great interest Matt Hougan’s comments in the section titled “The Flipside [And Scarcity] Of Alpha”. In the past, I’ve written about my concerns for finding alpha. I’m not sure if it will get harder as hedge funds are in the business of finding new markets and new strategies to exploit market inefficiencies. What concerns me is the large number of market participants that quickly enter such areas and dilute the opportunity set. The concept of ETFs attempting to “beat the market” is, to me, simply an explanation of how the industry is moving away from market cap weighted indexing. I don’t think Malkiel, Bogle and other like-minded individuals will be able to alter the shift that is occurring. Whether it’s good for investors is yet to be seen. I suppose my only concern is if investors get caught in the same trap as in the mutual fund world … trading too much too often leading to suboptimal portfolios with poor performance. Essentially, chasing returns.

• The rest of the piece covers some fairly obvious observations in the ETF industry, such as the recent focus on commodities as well as the push to greater international exposure.

What I would like to leave off with is a short list of other upcoming industry conferences that relate to the world of beta [not just specifically ETFs]. The previously cited event by EDHEC is geared towards professionals in the wealth management space, but most beta management conferences are organized for institutions. Here are some interesting ones:

World Series of ETFs: March 26-27, 2007, Miami, Florida. This is from the same organizers as the “Superbowl of Indexing” conference. Not as big of an event but likely lots of overlap if you missed out last week. Probably the best mix of retail and individual representatives you could find for an ETF event.

Beta Risk and Management: January 24, 2007, The Harvard Club, NYC.This conference is for the institutional crowd although there’s no reason why the concepts discussed here can not be applied to the individual investor’s portfolio.

A New Understanding of Hedge Fund Returns: February 12 - 14, 2007, The Landmark, London, United Kingdom. This is where things get complicated as the world of beta and hedge funds collide. A major area of discussion will definitely be replication strategies including the works of Harry Kat. We can only wonder if Goldman Sachs will be there to discuss their recipe as well.

World Cup of Investment Management: February 5-6, 2007, Rome, Italy. A last thought on the increasing dominance of ETFs. Here’s the agenda for a conference [again from the same organizers as the “Superbowl of Indexing” conference] but this one has a title that is much broader. Note the topics listed for day one. Nearly all discuss ETFs. Some related topics [enhanced indexing, commodity indexing] get pushed into day two. Many of the other topics revolve around broader portfolio discussions [asset allocation, portable alpha, risk management], but you can see how significant the area of beta is for an event that is not marketed as a World Cup of Indexing but a World Cup of Investment Management.

Still can’t get that Travolta strut out of my head.

Bloomberg recently published an article that gives a sort of “state of the union” review on the hedge fund industry. The following are some interesting points that I wish to extract from this article:

“Since 2000, the secretive world of hedge funds has more than doubled in size. There are now more than 9,000 of these funds with combined assets of $1.34 trillion. Everyone from Wall Street chieftains to the stewards of retirement nest eggs is chasing these funds …”

“Investors poured a record $110.7 billion into these vehicles during the first nine months of 2006 — more than twice what they did in all of 2005.

So many hedge funds have crowded into the markets that the industry is struggling to generate standout profits. As of Sept. 30, the average hedge fund was up 7.1 percent in 2006. Investors would have made more money buying a mutual fund that tracks the Standard & Poor’s 500 Index, which returned 8.5 percent through September.

And while hedge funds typically charge a fee of 2 percent of assets and take a 20 percent cut of profits, the Vanguard Institutional Index Fund charges expenses as low as 0.025 percent of assets.

Investors are coming to grips with slackening returns. At the California Public Employees’ Retirement System, Senior Investment Officer Christy Wood says hedge funds may have a hard time hitting her investment goals because of a rise in U.S. Treasury yields. Calpers, which has invested about $4 billion in hedge funds, targets a return of 5 percentage points more than T-bill rates. In 2003, that figure was 6 percent. On Nov. 8, with T-bills yielding 5.1 percent, it was more than 10 percent. “It doesn’t take a lot of research to realize that you’re going to have a harder time reaching that today,'’ Wood says.

The remainder of the article discusses new areas that hedge funds are exploring in their search for improved returns. Actually, most of the areas discussed are not new to hedge funds so it’s just a review of what areas are relatively hot: emerging markets, distressed securities, event driven, activist funds, etc.

The End of the ‘Alpha-Centric’ Mentality?
Based on the points listed above, perhaps we’re seeing the large hedge fund “conglomerates” understand and acknowledge the reality of “hedging their bets” (sorry). Hence, the recent press from the Financial Times regarding Goldman Sachs (GS) and their entry into hedge fund replication strategies.

This is an interesting development since, according to the same Bloomberg article above, Goldman Sachs is “ … the largest manager of hedge fund money, with $29.5 billion in assets …”

On the one hand, a firm like Goldman Sachs must be in the business of alpha, that rare commodity which is based on a manager’s ability to provide something beyond what the broad market itself can provide. Heck, they personify alpha when you consider what they supposedly know and the money they make.

The use of a program to replicate hedge fund strategies deviates from this “alpha-centric mentality” and suggests that the costs of highly active management are now making a significant impact. Clearly, institutional investors are demanding a true assessment of the costs of active management. For those who conclude that the costs they pay for something (alpha, diversification, access to niche managers, whatever it is they think they’re getting) are too high, we are seeing the industry’s attempt to respond.

I only wonder how GS and other entrants in this specialized area will market replication strategies. Will they add it to existing multi-manager hedge fund programs in an attempt to lower overall costs for the mandate? The FT piece claims that GS is charging a flat 1 percent fee. Are costs a consideration, but secondary to the attempt to achieve better, or specifically, more optimal programs to compliment a client’s core portfolio?

Is liquidity and transparency the bigger issue? According to the article it will be far more liquid, with trading available on a daily basis.

“This may be ideal for any large institution that has been looking at hedge funds but doesn’t like the fact that it takes six months to put money [in] and to take it out again,” said Edgar Senior, executive director in Goldman’s fund derivatives structuring team.

With all of these enticing attributes such as low cost and liquidity, my final question would be what’s stopping Goldman Sachs or someone else from building an ETF based on the underlying Absolute Return Tracker index? Nothing I suppose. One of the big problems in the hedge fund industry, especially with the “retailization” of hedge funds is the relative high level of expectation versus actual performance in aggregate. For ordinary investors getting into a hedge fund ETF, my fear is that this trend would continue.

Bottom line: It is way too early for me or anyone to make any conclusions based on recent developments. Hedge fund replication strategies require enormous resources in terms of checking “under the hood”. I hope to focus quite a number of future entries on this emerging area.