Further to recent articles by Tom Lydon we find continued interest in the exponential growth in ETF product development. The movement to more thinly defined sectors as well as alternative index weighting methods seems to be of great interest to many. Just yesterday I saw something from WisdomTree (WSDT.PK) about their upcoming earnings-weighted index ETFs.I wonder what’s the longer-term plan at WisdomTree? They’re certainly pushing the envelope with arguments against market cap weighted indexation in favor of fundamental weighted indices. But with their first wave (actually, multiple waves) of product offerings, the focus was on ETFs whose underlying portfolio is weighted based on each position’s cash dividend payout. The question I have now is why the shift to ETFs that track an underlying index whose focus is on another fundamental factor – in this case earnings? According to the press release (.pdf) these new offerings are very similar to WisdomTree’s existing “Domestic Dividend ETF” lineup. For example, the first ETF listed in the press release is the WisdomTree Total Earnings Fund (EXT) which has a 28bps MER. It seems to be the exact counterpart to WisdomTree’s Total Dividend Fund (DTD) which has the same MER. Little surprise to me, the backtested performance of the two underlying indices do not have significant deviations as shown on this chart on a page (.pdf) from WisdomTree site.

Despite what seems like a potentially redundant new set of ETFs due to what could be future performance within very close proximity to existing ETFs (is cannibalization a concern?), WisdomTree does give some suggestions for how an investor may decide to focus on one factor over another:

How Do I Decide Which Approach Is Right for Me?

All of the WisdomTree ETFs provide investors with an alternative to market cap-weighted ETFs, and all are designed to be used as core holdings within an investor’s portfolio. If you are seeking the potential for income-generating yields and relatively lower volatility, you may want to consider the Dividend Family. If you are seeking broad market exposure or exposure to traditional sector classifications through companies with an earnings track record, you may want to consider the Earnings Family.

I’ll be very interested to see the growth of assets in this new family of earnings based ETFs. Even more interesting, I’d be interested to know what market environment would cause any sort of significant deviation between WisdomTree’s dividend based ETFs versus their earnings based ETFs. I’m guessing not very many situations. If so, my feeling is that this provides more fuel to the existing discussions of there being too many ETFs. As Richard Ferri of Portfolio Solutions LLC puts it:

“What I am seeing is a rapid shift from ETF evolution to ETF pollution.”

As Keanu Reeves so eloquently said in The Matrix, “Whoa”. The above quote is from John Spence’s recent article “ETFs wade into a dead pool”, he puts out an argument that suggests a significant market decline could not only slow down ETF product development (he suggests consolidation and I’d buy that), but also close down some as well. I’d buy that too but to a lesser degree.

Let’s be honest. Fund manufacturers including ETF providers are just as bad market timers as any other investor. TD Asset Management up here in Toronto had to close their ETFs a few years back. They had a nice lineup of ETFs with broad market exposure to Canadian equity markets even with some value and growth biased ETFs and this was at a time when ETFs weren’t considered to be so “weed like”. Perhaps Canadian investors just didn’t have the will to accept the passive approach at that time to warrant product offerings beyond what Barclays had already been providing the market. But we also saw the same with a small US provider of bond ETFs. They didn’t last long either. Clearly, many of the new niche funds are providing investors access to markets which are hot and at or near their all time highs. Furthermore, the fact is that nearly all markets are at or near their highs. Beta is hot and thus ETFs are the flavor of the day. If we were in a 1970s-like environment we would surely see less interest in ETFs and more interest in hedge funds and defensive strategies. Perhaps even more likely the popular choice would be term deposits … I’m thinking an environment like the beginning of the 1980’s when no one talked about the stock market.

But we’re in 2007. After the risk taking environment of the late 90’s to the sudden risk aversion during and immediately after the bear market of 2000-2002 and the shift to “risk management” thereafter (Basel, Sarbanes Oxley, growth of hedge fund use, etc.) we find ourselves now again at a time of relatively high risk taking. That’s what a four and a half year bull market and VIX down to 10 does to the collective psyche of the global investing public. By the way, have you seen where VIX has been in the past week?! And don’t think that the Bank of Japan’s 25bps rate hike changes the carry trade situation.

It’s also little wonder that hedge funds are having a hard time finding stocks to short. Actually, it kind of sounds like value managers in the late 90’s saying they can’t find good stocks to buy. Shorting is a tough sport in today’s environment. The stock you might want to short could be the same one Carl Icahn is looking to take private, turn around and resell to the public market. It’s tough to be a hedge fund these days. They’re dying to finally get some decent performance fees. They need a bear market badly. Whether they actually do well in a future bear market is another story. Some will and some won’t. Maybe cash really is king. But until then, ETFs are king.

Unfortunately (or fortunately, depending on your view of monarchies), Kings get dethroned. Spence has a heading within his piece called “Shades of 1999”. He doesn’t mention this but it made me think if the ETF explosion could be compared to the dot-com bubble. Well in the one case you have money chasing various asset classes or sectors. In another case you have money chasing stories with no fundamentals to back them up. A broad generalization but enough for me to think that it’s not the same. Still, we’ll definitely see some ETFs disappear as Spence has given some examples similar to mine above. I don’t think it will be like all the tech mutual funds that closed up during the bear market. The King may get hurt, but I don’t think he’ll get dethroned.

What I don’t think people realize is that ETFs are not for the buy-hold investor. They can be; but the direction or trend of the industry is focused towards the more active investor who either prefers a slightly more tactical rather than strategic asset allocation framework or the investor who wants to do some sector rotation … or in fact a multitude of other active approaches including hedge fund like strategies.

Can’t it be possible that there is a level of “micro” efficiency within asset classes such that ETFs provide an ideal, or at least preferred, means for exposure whereas in the more broad “macro” world there can be a significant of overall global inefficiency such that some active management of positions (whether ETF or not) is required?

If so, then the active management of ETFs has some merit. The level of comfort, proficiency and experience as well as other factors will determine to what degree of activity one will allow for their own portfolio. Again, it’s good to have ETFs so as to allow investors that choice. If there is to be a concern, the concern should not be about instruments such as ETFs, but for the overall risk appetite in aggregate within the investing world and what repercussions that may have in a much broader sense if things turn for the worse.

To continue what seems like a series on chopping up asset classes into various investable components such as commodities and emerging markets I want to dig a bit deeper into the emerging market space, but specifically into the often cited BRIC nations (Brazil, Russia, India, China).Let’s start with a basic returns table for comparing a BRIC index and its 4 components with the MSCI EM Index (all in USD):

click to enlarge

The monthly return data used for this table goes back starting at December 31, 2001 but the Brazil, Russia and China index data only goes back to a starting value as of April 30, 2002 thus no 5-year returns for them in the above.

Pretty darn spectacular in what has been a pretty darn spectacular global bull run over the past 4 years. As usual, I now break out the charts starting with a comparison of the BRICs versus the MSCI EM Index:

So $1,000 grows to roughly $4,250 with the BRICs versus roughly $3,250 with an ETF like EEM. Clearly, a significant difference. So, now we see why that is:

So instead of comparing the MSCI EM Index with BRIC, we see it against its component indices. Despite the expansive discussion and coverage of “Chindia”, we find it’s Russia and Brazil that are the strong performers. Obviously, Russia is a big commodities play but Brazil is also commodity heavy. According to the iShares site for their Brazilian ETF (EWZ) the fund is roughly 25% in metals/mining and 25% in oil & gas.

Still, BRIC ETFs like the Claymore/BNY Bric ETF (EEB) in the US and the Claymore BRIC ETF [CBQ: TSX] in Canada, both of which track the BONY BRIC Index above, are not equally weighted by country. Both have the following country breakdown:

Brazil 45.88%

China 35.79%

India 13.56%

Russia 4.77%

You can see in EEM’s fact sheet (.pdf) that it has a 9.39% weight in Russia also as of December 31, 2006, nearly double the allocation in the BRIC ETFs. Yet despite this, EEM still underperforms the BRIC ETFs. Clearly the 18 other country exposures beyond the BRIC countries in EEM have an aggregate drag on return in relative terms. But in the bigger picture, we see that the divergence in performance is only significant in the past two years, but especially in the past six months.

The top five sectors are energy at 26%, 20% telecomm services, 19% financials, 14% materials and 9% IT. So, overall about a 40% commodity exposure and some decent sector diversification beyond that. No surprise then that the BRIC ETF tracks countries like Canada and Australia fairly well.

By the way, with regard to all the charts and data above, a big thanks to Som Seif of Claymore Investments here in Toronto.

It’s important to note that the indices mentioned in the above tables and charts are all from Bank of New York who is not a big name in indexing but who nonetheless has its own family of ETFS called BLDRS (Baskets of Listed Depositary Receipts). More info can be found on their site. I often mention EEM and VWO for emerging markets exposure, but I have been wrong not to include the BLDRS Emerging Markets 50 ADR Index Fund (ADRE):

This chart shows a slight outperformance of ADRE over EEM and VWO over this one year period but the ADRE factsheet (.pdf) from the BLDRS website shows that its benchmark actually trails the MSCI EM Index over the longer term. ADRE’s sector breakdown shows the same top five sectors as mentioned above but with an overall more diversified sector mix with less exposure to commodities.

With an underlying index of only 50 positions as opposed to EEM’s 275 holdings and VWO’s 862 holdings, you would expect greater volatility from ADRE. I would have expected more volatility than what is shown in the above chart. With a surprisingly low MER of 0.30% similar to VWO (unfortunately, the BRIC ETFs are both exactly double the cost at 0.60%), ADRE is an interesting choice for those who are willing to accept an even slightly higher level of risk, and thus potentially return.

Thus, ADRE nicely fits in between the (relatively speaking) low volatility EEM/VWO and higher volatility BRIC ETF as shown in this chart that only goes back as far as the inception date of EEB back in mid September:

Further to my closing comments on my previous piece specific to hedging strategies for emerging markets, if you’re looking to use these ETFs for opportunistic shorting during the relatively brief but often severe periods of distress, you may want to do some analysis on how their price movements compare historically. After the recent run (look at all the charts above and in my previous piece … many show them currently at highs), these positions as potential shorts could be truly spectacular, obviously if you get the timing right. For those with a more sensitive stomach, defensive posturing may be limited to simply reducing or outright selling positions if you, for some reason, lose your long-term orientation.

Hey, I just noticed one of my charts from the previous post, specifically the last one showing IFN and FXI. IFN looks now to be way down, in fact about 33% below its highs from May 2006. That looks a lot different from the light blue line for the BONY India Total Return Index which looks to be in a straight line up since roughly June 2006 in the second chart from the top above. Chalk up another one for the index.

So again back to basics: Not only is it difficult to choose a winning manager in the emerging market space (perhaps in the long only equity space overall?), but you also have to be right on the call among the various EM regions. For many, including the professionals, that can be tough. I’m all for having the choice to tilt EM regions and even countries like the BRIC components, but for most investors, a broader EM pick (EEM/VWO/ADRE) and/or a BRIC ETF should be sufficient exposure. Figuring in MERs and the costs of trading too many positions for what should be a rather small part of your portfolio, unless you really want a high vol program, one or two holdings is all you’ll really need.

In the past, I’ve commented on how a Canadian investor should not consider emerging market investments, in general, as a diversifier to their total portfolio. If in fact they do have a home bias, as most investors do, the results during times of distress can be quite agonizing. Not only are the correlation in returns high between Canada (EWC) and the emerging markets, but they are the perfect anti-diversifiers:

The same is true for other resource heavy economies such as Australia (EWA):

And South Africa (EZA):

Interesting that in this last case we see that the South African ETF is actually more volatile than EEM but that isn’t surprising when you see that nearly 25% of the fund is in the metals and mining sector.

Based on the above, it’s fair to assume that this correlation risk can be applied to any investor with a relatively large exposure to the commodity complex, no matter where they are located. However, you don’t simply want to avoid the greater macro story coming out of the developing world, do you? We need to think about what other possible choices there are beyond broad EM exposures such as EEM and VWO.

Latin America

Let’s take a look at these ETFs for the Latin America region:

Again, I use the same 3-year timeframe as the charts above. Probably not surprisingly, we see that the broad Latin American ETF (ILF) zigs and zags in tandem with the Mexican ETF (EWW) and Brazilian ETF (EWZ). Suddenly, EEM looks conservative in comparison to these but follows the same upwards and downward oscillations. The correlations are to be carefully considered if you hold some (or all!) of these.

East Asia

Here we finally see some variation in price movement, in this case from the far east:

The Malaysian (EWM) and Taiwanese (EWT) ETFs seem to move closest together. China (FXI) and South Korea (EWY) show great appreciation but at different times. However, what we find again is the synchronized down movements not only in the summer of 2006 but in March and October of 2005. Scroll up to review all the other charts and you’ll see that when I say “synchronized”, it’s global in scope.

Central/Eastern Europe

What about this region? We don’t have an ETF for this region yet although Roger Nusbaum discussed a new index that could be easily tracked by an ETF … but c’mon, 15 stocks! Bogle will go bananas over this.

So, I dig into the closed end fund world to build this chart which has the Central Europe & Russia Fund (CEE), Morgan Stanley Eastern Europe Fund (RNE) and the Templeton Russia & East European Fund (TRF):

Same moments of downward movement as described above, and then some. No doubt investors in this region experienced a “Maalox moment” last summer.

So, we can see that within each region there’s quite a bit of correlation, but especially during times of significant market distress where, in fact, the correlation is not just high within that region but within what looks like all emerging markets. What about the BRICs?

Although we have news of Van Eck soon to launch a Russian ETF, the best I can do for charting Russia is ING Funds’ Russia Fund [LETRX]. Similarly with India, the iPath MSCI India Index Exchange Traded Notes (INP) from Barclays does not have a long track record like The India Fund (IFN) which I use in its place.

The chart only goes back 2 years because of the shorter record for FXI. However, the real problem with this chart is that we have a mix of indexing and active management. For example, someone else may have chosen another proxy for India, such as the Eaton Vance Greater India Fund [EMGIX] and the results would be significantly different from IFN as shown in this 12-month chart:

But I think the point is that if you have regional emerging market exposures as shown with the BRIC exposures from the 2nd chart up, you’re getting about as good an amount of diversification as you can get … still getting the upside boost of these regions’ returns but also with the coordinated downside which it seems you can’t escape without some serious timing abilities.

Whether you call it timing or active management, it seems as if it is required for the emerging market space. And I say this despite the fact that the SPIVA scorecards from Standard and Poor’s show that active managers in even this space have a difficult time beating their relevant benchmark. Nevertheless, you either rely on some timing or else you’ll have to accept some serious drawdowns like we saw last summer as part of the plan.

I specifically chose some funds above from the individual BRIC countries but of them, it’s nice to see that it’s the big newsmakers, China and India, that show somewhat reduced levels of correlated returns:

To me, it’s unfortunate that Brazil’s weighting is so large in BRIC ETFs (nearly half) with China, and especially India, with smaller allocations. Thus, I like the idea of country specific ETFs for China and India as well as the idea of a Chindia ETF. Some news here about an upcoming ETF for this combination.

For the future, emerging markets, but especially China and India, are the real stories. If I were consulting on a hedge fund mandate related to these regions (which I’m currently not), the problem I’d focus on would not be the long exposures but the ability to be opportunistic on the short side. Based on the charts above, the down periods can be short but painful. However, it’s important to note that these are not just emerging economic markets but emerging securities markets. Thus, the regulatory environment does not often allow for easy and opportunistic trading. You will often have a tough time shorting stocks in these new jurisdictions. A combination of stock selection on the long side (bottom up analysis) with shorting of ETFs (top down analysis)? Sounds pretty basic but this may be the real value of emerging market focused ETFs.

I follow quite a few blogs. but there are only a small number that I would say I track faithfully. Charles Kirk’s The Kirk Report is one of these blogs that I follow and I especially like the occasional list of links.Early last week, Charles had some nice coverage of ETFs but it was some common sense advice from Paul Merriman that was especially good to see. Although I often write about ETFs, I have suggested on occasion that for a large number of investors, broad asset class mutual funds from Vanguard and Dimensional Fund Advisors may be the preferred route, especially for relatively smaller accounts and for those who apply the use of dollar cost averaging.

The arguments for and against ETFs and index mutual funds are only a part of this piece’s discussion but I strongly suggest this for not only the novice investor but for the more advanced participant who may want (need?) to review the basics.

Aside: My parents had me learn the piano and martial arts when I was very young, well before I entered the public school system. What’s most amazing to me is how those in the most advanced levels of their craft spend the greatest amount of their time focusing on the basics. In music, for example, this would include practicing scales. In any sort of close quarters combat, this would include body conditioning, balance exercises and basic hand-eye coordination drills. So, for investors who may consider themselves to be advanced, the question to ask in the mirror is: Do I have the basics down pat? Because if you get that wrong, all the fancy stuff won’t matter.

Further to this “focus on the basics”, Charles mentioned in his blog yesterday that he will be centering his attention this week on “lazy portfolios.” These portfolios certainly aren’t for everyone but they give an idea of a “home portfolio.” From these portfolios, which could be considered as your core holdings, the decision can then be made thereafter to complicate things further. With these portfolios, the key is not to actually become lazy but to keep things relatively basic. If you don’t have the time to put into your portfolio yet want to do it yourself, for whatever reason, this is a good start.

As I mentioned in my piece yesterday, TheStreet.com has their own ETF based portfolio and if you do some simple searching you will find many. Using these as guides to get an understanding of how different methods are used to construct a portfolio will give you incremental bits of knowledge that can help you with your own process. I suppose the trick is to limit the complexity where possible. And this always brings us back to Bogle.

John Bogle has his own blog (hey, who doesn’t … just kidding). Bogle has been critical of the major expansion in the ETF industry, which has moved away from the focus on traditional, market cap weighted index trackers whose purpose is to minimize tracking error at the lowest possible cost. Much of his commentary recently (mentioned in his article published in Friday’s WSJ) has been focused on the recent attention to non-market cap weighted ETFs such as those from PowerShares and WisdomTree. What I find most ironic however is how Bogle seems to be in the same camp as, of all people, Jim Cramer. They both give similar negative comments on the ETF industry and say that with many of the new product offerings, they provide a disservice to investors. Somehow, I have a feeling that Bogle and Cramer have two different premises that are leading them to this same conclusion.

What I don’t think a lot of people understand (or at least don’t admit outright) is that ETFs are for everyone. If you want a ten holding, long-term portfolio for your retirement savings, you can use ETFs if you plan on adding new investments on a yearly basis, for example. At the other end, there are hedge funds who want exposure to a basket of international real estate stocks, carbon credits or some other corner of the capital markets. There are many other participants in between these two examples who will want some form of instrument suitable for active trading. The degree of active trading will have an effect on portfolio returns but along with other freedoms, investors will do as they please. Bogle and Cramer can persuade investors to implement in a style or philosophy similar to theirs, but it’s with ETFs, not in isolation but in combination with other instruments including index funds and/or direct stock picks, that investors can actually implement in these ways or countless others.

I have found an interesting forum on financialwebring.com with significant and specific discussions about ETFs. It’s Canadian based but much of the discussion can be applicable to any investor. Much of the discussions found here will be of best use to the novice investor. Lots of commentary that sound more like rants and petty fights but if you dodge those, you’ll find many more bits of information that can add up to something of great value.

Like any blogger, I write commentary for no one in particular. Everyone should start from the basics of asset allocation, risk management and diversification which are in ways all the same when applied to the portfolio construction process. I believe that when I and many others write about new ETFs in niche areas, it is for those who have the basics in place and are essentially searching for alpha through beta, and even further, hoping to provide better risk-adjusted returns for the longer term.

Chris Holt sent me an article from TheStreet.com summarizing a video interview with Jim Cramer on his opinions of ETFs.The article’s a bit vague on details, but the video is quite clear. I’d say that Cramer goes to great lengths to bash the industry as one that does not really care about the needs of the client/investor. He starts out by characterizing the industry as one involved in a “corrupt process”. Just like any merchandiser, he says they’re “pushing products”. I can’t really argue with that. In an industry revolving around money, there will always be conflicts and biases, some more visible than others due to one’s position or background within the industry.

Whether the comments made on the industry are especially relevant to ETF providers, I’m not so sure. Like mutual funds, it’s all about building the assets under management. Newer products with better sizzle are what sell. For better or for worse, ETFs seem to be what’s hot right now. Could it simply be that ETFs are gaining market share from traditional mutual funds? (More on that later when I bring up some recent stats from AMG Data.)

There are many points in the video that are obviously one sided. Commissions driving the ETF push? What about I-banks pushing stocks with buy recommendations left, right and center even after all the regulatory brouhaha after the market collapse of 2000-2002? What about prime brokerages doing whatever they can to fight for hedge fund business that pays top dollar for various services and with the desk making great margins on the related trading activity? I don’t see the ETF push being that significant in the realm of commissions versus other entries in the income statement for the I-banks.

With regard to the idea of “anti-diversification”, Cramer’s talking about the new wave of ETFs that are highly focused in a sector like nanotechnology or a certain area of healthcare (cancer drugs for example). No doubt he’s got a point there. But, his example of 5 stocks (Microsoft, Marvell, HP, CA, Merck) versus an ETF is unclear. I suppose what Cramer is saying is that whether you choose a few tech stocks or one of the newer, highly niche sector ETFs, in both cases you’re not getting diversification. That’s true and I’m betting that anyone who implements in any of these two ways is consciously and purposely making a bet in that sector. The question is if you want to make a bet in a specific sector, do you go with some direct stock picks or a sector fund/ETF? To each his own, but not everyone is a pro with the resources (especially time) to make a precise decision. This is just one of the many reasons for the ETF.

The issue I have with the above is highlighted when Cramer says “… I want to be in a sector fund which is an ETF” at about the 1:50 mark of the video. The context of this quote is not that Cramer wants to be in a sector fund/ETF, but that he equates sector funds to ETFs. So you can see he is focusing on the new niche sector ETFs. Like I said earlier, his is a worthy comment if the point is that there are too many products being pushed into the market, each covering a very specific area. But like I’ve also said many times before, if the market is allowed to take its course, unwanted funds will disappear. Maybe there’s a flaw there, but the Pontiac Fiero and Aztec are other examples where the market decided and the product was pulled earlier than likely expected by the manufacturer.

Simply put, equating sector funds with ETFs is wrong. Cramer knows that ETFs are more than simply a means for a sector play. You can get broad global exposures, regional exposures, country specific exposures as well as style based, cap based and sector based exposures. We’re also getting into alternative investment territory. ETFs are like tools in your toolbox, animals in a biosphere and hedge funds. There are many types, all with varied purposes some more useful than other depending on your point of view.

Near the end of the video clip, Cramer says ETFs should be avoided and that a portfolio of ETFs is just a mutual fund. That is somewhat true if you are overdiversified, long only and are in a generally static state. What’s hilarious is the fact that that he thinks it’s preposterous to try to be anything like an index fund because of the “… empirical nature of the returns I’ve been generating on my show.”

There you go. Some may perceive ETFs as a threat to their OM. As more investors use ETFs, they have less use for shows like Cramer’s and specific stock calls.

But let’s be honest… they’re no threat to Cramer or anyone else. Indexing, ETFs and related methods will never be a threat to the active investor, Jim Cramer or his media efforts. We live in a world where everyone (or at least nearly everyone in the investment industry) thinks they’re better than the rest. It’s part of the modern capitalistic world and it’s what allows for progress and innovation… and that’s good. Greater effort leading to greater achievement should be rewarded. Our industry is one where most have been leaders and overachievers since the sandbox. Thus, based on this, how can we then possibly settle for “average”? Many investors can’t. The investment industry won’t. So, indexing as a means of investing will never take over the world… and rightly so.

Aside: The evidence from Standard and Poor’s and their SPIVA scorecards seem to show that index returns are anything but average. The index return may not always be top quartile, but long-only managers seem to be having a hard time keeping up with the “average” in the longer term.

What I believe is that, in the search for alpha, ETFs are just another trading instrument like derivatives, closed end funds, or specific stocks or bonds. For some investors, having a portfolio of 5 ETFs held for the long term is what’s appropriate. For some, it’s trading a portfolio of 50 to 100 stocks with roughly 200% annual turnover. To each his own. ETFs can be played in so many ways just as derivatives or even a small basket of actively managed stocks.

Think of these as ingredients. I can give ten ingredients to ten chefs and you’d get ten menus of varied offerings (ever watch the Iron Chef?!).

The market would seem to agree. This is from Friday morning’s “Early Look at the Market” email from Bear Stearns:

Including ETF activity, Equity funds report net cash inflows totaling $10.756 billion in the week ended 2/7/07 with Domestic funds reporting net inflows of $8.486 billion and Non-domestic funds reporting net inflows of $2.270 billion;

Excluding ETF activity, Equity funds report net cash inflows totaling $2.571 billion with domestic funds reporting net inflows of $1.210 billion and Non-domestic funds reporting net inflows totaling $1.361 billion. – AMG Data

Equity inflow statistics show that it’s the ETF activity that is significant. Thus, it’s not surprising that nearly every business media outlet has some sort of coverage in the ETF space. This even includes TheStreet.com. From this recent article you get an update on TheStreet.com Ratings’ model ETF portfolio which is a “theoretical portfolio of 10 ETFs that we use to track market trends”. Furthermore, the article states that “TheStreet.com’s Ratings coverage universe now consists of 216 of the 362 actively monitored U.S.-traded ETFs.”

So, first, TheStreet.com seems to have enough coverage of ETFs to even warrant the construction of a sample portfolio consisting only of them. Second, although I won’t comment on the merits of this portfolio specifically, it does look nicely diversified to me.

In isolation, a niche sector fund may be anything but diversified and I think investors realize this. Using ETFs, whether exclusively or not, within a broader portfolio is an excellent way to establish the required diversification for any type of investor. Not everyone will buy in to them but many will for many, many different reasons. ETFs allow for more choice. If Cramer really cared about the investor… no reason to think he doesn’t… he’d realize that that means something.

Harry Kat, Goldman Sachs and a few other names have recently made news related to strategies designed to replicate hedge fund performance characteristics. HedgeWorld.com reports that Merrill Lynch has now joined the fray.Of importance is this paragraph:

“Our objective is to replicate the success of [exchange-traded funds] in the mutual fund industry and to apply it to the hedge fund industry,” said Heiko Ebens, head of the relatively new Americas Equity Derivatives Research group and one of the authors of the research that supported the new product. Concretely, this means the future creation of ETF products that would be linked to the new tracker, he said.

I’ve said it before and here’s further evidence that some form of ETF linked to an underlying hedge fund related instrument will one day be available. This in no way makes me a clairvoyant. After inflation indexed bonds, alternative energy, nanotechnology, private equity, infrastructure … you name it … it’s just a matter of time before the next domino falls.

But unlike what many including myself may have guessed, if this ETF is launched, it would not track a broad, commonly cited hedge fund index like those from Credit Suisse-Tremont or Hedge Fund Research. No, this one (again it’s “IF” … this is news on an index, not of an ETF yet) is quite specific referring to the Merrill Lynch Equity Volatility Arbitrage Index which attempts to replicate the returns of an S&P 500 volatility arb strategy. (Those fluent in the “greeks” can dig deeper.)

If you still have no idea what volatility arbitrage is, you know you’re not in long-only vanilla “let’s pick an ETF and plug it into our asset allocation optimizer” world anymore. Often, I try to comment on how ETFs may be used by hedge fund managers. Now we’re looking at how hedge fund strategies can be used by ETF investors.

How does a hedge fund strategy fit within a portfolio, especially one that is predominately implemented through the use of ETFs? There are many answers, but I’m not sure if going ETF all the way is the answer. I know that I’m not a fan of hedge fund indices, or some instrument whose underlying is an HFI, nor am I the biggest fan of a fund-of-funds in the vast majority of cases. Hell, I’m just not a big fan of hedge funds in general for the vast majority of retail investors period. At a certain size, the wealthy investor thinks about and implements the portfolio construction process in an “institutional” manner … whatever that is. The point is, after a certain threshold in size, fees are less onerous and detrimental to performance on a relative basis and the investor has the resources to apply the right amount (or at least better amount) of talent for the endeavor.

I’m going to watch this closely. Many investors may be enticed by the liquidity and perhaps added transparency of an ETF based hedge fund product. I wonder just how much in assets will make its way in.

Recent news of more commodity ETFs (actually ETCs trading out of Paris) makes me wonder about some of the truly “high flying” sectors within the commodity complex. For example, here are some recent press releases related to steel:

AMEX STEEL INDEX UP 9.08% IN JANUARY

NEW YORK, February 5, 2007 – The Amex Steel Index [STEEL] rose 9.08 percent in January.* STEEL is a modified market capitalization-weighted index comprised of the common stocks or ADRs of publicly traded companies involved primarily in activities related to steel production. As of January 31, 2006, STEEL included 37 securities. STEEL is rebalanced quarterly. The next rebalancing will occur on March 16, 2007. The Market Vectors – Steel ETF (Amex: SLX) is an exchange-traded fund that seeks to replicate, as closely as possible, before fees and expenses, the price and yield performance of STEEL. SLX generally holds all of the securities that comprise STEEL in proportion to their weighting in STEEL. Options on SLX are listed on the Amex.

AMEX STEEL INDEX UP 40.70% IN 2006

NEW YORK, January 4, 2007 – The Amex Steel Index [STEEL] rose 0.77 percent in December and gained 40.70 percent for the year ending December 31, 2006.* STEEL is a modified market capitalization-weighted index comprised of the common stocks or ADRs of publicly traded companies involved primarily in activities related to steel production. As of December 31, 2006, STEEL included 38 securities. STEEL is rebalanced quarterly. The next rebalancing will occur on March 16, 2006.

The Market Vectors – Steel ETF (Amex: SLX) is an exchange-traded fund that seeks to replicate, as closely as possible, before fees and expenses, the price and yield performance of STEEL. SLX generally holds all of the securities that comprise STEEL in proportion to their weighting in STEEL. Options on SLX are listed on the Amex.

Here’s the chart since SLX’s inception:

Up about 22% over about a three and a half month period. How does this compare with some other related ETFs?

We see from this second chart how the Steel index moves in a fairly close pattern with the Vanguard Materials ETF (VAW), iShares Dow Jones US Basic Materials (IYM) and SPDRs Metals & Mining (XME). I’m surprised that SLX, being less diversified than the other ETFs mentioned here, has not shown more overall volatility over this period although it has shown greater strength in the run up over the past month.

PowerShares DB Base Metals Fund

But the real question is what’s going on with the PowerShares DB Base Metals Fund (DBB)? Based on the above chart, it’s the odd guy out. According to the fund’s site:

Description

The PowerShares DB Base Metals Fund is based on the Deutsche Bank Liquid Commodity Index – Optimum Yield Industrial Metals Excess Return™ and managed by DB Commodity Services LLC. The Index is a rules-based index composed of futures contracts on some of the most liquid and widely used base metals – aluminum, zinc and copper (grade A). The index is intended to reflect the performance of the industrial metals sector.

No mention of steel here, just aluminum, zinc and copper. More specifically, according to the fund’s fact sheet the underlying index is reset to have equal weighting to the three metals “annually during the first week or so of November. Throughout the year, the precise weight of each commodity in the Index will change based on price changes.” The current weights are updated each day. A quick scan of that link shows currently an approximate 41% weight in aluminum, 29% weight in zinc and 30% weight in copper.

Further to my blog entry yesterday about the commodities ETF launch by ETF Securities, I refer to some of their funds to see how these specific metals have done recently. A London Stock Exchange site provides a chart for an ETF linked to Aluminum from ETF Securities. They provide a chart for the zinc ETF and the copper ETF. So while most of the lines have been going up in the 2nd chart above, clearly DBB has been moving in the opposite direction due to significant weakness in zinc and copper prices.

Update on my entry from yesterday: As discussed, the new offerings (they’re termed ETCs) from ETF Securities will be launched on Euronext Paris, but they are already listed on Euronext Amsterdam, Deutsche Börse and the London Stock Exchange. For U.S. investors, the LSE is particularly interesting as the ETCs are USD-denominated on that exchange.

Here’s some information on the other ETFs mentioned above:

Vanguard Materials ETF

From the Vanguard ETF site specific to VAW (click to enlarge):

VAW seems quite well diversified (like IYM, it’s a broad materials fund as opposed to the others), including an 11.3% allocation to steel, all with a cost of 25bps … not bad at all. However, as a general materials fund, there’s significant chemical exposure.

iShares Dow Jones US Basic Materials

Information on the iShares Dow Jones US Basic Materials (IYM) can be found on the iShares site. Also note that BGI also has a global ETF called the iShares S&P Global Materials Index Fund (MXI). Like VAW, IYM has its biggest exposures (roughly 53%) in chemicals. Just over 12% of the fund is allocated to steel. No surprise then from my 2nd chart that VAM and IYM track very closely.

MXI only has a track record going back to September 12th of last year but as you can see, as a global version of IYM, it also tracks it closely (3-month chart):

SPDRs Metals & Mining (XME)

This ETF from SSGA is more focused than those from Vanguard and iShares. According to the fund’s site, and in particular it’s holdings list, there’s a lot of exposure to steel. So, here’s the chart comparing XME and SLX:

Fairly close, as expected.

So, what does this all mean? There are a lot of products that appear to be covering the same space. But in fact, the overlap is not as great as one might think. If you want exposure to steel in its purest form, it’s got to be SLX — though you’re getting exposure to an index of companies in the steel industry. For exposure to other industrial base metals (though in this case the exposure is directly to certain commodities markets), there is the PowerShares DB Base Metals Fund (DBB) as well as a similar fund from ETF Securities. For even broader exposure, and back to a basket of underlying stocks, there’s XME, IYM, MXI and VAW.

So despite a significant push of new offerings in the commodity space, and in this case specific to base metals, we can see that investors now have the opportunity to more adequately fine tune their exposures and be more precise with their opportunistic calls.

I see an opportunity here also for infrastructure and alternative energy (especially wind farm) fund managers to use an instrument related to steel for hedging purposes, although considering size, they may already be implementing hedges through the futures markets. Certain manufacturers in the computer hardware sector may be more interested in something like DBB. One can go on and on with examples of how certain investors would want (or need) instruments specific to a certain commodity.

Whether the relevant ETF instrument is redundant considering the availability of its counterpart in the futures market is an interesting thought — it all depends on the type of users that are out there and the demand from each segment.

I don’t believe I’ve ever written about ETF Securities out of the UK, which is a shame because I’m all for the little guy getting into the market and making a name for themselves… well, I wouldn’t actually call them small as according to their site they have just over $1 billion in assets under management.If you’ve never heard of them before, this might interest you. They’re best known for Exchange Traded Commodities (ETCs) and here’s the list of 31 ETCs (21 individual, 10 indices) to be launched on Euronext Paris:

OK, so this kind of takes the sizzle off of the recent related commodity ETF news from PowerShares but really it just allows for even finer tuning. Your scalpel just got a bit sharper. In reality, most active managers with a certain level of sophistication will know that all of the above is not really knew in terms of exposure due to instruments available in the futures markets. This really comes down to a choice of ETFs versus futures, assuming you’ve decided to play the commodity complex in a manner that warrants the use of such instruments.

The question now is whether the masses will see recent price strength over the past months (see 6-month chart below) as a buying opportunity, a shorting opportunity, or don’t know what the %&#@ is going on:

This recent article from Reuters seems to address what’s behind the increased pace of ETF development in the commodity space:

Investors are now more nervous of taking up long-only positions in the indexes, which traditionally have been the most straightforward way for pension funds, insurance companies and high net worth individuals to access commodities.

Analysts say much of the institutional money already invested in indexes is unlikely to exit in a hurry, but new money is expected to take more active approaches, which involve taking short as well as long positions.

If the commodity complex is an area where you don’t want to be “long only” because of its inherent volatility (I think this is so true), it only makes sense that ETFs and derivatives be the natural choice for investors who wish to manage the asset class actively. After the run up of the past few years, they might just have to.

Sidenote: There will come a day, hopefully soon, where we have something similar to Globex (Chicago Merc) so that investors can trade ETFs electronically, 24 hours a day, all over the globe in the same manner as derivatives are traded today. Perhaps with increased mergers between the large stock exchanges on both sides of the Atlantic, and with a couple from east Asia hopefully thrown in, this will happen sooner rather than later.

As a follow up to my entry of December 20th, 2006 titled An Overview of Shariah Compliant Indices, we get news from HedgeWeek.com of “the first Shariah compliant ETF to be offered in western Europe.”Trading on the SWX Swiss Exchange, the EasyETF DJ Islamic Market Titans 100 will be managed by BNP Paribas Asset Management. This ETF tracks the Dow Jones Islamic Market Titans 100 Index, a blue-chip index tracking the 100 largest global companies that comply with Islamic investment guidelines. Again, from my December 20th piece, here’s the link for more info on the DJIMT and a brief outline of the composition guidelines for the 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.

No word on fees or if something similar in terms of a US domiciled offering is in the works. I couldn’t pull up the Dow Jones Islamic Market Titans 100 Index on Bigcharts.com, so this chart is from Yahoo Finance:

I’ve compared the DJIMT 100 Index with the iShares S&P Global 100 Index (IOO). The two “top 100” indices seem to be moving in line over the past 3 years. Only a slight overperformance for IOO during the strong run up in 2003 but again, nothing too significant. Taking a look at the composition of the two ETFs over time, I don’t see anything that could cause too much of a difference between these funds. My sense is that if the financial services subindex greatly deviates from that of the broader benchmarks, there could be some significant divergence between the two “top 100” indices. However, here’s a chart showing IOO versus the iShares S&P Global Financials Sector Index ETF (IXG):

Clearly, we have some divergence here as the financials have greatly outperformed the global top 100 stocks. Since the Shariah compliant index must be underweight financials to some significant degree based on the given guidelines, this explains the DJIMT 100 Index’s underperformance versus IOO.

Financials are a significant component of global indices unlike other sectors mentioned in the Shariah guidelines so I’ll leave my comparative analysis at that.

Like their recent innovation of an ETF with a principal protection component, Societe Generale Asset Management is again moving into relatively new territory by introducing a new private equity ETF called The SGAM ETF Private Equity LPX50. Here’s the posting from Hedgeweek.com.When I say “new territory”, I am referring to private equity where, aside from the arrival of the PowerShares Listed Private EquitySM Portfolio (PSP) late last year which caused quite a bit of buzz, there is little else out there for investors aside from more direct private equity funds or “fund of funds”. However, in my piece on November 6, 2006 (Can Retail Investors Profit From Hedge Fund Access?) I did comment on the Private Equity Index (PRIVEX) and how “we may soon see an ETF linked to this new private equity index which is a collaborative effort between Société Générale Corporate & Investment Banking and Dow Jones Indexes/STOXX”. Well, SGAM has gone forward instead with LPX, a Swiss-based specialist provider of private equity research, on this ETF offering.

Here’s what caught my eye in the piece regarding the underlying index:

• “The LPX 50 Total Return Index is currently the principal benchmark reference of the listed private equity sector, offering liquid and immediate access to the 50 largest listed companies whose core activity is the allocation of private equity capital.”
• “The universe of the LPX50 Index consists of companies and funds that are listed on a recognised stock exchange and at least 50 per cent of whose total assets are invested directly or indirectly in the private equity sector, while pursuing a defined and clear exit strategy for their committed investments in order to redistribute capital gains to their investors.”
• “The index represents 70 per cent of the sector’s global market capitalisation and is diversified across all segments of private equity (venture, growth and buyout capital) and regions (Europe, the US and Asia).”
• “The LPX50 Total Return Index covers firms and funds selected not only for their size but also for their liquidity. Index composition is determined on the basis of a wide range of factors, including market capitalisation, weekly trading volume and average bid-offer spread. The index is rebalanced twice yearly.”

In many ways, this ETF looks similar to PSP, but there are some differences:

• Cost: It’s slightly more expensive at 70bps versus PSP at 60bps.

• Number of holdings: According to the PowerShares site for PSP, there are about 35 holdings as of January 30th versus the LPX 50.

• Rebalancing: SGAM’s offering is rebalanced semi-annually versus PSP which is quarterly.

• According to the new information, the SGAM ETF will have exposure to Europe, US and Asia while PSP has exposure only to the US.

I like the idea of accessing private equity with the benefits of an ETF, but I like even more the idea of global exposure. There’s been a lot press on the various downsides of private equity investing via an ETF (or at least focused on the mechanics specific to PSP), so it will be just a matter of time before similar analysis is done on this new ETF from SGAM.

With recent news of an infrastructure ETF and now more for private equity, I guess the only area left to be covered is hedge funds. There are various hedge fund indices out there… who will be first to link an ETF to one? I personally hope that doesn’t happen. A hedge fund index is a “fund of funds” being marketed as an index… but with a significant number of flaws (biases) not found in traditional indexing.

My feeling is that if you’re going to invest in hedge funds and want someone specifically mandated to run a portfolio of hedge funds, they should be given the discretion needed to manage them actively, not in the form of an index. Just my opinion.