A big thanks to David Hoffman at InvestmentNews.com (who covers ETFs in a big way!), as we now have more information on the new infrastructure ETF that I wrote about Saturday. SSGA’s infrastructure ETF begins trading today under the ticker GII. Some further details on the underlying index are in this latest press release from SSGA:

State Street Expands International ETF Offering

New SPDR Tracks Infrastructure Investments in Developed and Emerging Countries

BOSTON–Jan. 29, 2007–State Street Global Advisors (”State Street”)*, the investment management arm of State Street Corporation (STT), today announced that it will launch the SPDR[R] FTSE/Macquarie Global Infrastructure 100 ETF (GII) on January 30.

This SPDR seeks to track an index of developed and emerging country stocks involved in infrastructure industries such as pipelines, transportation services, electricity, water, and telecommunications. The Macquarie Global Infrastructure 100 Index, calculated by leading global index provider FTSE Group, serves as the underlying benchmark for GII.

“With the launch of this SPDR, we are responding to our clients’ demands for access to stocks that cover infrastructure industries on a global scale,” said Anthony Rochte, senior managing director of State Street Global Advisors. “This product is part of our steadfast commitment to provide quality offerings that precisely align with investors’ investment strategies.”

This SPDR complements State Street’s series of international ETF offerings. Recently, State Street launched the SPDR[R] MSCI ACWI (All Country World Index) ex-US ETF (CWI) on the American Stock Exchange[R] (Amex[R]). It is benchmarked against the MSCI All Country World exUSA Index and includes both developed and emerging markets outside of the United States.

State Street manages more than $113 billion ETF assets worldwide (as of December 31, 2006) and is one of the largest providers in the U.S. and globally, with a market share of more than 20 percent.** State Street continues to experience significant demand for these investment strategies and today manages a total of 70 ETFs worldwide.

About State Street Global Advisors

State Street Global Advisors, the investment management arm of State Street Corporation, delivers investment strategies and integrated solutions to clients worldwide across every asset class, investment approach and style. With S$1.7 trillion in assets under management as of December 31, 2006, State Street Global Advisors has investment centers in Boston, Hong Kong, London, Milan, Montreal, Munich, Paris, Singapore, Sydney, Tokyo and Zurich, and offices in 25 cities worldwide.

* The Funds are advised by SSgA Funds Management Inc., a registered investment adviser and a wholly owned subsidiary of State Street Corporation.

** Source: SSgA Advisor Consulting Services as of December 31, 2006

ETFs trade like stocks, are subject to investment risk and will fluctuate in market value.

Foreign investments involve greater risks than U.S. investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.

Funds investing in a single sector may be subject to more volatility than funds investing in a diverse group of sectors.

The Macquarie Global Infrastructure 100 Index is a trademark of Macquarie and has been licensed for use by State Street Bank and Trust Company through its State Street Global Advisors Division. The SPDR[R] FTSE/Macquarie Global Infrastructure 100 ETF is not in any way sponsored, endorsed, managed, sold or promoted by FTSE International Limited (”FTSE”), Macquarie Bank Limited or its affiliates or subsidiaries, the London Stock Exchange Plc (the “Exchange”) or by The Financial Times Limited (”FT”). For further important information and disclaimers regarding Macquarie, see spdretfs.com.

The “SPDR” trademark is used under license from The McGraw-Hill Companies, Inc. (”McGraw-Hill”). No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by McGraw-Hill.

The SPDR[R] MSCI ACWI ex-US ETF is based on an MSCI Index. This ETF is not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such financial product or any index on which such financial product is based. The prospectus contains a more detailed description of the limited relationship MSCI has with State Street.

The Macquarie Global Infrastructure 100 Index ('’MGI 100 Index'’) calculated by the Financial Times Stock Exchange ('’FTSE'’) is designed to reflect the stock performance of companies within the infrastructure industry, principally those engaged in management, ownership and operation of infrastructure and utility assets. The MGI 100 Index is a composite of the broader Macquarie Global Infrastructure Index ('’MGII'’) which is based on 255 stocks (as of September 30, 2006) in the FTSE Global Equity Index Series. The MGI 100 Index is based on the universe of the MGII with a further country screen allowing only constituents in the FTSE developed and FTSE Advanced Emerging regions. Eligible countries from the MGII are then re-ranked by investable market with the top 100 being included in the index.

The MSCI ACWISM ex USA Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in all global developed and emerging markets outside of the US.

State Street Global Markets, LLC, member NASD, SIPC, distributor.

Note: Just after getting the notice yesterday of GII’s eminent launch, I find today that there’s nothing on my screen when I punch up GII. Being the sharp guy that he is, I see on Roger Nusbaum’s site (http://randomroger.blogspot.com/2007/01/gii-delayed.html) that he has seen the same. Wouldn’t it be funny (I guess not “ha ha” funny over at SSGA) if PowerShares or Claymore quietly launched their infrastructure ETF right about now? No, I don’t have anything at all as evidence that either of them, nor anyone else, is working on an infrastructure ETF but something like that would not surprise me at this juncture of the ETF industry’s development.

Hedge Fund Daily, an online daily newsletter from Institutional Investor magazine, published an interesting piece on the use of index instruments by hedge fund managers. The article revealed that, according to VanthedgePoint Group’s second annual Emerging Hedge Fund Manager Sentiment Survey, more than three out of five emerging hedge fund managers are now using index products.The latest poll found that 62% of emerging hedgies say they are using indices and another 8% are considering them, compared with just 44% in the 2006 survey. In addition, 70% of respondents note that raising capital and marketing is the most difficult aspect of running a hedge fund. As for the sentiment side of the survey, VanthedgePoint found:

57.4% are neutral on the U.S. economy, while 32.8% are bullish.

44.3% are neutral on U.S. equity markets, while 37.7% are bullish.

Sectors in the U.S. stock market seen as performing best in 2007 are technology (41%), financial services (31.2%), consumer goods (26.2%), food and beverage (21.3%) and defense (21.3%). Worst performers: automotive (32.8%), real estate (27.9%), energy (21.3%) and home building/furnishing (21.3%).

36.7% says large cap stocks will perform best this year in the U.S., while internationally, 34.4% predict China and Japan will be top performers. Latin America and Russia were considered the worst places to invest this year by 37.7% and 23.0%, respectively.

U.S. equities were voted best asset class for 2007 by 44.3% of respondents, followed by international equities (31.2%). Worst performers: real estate (27.9%), high yield debt (24.6%) and commodities (21.3%).

The observations by the survey are worth noting. According to VanthedgePoint, the 2006 survey accurately predicted rising energy costs, a real estate market slowdown, and which sectors would perform best. About half those participating in the survey managed hedge funds with under $10 million in assets, while more than 85% manage less than $100 million. Nine of 10 polled live in the U.S.

I wish there was data more robust than that of this survey (we don’t know much of the sample size in this case). We do know that there is a significant US-centric bias with 90% of respondents being in the US. Interesting to note just how small the respondents were given that half have less than $10 million in assets under management … that’s what you get from an “Emerging” hedge fund manager survey. It’s easy to be agile with such a small fund versus a billion dollar fund especially if dealing directly in stocks. Market impact and so many other factors actually become rather “non factors” with the management of a small fund, thus you see a lot of hedge funds capping at a certain size. Of course, mutual funds don’t cap because they get paid solely on a function of assets under management and closet indexing is easy at any size.

Back to hedge funds: With many funds being of the $10 million size and under, it’s no surprise that hedge fund managers, especially the large number that are small, have to use ETFs in addition to futures. The common thinking was that ETFs were just for added beta exposures, but we can see that for hedge funds it’s also because of size constraints. It would be interesting and useful to fully understand what proportion of the ETF market is held by hedge funds and how big this proportion has been growing over the past 3 years. It wouldn’t surprise many of us if the percentage was a high number for something like VIX futures but we may be surprised at the proportion of SPY positions held by hedge funds. Well, maybe not so much of a surprise if you think how many “emerging” managers are out there.

Also of interest is a piece from Rob Carrick at the Globe and Mail that discusses changes in regulations that will allow hedge fund managers to be allowed more freedom regarding the use of ETFs.

Carrick quotes me near the end of his article but my comments are repetitive of what I’ve written here for SA over the past month. The main take away from the article are these two sentences which refer to reduced constraints in terms of margin requirements for ETF investing:

“Hedge funds will be able to buy ETFs by putting down a minimum of just 15 per cent of the actual cost and borrowing the rest, down from the current 50 per cent. Many hedge funds love to buy on margin because it magnifies their potential gains — and losses, of course.”

Carrick asked me my opinions regarding the ETF explosion and their use by hedge funds but he wasn’t able to give me any exact ruling or text direct from the SEC. My thoughts now are that this change in margin requirements for ETFs apply to all investors not just hedge funds. Of course, he assumes correctly that this reduced constraint will be taken full advantage of by highly active investors such as hedge funds. Whether this is good or bad for the less active ETF investor is debatable. Yes, the aggregate effect of hedge fund use of ETFs could result in excess momentum.

My bigger fear is that ETF product development in aggregate could be added fuel in what looks to be a longer than expected bull market. We hear about M&A activity, low inflation due to cheap labor in Chindia and another dozen reasons for this bull market that started well over four years ago. But what happens when things go bad. This past summer could be a relative hiccup in comparison. I’m not calling for a correction or crash anytime soon, although a correction in the next couple of months wouldn’t surprise me at all, but you have to wonder what the effect of the recent ETF explosion will have. I hate to call the ETF product development of the past few years the beginning of a bubble but could it lead to a bunch of smaller bubbles in various asset classes … commodities for example?

If so, I’d be interested in seeing how the hedge funds do. Those that have survived the past four years (ideal buy-hold long only strategy environment), must be aching for some bubble bursting (recent copper action is a good example). In terms of a more sustained and severe down markets, which we haven’t seen now for about five or six years, the result would be massive shorting of various ETFs. Of course, the hedgies will also be shorting in the derivative markets, their more traditional playground. However, the derivative product makers, like mutual fund companies must also be concerned about the ETF assault, and the fact that hedge funds may be looking to an ETF instead of a derivative contract to get access to a particular asset class. Everybody’s got to watch their back. Sounds familiar.

Bloomberg News has the scoop on an ETF for a new asset class. Well, ‘new’ except for the hundreds, if not thousands, of large institutional investors who have already implemented exposure to the infrastructure sector.

Details of the fund

The article states that the fund will track the Macquarie Global Infrastructure 100 Index. It also specifically mentions the following sub-sectors:

• Telecommunications companies
• Electricity companies
• Water companies
• Gas-distribution companies

For anyone outside of Australia, the name Macquarie is synonymous with nothing but infrastructure investing. A Google search on this index leads you to this FTSE website that covers the Macquarie Global Infrastructure Index Series which according to the site is composed of:

• Macquarie Global Infrastructure Index
• Macquarie Global Infrastructure 100 Index
• Macquarie Global Infrastructure Hedged Index
• Regional infrastructure indices: Australasia, Japan, North America, Europe and Asia Pacific/Japan/Australia/New Zealand
• Sector indices: global oil & gas pipelines, global transportation services, global telecommunications equipment and global utilities with subsectors of global electricity, multi-utilities, gas distribution and water.

A lucky break: If you check out the “Constituents” subpage, it actually provides details for only one index which happens to be the one in question, the Macquarie Global Infrastructure 100 Index.

We find that nearly half of the positions are from the US with the internationals consisting primarily of EAFE plus Canada. For those looking for some BRIC exposure, I only see three Brazilian positions. The Bloomberg article refers specifically to “companies in countries including the U.S., Australia, U.K., India, Brazil and Russia”.

However, contradictory to the article, I see nothing in terms of direct exposure to India or Russia on the constituent listing. Nothing in China. Likely, the Bloomberg article implies that many of the companies in the index have significant exposure to these countries, but it could also be an oversight.

Infrastructure – New hot sector?
Another hot sector justifying the pumping out of a new ETF? Not so in this case. Let’s look at a few existing closed end funds in the sector — I’ve limited them to those also from Macquarie:

Macquarie Infrastructure Company (MIC)

Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund (MFD)

Macquarie Global Infrastructure Total Return Fund (MGU)

OK, I lied. These funds are near their highs. Don’t pretend like you’re shocked. I, like many others, have been talking about this type of occurrence for a while. However, in reality, I don’t see this as a “hot” sector that is out of line in terms of overvaluation. Certainly, we’re not anywhere close to a mania in this area.

It’s true, large and sophisticated institutional investors (mega-pensions with over $100 billion in assets) are buying ports, toll highways and other large scale infrastructure projects, but I believe there is much more in the pipeline available for all other investors as various global economies are modernizing to something more similar to what we have.

Global exposure and the search for yield
Take the most often cited story of this decade: India and China. India’s “golden quadrilateral” super-highway and its associated network of roadways are in their early stages. If India is to be the US of the future, then what is to stop India from having a highway system similar to that of the US? Break out your atlas or give your globe a spin and you’ll see that, geographically speaking, India is about a third the size of the US. It’s not small and there is a large (understatement here) group of middle class workers who will want to experience the freedom of driving.

What about China? Like South Korea in 1988, there will be an explosion of tourists who will come after the Olympic games to explore China. China is already working on expanding its airports and highways for the expected traffic. They’re going to need it and more… aside from Beijing and Shanghai, most of China looks more like a truly developing country rather than a major cosmopolitan center. Although the prospects for an ambitious highway complex as in India may not be developed soon, there are so many other areas of infrastructure where China will need significant amounts of investment.

In terms of recent product development, State Street Global Advisors is on a bit of a roll with this ETF and their recent SPDR® MSCI ACWI (All Country World Index) ex-US ETF (CWI). Kudos to them on bringing a key and missing alternative asset class on line.

To some observers, infrastructure is an industry class just like technology or financials. I think that the institutions see infrastructure as an asset class because it is different in that it’s a bit like private equity in many cases, but more importantly it provides one thing that they, especially pension funds need: flow. Flow, meaning cars on a toll highway, planes passing through an airport, oil flowing through a pipe, data traveling through fibre optic cables. To them, this flow equals income.

If you go to the above charts online via bigcharts.com, you will be given some statistics along with the charts. For example, from the chart for MGU, we can calculate the 12-month price return as just over 30%. However, this does not include the 12.5% yield (according to BigCharts.com), paid through quarterly distributions.

Infrastructure is an area that interests me so I get updates directly from Macquarie. A December 6, 2006 press release mentioned the following:

NEW YORK, December 6, 2006 – Macquarie Global Infrastructure Total Return Fund Inc. (NYSE: MGU) (the “Fund”) yesterday declared its regular quarterly distribution for the period ending December 31, 2006 of $0.40 per share.

Based on the Fund’s net asset value of $29.37 and New York Stock Exchange closing price of $27.37 on December 5, 2006, the $0.40 per share distribution is equal to an annualized distribution rate of 5.45% at NAV and 5.85% at market price respectively.

The $0.40 per share quarterly distribution reflects a distribution policy of the Fund intended to provide shareholders with a relatively stable cash flow. This policy may be changed or discontinued without notice to investors.

In addition, the Fund declared a special annual distribution of $0.50 per share relating to additional short term capital gains earned on the sale of portfolio securities during the year.

This is just one example, but in the search for yield, infrastructure delivers. In this environment, this is not only true for the mega institutions, but for all investors. A significant global economic slowdown could put a dent into many sectors including some of those that may be classified under infrastructure, but only for a relatively short time. Infrastructure is one of those “must haves” in life. Again, kudos to SSGA.

To be perfectly honest, SSGA, like Barclays Global Investors, is more known for relatively low cost, broad exposures with their ETFs. If I were a betting man, I would have guessed that something as unique as this new infrastructure ETF would have been brought to market by one of the new and smaller players like PowerShares, Van Eck or Claymore.

I’ve been thinking lately that maybe the ETF industry would start to diverge where the big providers (SSGA, BGI, Vanguard) would go “Wal-Mart” and stick to broad, low cost exposures while the newer entrants would focus on higher margin niche products. I guess not. Everybody’s got to watch their back. Just the way I like it.

The fixed income ETF space is another area where we could see some serious expansion. International bonds, even in emerging markets, has been of great interest to a wide variety of investors in the global search for yields. So the good news is that along with BGI’s release of new fixed income ETFs on top of the six they had at the end of 2006, Vanguard is coming along with their first foray into the space. Vanguard has filed a registration statement with the SEC to offer ETF versions of four existing Vanguard bond index funds. Vanguard ETFs are structured as separate share classes of an existing Vanguard mutual fund counterpart.

The bad news is that Vanguard isn’t really venturing into new territory. Here’s the lineup with a table from Vanguard’s website:

With an expense ratio of 11bps, these are cheap especially in comparison with the appropriate iShare counterpart. For example, for the broadest exposure, Vanguard’s Total Bond Market ETF is nearly half the cost of AGG which sits at 20bps. They both track the Lehman Brothers Aggregate Bond Index.

Comparisons between the remaining three Vanguard ETFs with their iShare counterparts is not as simple. First, the Lehman 1-3 Year Treasury Bond Fund (SHY), Lehman 7-10 Year Treasury Bond Fund (IEF) and Lehman 20+ Year Treasury Bond Fund (TLT) all have a 15bps fee which is not that far off Vanguard’s proposed 11bps. Next, you’ll note the difference in benchmarks:

In this environment, and at first glance when looking at this table, you might not expect to see any significant performance differences between the Vanguard and iShare ETFs within each of the three groupings. However, a little digging on their respective websites leads to some interesting findings. The first thing I notice is the number of holdings in each fund.

I couldn’t find data as of the same date, but despite this you still see quite a difference here. Just as an example/proof, the page from the iShares website shows the 10 holdings in TLT and, yup, they’re T-bonds going out about 20 to 30 years.

TLT’s ETF counterpart from Vanguard will be a share class of their Long-Term Bond Index Fund [VBLTX]. Although their data is a bit dated (as of September 30th, 2006), it does confirm that the number of holdings is roughly around 650 securities and lists them

Unlike TLT which is limited to US treasuries, Vanguard’s version is quite diversified in terms of type of issuer, maturity and credit quality.

A quick review of the other Vanguard mutual funds (VBISX, VBIIX, VBLTX) show a similar degree of diversification far beyond what iShares provides. So, although at the very beginning I said that Vanguard is not venturing into new territory, they are providing something different and at a low cost.

So, for the short-term fixed income group, here’s the 3-year comparison price chart:

Here’s the 3-year comparison price chart for the intermediate-term fixed income group:

Here’s the 3-year comparison price chart for the long-term fixed income group:

Not too much to comment on with these three charts. In the chart for the short-term funds, we see greater month-to-month volatility in Vanguard’s fund versus the iShare which is not surprising. What surprises me a bit is how similar the month-to-month volatility is for the 2nd and 3rd charts. There are a small number of months, like April 2005, where there’s a bigger jump in the iShare versus the Vanguard fund, but otherwise they move almost in lock step.

Last thought. I wonder why Vanguard didn’t enter with a real return bond ETF? Vanguard’s Inflation-Protected Securities Fund Investor Shares [VIPSX] tracks very closely with iShares’ Lehman TIPS Bond ETF (TIP):

With TIP priced at 20bps, Vanguard could do what they did against AGG with an 11bps fee (along with other situations like (EEM) versus (VWO)) and force BGI to consider their overall ETF pricing strategy. With many of the recent and proposed ETF offerings venturing into new spaces, and with their associated relative higher costs, I’d like to see BGI go toe-to-toe with Vanguard in the more traditional asset classes and bring costs down.

Tom Lydon’s piece on trends for 2007 and various other recent entries here at SA have noted the recent expansion, and supposition of continued growth, in the ETF products around the globe. Although I believe in the KISS principle and the use of very low cost ETFs, I do have a strong interest in new product development and where this could lead the industry and those who are interested in it:

• Hedge funds and other who use these instruments
• Mutual fund companies and other investment management dinosaurs who realize that they might need to acquire ETFs and/or hedge funds to adapt to the changing environment
• Index providers who are caught somewhere between trying to figure out the new benchmarks that institutions will want to have their portfolios (or parts of) linked to and determining where the ETF product development people are finding potential demand

There have been recent developments where new forms of ETFs have begun to expand globally. For example, what ProShares, and soon from Rydex, have done with levered and inverse ETFs, we have seen similar launches from BetaPro ETFs in Canada and Société Générale Asset Management in France. There could be more of these types of ETFs in other countries and if so, please add a comment further to this entry (oh, the beauty of blogging!).

But let’s step back and get back to basics. There was a press release on a new ETF from SSGA launched on January 17th. This ETF, the SPDR® MSCI ACWI (All Country World Index) ex-US ETF (CWI) should be of great interest to US investors who believe in the most extreme forms of KISS … aside from the fact that the name of this ETF is “SPDR® MSCI ACWI ex-US ETF”. Killer. Add a few addition signs and and arrow in there and you could have a chemical formula (remember high school chem class). Hey marketing people … come on!

But seriously, in one trade, exposure to the MSCI All Country WorldSM ex USA Index can be established. CWI provides for the first time robust international exposure that includes both developed and developing markets and this places this instrument in a fairly unique space. I don’t think that any sophisticated investor would use CWI as a component of a globally diversified asset allocation program in isolation. Perhaps another “5 position ETF portfolio” will be created suggesting CWI for international equity exposure along with a US ETF, a bond ETF, etc, etc, etc. Not a bad idea for the small and highly novice investor but considering costs, they might do best with no load index mutual funds. Nevertheless, with regard to these “one stop simple portfolios” … are we done with those yet?

For everyone else, for the purposes of transition management or quick cash equitization CWI is ideal. For many investors in times of transition (acquiring a new client account, starting up a new fund, etc.) CWI could be an ideal launching pad before breaking out into EAFE/VWO combinations and further allocations divided by region, industry sector, style and other factors.

This line of thinking makes me now think of SSGA’s recent international real estate ETF (RWX) also mentioned in the press release. That could be an ideal starting point for then tweaking allocations to various regions for real estate exposures. Problem is that we don’t have ETFs for this yet but CEFs and other direct securities selection will allow for this.

Clearly, despite recent news of potentially hundreds of new ETFs coming down the pipe, there will always be new areas where someone will say “Build one for this, too!”

Further to Matt Hougan and Roger Nusbaum’s recent entries, let me ante up and note that Russell Investment Group has launched an onslaught of over 300 new global equity indexes, covering roughly 10,100 securities. Russell has further acknowledged that talks are under way to develop ETFs based on these new indices.This move into globally oriented indices brings Russell toe-to-toe with MSCI whose iShares EAFE Index Fund ETF (EFA) and World indices have mass acceptance in the institutional space. To counter, MSCI has begun work to enhance its indexes and create additional benchmarks expanding its reach to roughly 98% of the world’s investable equity markets. This would match Russell’s coverage after the inclusion of their new indices.

So are we going to get hundreds of new ETFs linked to these new benchmarks? We won’t likely see new products for all of the new indices but we’ll see. I don’t believe that retail investors will want to have access to every country in Africa or central Asia (anyone interested in natural gas from Uzbekistan … I’ll bet there is!). But what about hedge funds? They are in the business of looking under every rock in every corner of the world. Certainly, hedge funds will have to expand further on a global scale and more significantly, into emerging markets. Within the ETF space, there is plenty of room for expansion in this area. There’s nothing specific for central/eastern Europe or the Mideast. What about Africa as a whole?

Perhaps it’s still early now, but hedge fund managers must be considering these areas if they have a global mandate. With hedge funds as significant users of ETFs, we will have to see just how realistic such a development is. The logistics are the problem. Will a market maker be able to provide the proper underlying requirements within the ETF structure in regions where capital markets are not as modern or robust? Hedge funds will find other means for exposure (private markets, etc.) but in time local market participants will surely do what they can to create locally domiciled ETFs to further their nation’s forward progression.

Keen ETF investors/observers should watch to see how new product development efforts continue in certain areas such as south-east Asia and other parts of the developing world.

If there’s an area where commentary has exceeded that which is required, it has to be in the commodity complex. For every Jim Rogers on the bullish side there is more than likely an equally vocal counterpart on the other side. True to expectations, with such a hot sector, we have seen a decent share of commodity related ETFs, with certainly more than enough in the energy subsector. Broad based commodity index ETFs [PowerShares DB Commodity Index TrackingFund (DBC) and iShares GSCI Commodity-Indexed Trust (GSG)] have allowed for a one-stop shotgun approach but now Deutsche Bank (DB) and PowerShares have sliced and diced yet another sector (follow the Deutsche Bank link) but, to me, this development does deserve merit.

What investors now have is the ability to fine tune their required commodity allocation instead of letting DBC and GSG do it. The new funds are:

PowerShares DB Agriculture Fund (DBA)

PowerShares DB Base Metals Fund (DBB)

PowerShares DB Energy Fund (DBE)

PowerShares DB Oil Fund (DBO)

PowerShares DB Precious Metals Fund (DBP)

PowerShares DB Silver Fund (DBS)

PowerShares DB Gold Fund (DGL)

Is this slicing and dicing really required?

According to the factsheet for DBC on the DB Funds website, this is its breakdown:

35% light sweet crude

20% heating oil

12.5% aluminum

11.25% corn

11.25% wheat

10% gold

According to the iShares website, GSG, which tracks the GSCI Total Return Index, has a breakdown of:

71% energy

11% industrial metals

11% agriculture

5% livestock

2% precious metals

The DBC factsheet also gives some information that should be of no surprise to the commodity index investor. The performance table shows 1 year returns as of September 30, 2006 of 9.32% for the DB Commodity Index, -21.14% for the GSCI and -6.11% for the DJ-AIG Commodity Index. This type of wide discrepancy is commonly found when comparing various hedge fund indices but not your more traditional indices. The problem is in the composition. I would strongly suggest that investors in this space read this feature article from IndexUniverse.com written by Matt Hougan titled “Choose Your Commodity Index Wisely”. (The site requires membership which is free.) You’ll note that Matt’s article was written in May 2005 and the index breakdowns differ slightly from the data above but they’re not far off. Take special notice to the table at the end of his article that gives a nice comparison of the various indices and their breakdowns. Unfortunately, the DB Commodity Index was not one of the indices included in his analysis.

There’s not a lot of trading history, so here’s the six month chart showing DBC and GSG:

The general trends are similar but the gap is significant starting in early September when the lines diverge.

Bottom line is that there’s little surprise that the GSCI had by far the worst performance of the three cited commodity indices due to its roughly three-quarters exposure to energy.

Although I’m not as big an oil bull as I was one year or two years ago, longer term I’m still a bull. Recent news has suggested that the environment is as high a priority as any other to the average citizen. How will this play out in the energy/alternative energy space is a whole other blog entry. Whatever my call (or your call is), for sizeable portfolios and for sophisticated investors, DBC or GSG just can’t provide the precision required for adequate portfolio management. The commodity complex is just too broad a space to be managed with just a DBC or GSG position … aside for the very small sized portfolio.

Clearly, the new PowerShares ETFs overlap considerably with existing ETFs. Still, we’re seeing what I believe to be the first exposure into the agricultural space. The base metals ETF allows for exposure to aluminum, zinc and copper which have gained considerable online chatter over the past few years. The energy ETF is similar to USO and provides for a more diversified instrument compared to its counterpart, DBO.

To those that argue that the ETF market has, and continues to, “slice and dice” … I say their argument is strong for certain areas like the US equity market. In the case of the commodity complex, what Deutsche Bank and Powershares have brought to market is ideal.

Pension and Investments Online published an article last week discussing some of the developments happening in the background of the ETF industry. So much of the focus has been on new product development and asset growth, however this is clearly having an effect on other parts of the industry.Certainly, the management at mutual fund manufacturers must be considering the purchase of ETF providers, as well as hedge fund managers, to help gain access to the two poles of the investment spectrum. They may not go full throttle to the pure separation of beta and alpha, but being “stuck in the middle” is a term many students of first year economics will recall. Recent news of Power Corp of Canada (holder of various finanicial services companies) buying Putnam Investments (PGM) for US$3.9 billion makes me wonder what will be the stimulus that leads to major investment firms lining up to buy ETF providers.

No surprise then that the VCs and private equity firms are ahead of the curve … not difficult compared to the mutual fund dinosaur. Still, I find this sentence in the article interesting:

That growth rate has venture capitalists and merchant bankers looking for the next hot ETF provider.

When I think of “hot” in the investment space I think of the dot.com IPOs of the 90’s or hedge funds of the past few years. But a hot “ETF provider”? You’d think we’re talking about alpha! We’re still talking about boring ol’ beta, right? I guess beta really is hot and the proof (new products, exponential asset growth) is the pudding that should not make this a surprise. However, this leads me to believe that the growth both in number of new offerings and assets under management we have seen in the past few years will easily be eclipsed in the next year or two (or more). This will especially be true on a global scale as there are so many international markets that have yet to be “ETF’d”. Consider how international real estate just became online as an ETF last month.

Of course, this bull market that has got to be one of the longest in terms of duration (but not actual percentage gain), however it will obviously have to end at some point in time and with potentially significant downside. Depending on the scope of a correction, how the ETF industry is affected by this will, in my opinion, be the most important development in this area for this decade. My guess is that it might cause a slight hiccup in terms of asset gathering but it will be very hard to turn this ship off course.

This is the time of year where we get the usual reviews and reminiscing of the past 12 months and outlooks/forecasts for the coming year. Looking back at the hedge fund space in 2006, I think the two big stories were the continued growth of the industry as well as the Amaranth debacle.Lack of Regulation = Explosive Growth
On growth: Many are saying it’s good, many more are worried. Growth in both assets under management (before and after the use leverage) as well as the number of actual funds to choose from are indeed incredible. Some of the growth, I would admit, is in questionable areas.

For example, the concept of F3, or “funds-of-funds-of-funds.” When you think about the logic, the “fund of funds” is the relatively simplistic way to build the hedge fund component for a diversified portfolio. I see it as synonymous to the mutual fund instead of directly picking stocks. We have seen globally the manufacturing of multimanager mutual fund packages where a distribution oriented financial services firm organizes some form of asset allocation package that leads to a selection of mutual funds to match the investor type.

The term “wrap program” is appropriate, however, the aggregate cost structure I think is prohibitive in so many ways. On the hedge fund side, having someone pick a group of “funds of funds” as is the case of an F3 would be counterpart to the wrap program. If the costs are a drag on performance in a wrap program, how much of a drag are they on an F3. It brings a fresh perspective to the term “negative alpha”.

I really wonder when the regulatory environment will be such so that the industry moves beyond the current fog. Registration or not? Based on a certain minimum investment amount or other constraints to form some agreed upon accredited investor rules? Until questions related to regulations are more concrete, we will continue to have strong growth from startup firms as the barriers to entry remain quite low. As an industry participant who has always been involved with very small and entrepreneurial investment management firms, I’m not asking for high barriers to entry. I just don’t like driving in fog.

ETFs Also On the Rise
Speaking of fog and low barriers to entry, it is becoming very clear to me that has never been more difficult for investors to build a hedge fund portfolio. Certainly, with nearly all asset classes going straight up for the past four years except for the occasional bump on the road (this summer being the main one), it has been tough for the highly active manager. Perhaps this is why we are seeing the synchronized growth at the other end of the investment spectrum.

Like hedge funds, exchange traded funds [ETFs] have grown both in total asset size as well as in the number of total instruments. For the forward-thinking investor using a “portable alpha” view of portfolio construction, the growth of available instruments globally both on the beta side as well as on the alpha side makes it possible. The problem is that both ends of the spectrum are deviating from the original purpose.

Pure beta: On the one hand, gaining broad market exposure and the related market risk therein (beta) should be acquired at the lowest cost possible. For institutions, this is through derivatives such as futures and swaps. For retail investors, ETFs, futures and options are reasonable choices. However, regarding ETFs, we are seeing an evolution in the industry where new offerings focus less on broad exposures at low cost and instead bring access to highly niche areas at relatively higher costs. I am a fan on some of the new exposures available from ETFs (gold, alternative energy, etc.) and have written extensively on new offerings in less traditional spaces, but I am still a bigger fan on ETFs and the fund companies that manufacture and promote extremely low cost alternatives. Thus, I am a big fan of Vanguard when their fund is available for a particular asset class.

The divergence in the ETF industry towards very broad/low cost funds versus very narrow/higher costs funds is good. For those focused on the separation of beta and alpha, they will likely focus on the former. Asset allocators and those who like to play their macro calls will employ the use of ETFs that allow quick exposures to areas like water and international real estate.

Pure alpha: Many complain that the problem with hedge funds is their fees. I generally don’t agree, although I’m not the biggest fan of the retailization of hedge funds. The argument for hedge funds with regard to fees can be found here.

Bottom line: Mutual funds and traditional investments provide more beta than alpha but the MER you pay does not differentiate between the two. A fund’s performance that is driven due to beta (market risk as opposed to manager skill) should come at a cost closer to ETFs than that of the typical managed fund.

That’s fine but when this line of thinking moves over to hedge funds it should not be a strong argument as many (not all) hedge funds aim to “perform well in both good and bad markets”. In other words, for such funds, they should be market neutral, or what I think is the correct term: beta neutral. If a hedge fund is truly beta neutral, then its performance is based truly on the manager’s skill rather than the oscillations of the market. In this case, many would agree that there is good value as you get what you pay for.

Hedge Funds Generally In Step With Markets
But how many hedge funds exist in this beta-neutral manner? In general, I would say not many. In a previous piece I showed a chart plotting the growth of two hedge fund indices with the S&P 500. In general, I surmise that in aggregate, hedge funds behave like the market more often than many investors would believe to be true.

In the shorter term, single hedge funds or even fund-of-funds may be able to provide strong diversification benefits from long-only market exposures. However, the chart shows that in the longer term, hedge funds only deviates from market returns in times of extreme drawdown. In a way, that’s great. Both the HFR Index and the Credit Suisse-Tremont Index were flat when the equity markets fell in 2000-2002. The problem is that during the periods outside of 2000-2002, the hedge fund indices move in step with the markets, albeit with considerable outperformance in the three years leading to the top versus the S&P 500.

Still, when you look at the last four years, hedge funds in aggregate perform too much like the broad equity markets. This is also very true in Canada. Generally, hedge funds did not seem to protect well this past summer so they will have to prove themselves when the next major down market occurs. I am very interested to see what happens when the next 15% or greater correction occurs. Many strategists are calling for something in this range for the first quarter of 2007 but for their to be a rebound rather than an extended drought. If something close to this occurs, we could have a repeat of this summer where there was a synchronized drop in nearly all asset classes as well as strategies including most hedge funds.

That’s the caveat. The opportunity, however, remains in that there are hedge funds and even fund-of-funds that are very much beta-neutral. So, for the investor looking into hedge funds, digging through the data to monitor beta neutrality as well as correlation analysis with various asset classes (and of course with current holdings within one’s portfolio) is very important. Luckily, in this day and age, the low cost of computing power allows many market participants to conduct the necessary quantitative due diligence that is required.

Lessons From Amaranth
The problem is that it’s the qualitative due diligence that is so much more important and more difficult to conduct. This leads to Amaranth.

Here’s a recently posted “Top 10 Lessons” list from William Hutchings at Financial News Online on the Amaranth affair.

Some of my thoughts from each of the ten points:

Risk managers: In a way, the risk manager at a hedge fund has to be like a “mother-in-law from hell” who monitors the situation. However, just like no one wants someone watching them as they cook saying “too much salt”, managers don’t like constraints. Hedge funds are like mutual funds with less constraints. So for the risk manager, there has to be some balance and therefore their job is difficult in that it involves some politics. Brian Hunter had the hot hand. If the risk manager was based in Calgary, or even if he/she flew west every week, do you think things would have turned out differently? I’m assuming they had all the correct data. How is this different from Barings and the Nick Leeson situation? The official story in that case study is that England did not know what was happening in Singapore. If that’s true then they were incompetent. If that’s false, yikes. Yikes as in LTCM and Amaranth. The risk managers had sliderules that adequately gauged the risks so risk measurement was not the issue. Human nature is quite simple: It’s hard to walk away from the table when everyone sees you as the one with the hot hand.

Concentrated positions: I’ll talk a bit more on diversification versus concentration in a following point. But with regard to concentration, I spoke with various participants in the Canadian energy markets in late September and was informed that Amaranth was not the only one with massive exposures to natural gas. No surprise, as everyone from hedge funds to utility companies has an interest in the commodity. I do not know if Amaranth had the largest exposure to natural gas and if others were simply successful in winding down positions in a more effective manner but it seemed to me at that time that what occurred seemed to be a non-event to so many. The only detail suggested to me that was different in this case was the fact that the losses were skewed so heavily to one participant.

Manager pressure: I’ve written about this many times in the past. Low barriers to entry allow for a greater number of participants and the idea of less “alpha per capita”. I don’t know if there’s more or less alpha than in the past or if the amount is even relevant. However, the idea that there are more funds searching for alpha leads me to believe that there will be greater use of leverage to squeeze out as much juice as possible. LTCM, Barings, Amaranth. Obviously, leverage works both ways.

Position transparency: This is what institutional investors are asking for more and more. Let’s say they get it. Full position transparency. I guess they become the mother-in-law of the mother-in-law. Just think about it.

Large versus emerging funds: Another trend in the institutional space is interest in emerging fund managers. The logic is that these hedge funds focus on new areas that have relatively less competition and thus greater “alpha per capita”. The problem is that the hedge fund manager will be less likely to provide any amount of secret sauce and that obviously includes position transparency. Hopefully, process transparency will suffice. I personally think that this logic makes sense. The problem is sustainability. Will a hedge fund company be more sustainable if it is acquired (Morgan Stanley?) but allowed to manage the investment business with yet another mother-in-law in the kitchen? There’s just that added dimension of risk in putting money with a relative start-up that makes this an interesting dilemma for institutional investors. I can only guess that they can take an equity position with the hedge fund company and help them eventually gain some business from other similar institutional investors.

Financial system: Not much for me to comment on this. I only hope there is some rigorous yet coordinated effort amongst regulators and central banks.

Industry aggregated position transparency: On the one hand, my comments on the point above apply here as well. However, let’s say that there is a global watchdog that communicates with AIMA or some other representative of the hedge fund industry of an extreme concentration and over-investment. Then what? So, let’s say for example, that gold flies by $1000 and money continues to be dumped into gold ETFs, gold futures and gold everything. What about if it’s in a far smaller scale (yet still significant) but applied to a stock? I believe the market already provides the necessary existing mechanisms to handle this. Market participants will be quick to implement the necessary positions when things get out of hand in such a manner.

Diversification: Although portfolio theory is about adding non-correlated investments to lower overall volatility, I believe that true active management in its most extreme form (the hedge fund) means allowing for concentrated positions. Clearly, the issue is to what degree of concentration. Too much diversification and you become “index like”. Too much concentration and you rely on the poor risk manager mentioned above to make sure that the risk measures are agreed upon and the procedures related to risk management are firmly adhered to.

Fund of funds risk taking: I hate to use the term again because I have a wonderful mother-in-law, but the FoF is another example of an overseer to the hedge fund manager. I know of a FoF that had its largest exposure to Amaranth. Certainly, the event hurt their performance in a very significant manner but hopefully they learned something from it. If it helps better define their risk measurement and management process, then that’s all that can be asked after the fact. In this case, the FoF was down less than 9% for the month. According to the Hutchings article, “Investors expected falls of 10% or so in any given month. What they did not anticipate was a loss of 70%.” I would agree with this and, in fact, seeing a manager go through an “Amaranth” is healthy as part of the ongoing due diligence of a manager especially in the area of hedge funds.

Liquidity: Hedge fund investors should hopefully know before they get anywhere near actually investing that illiquidity is part of the game. However, they should also know that in many cases, fund-of-funds may also be limited in their ability to redeem when they wish. Knowing the full extent of the situation and what one can and cannot do is something I wonder if investors take the time to adequately study.

I’ve slowed down a bit in terms of writing as the holidays bring so many nice distractions. This will definitely be my last piece for the year and it’s been a real joy writing for Seeking Alpha over the past seven months. To those who have sent comments (kudos or otherwise) over this time, many thanks. Best for the new year!