Due to my background as a CIO/portfolio manager I have a top-down view of the portfolio construction process. Unlike PMs with a fundamentally or technically based bottom-up approach, I often am involved in mandates that limit the use of stock selection to where it is the last course of action. So, if I want to have timber or uranium exposure, for example, I’m pretty much stuck and will have to pick some stocks or perhaps select an active manager in that space, whatever I feel is more appropriate. If I were involved with a very large institution, then this type of investment would be direct and through private as opposed to public markets.

When I look at any asset class and then instrument or manager, I think of it as I would any piece on the chessboard. How does it fit in the overall strategy? What is its purpose? ETFs are tools that were created to be replacements for certain parts of the traditional components of a portfolio. These traditional components could include direct investments in stocks and bonds as well as some form of managed product such as a mutual fund. Some may argue that ETFs are passive and hence should not be thought of as “managed” products but they are to some degree, albeit to a lesser extent compared to mutual funds. If ETFs are not managed, then why do they charge a management fee? Simply put, on the active versus passive spectrum, ETFs have been closer to the passive end but as we’ve seen lately, the industry is attempting to move slowly closer towards the active end. I personally think that the push will only go so far. Investors of all sorts will remain vigilant with regard to costs. Furthermore, the “performance to cost” ratio will be something investors focus on more as the market environment changes. In a time of relative calm and bullishness as we’ve seen over the past four years, investors have become less risk averse and less concerned about costs. True, investors are becoming more aware of costs but it usually takes a back seat when times are good and performance dilutes the effects of costs. But should we experience a serious market decline as we did after 2000, the expectations of investors will be recalibrated and decisions made thereafter.

Will investors remain long-term oriented as they say and stay the course? Or will they shift greater allocations to actively managed products such as hedge funds to hopefully reduce the pain of a downside market? If it is for the latter, the shift may come too late. Furthermore, I’ve commented repeatedly about the sorry state of the hedge fund industry. It’s not that hedge funds are all bad. But here’s a quick list of points that stack up against hedge funds as an investment for the vast majority of investors:

• The search for alpha: Alpha is out there. Whether there’s more or less alpha than there was ten, twenty or thirty years ago is academic to me. There will always be winners and losers in the market. In the days of Soros, Robertson and Trout there weren’t many hedge fund managers finding the inefficiencies in the market and exploiting them. Today, there are many more participants due to the low barriers to entry into this field. So even though the amount of available alpha may be the same (or more, or less … it doesn’t really matter I think), the point is that the amount of “alpha per capita” has been greatly reduced.
• I read recently that Soros was only right roughly 30% of the time. When he was wrong, he was wrong a little. When he was right, he was right big. Further to bullet point #1, it’s tougher to be right big when there are so many other participants in the markets. Unfortunately, this pattern is not symmetric. Amaranth was an example of a manager that was wrong big. Clearly, there were many other participants on the other side who were right small. That might be the future of hedge funds: Not swinging for the fences but maybe hitting more like Pete Rose. I didn’t say betting like Pete Rose, I said hitting like Pete Rose!
• With the low barriers to the entry into this field, we have two further problems. First, many new hedge fund managers are simply focusing on simple long/short strategies or other traditional and more established hedge fund strategies. Obviously, with greater competition in a certain space, the harder it is to attain success. So perhaps newer yet more esoteric strategies (carbon credit trading, for example) may be areas where a manager can have a legitimate shot to attain some sort of advantage. For those who stick to the more traditional hedge fund strategies, it will only get more difficult. Just because you were successful as a long only manager (to what degree of success?), doesn’t mean that running a long/short program successfully is assured. Furthermore, the evidence shows that a very large proportion of hedge funds have incredibly high correlations with broad capital markets, especially the equity markets, likely due to the long bias as a result to one’s traditional investment management background. Problem 2: Paying 150bps for a “closet index” mutual fund manager is bad. How about paying 2% + 20% performance fees for a closet index hedge fund manager? Clearly, an effective quantitative screen is required to filter out not only the poor performers but those that provide more beta than alpha.
• On the plus side, there are a relatively good number of young hedge fund companies (sometimes run by young hedge fund managers) that have shown success in their performance, and thus in the overall sustainability of their company. These “emerging” managers seem to be able to exploit one or two (or basically a small number) of inefficiencies in the market. In fact, there have been a significant number of academic studies that have demonstrated that a universe of younger funds is a better place to start hunting for hedge funds with the potential for greater performance.
• Oh, the potential for greater performance … with increased investor attention towards hedge funds, the sport of “chasing returns” will have moved to the next level. Chasing performance is tough enough in the mutual fund space but the risk transfer is not significant. Because of the high correlations that mutual funds have with the markets, investors are basically taking on market risk whether invested in mutual funds or directly through positions in the market. It’s different with hedge funds. With hedge funds, investors are (supposedly) taking on manager risk to offset market risk. If a hedge fund is truly beta or market neutral, then this is true. However, if there’s the high correlation I’ve mentioned earlier, then it’s still market risk that’s the concern. Plus the manager risk! The worst case scenario is where a hedge fund manager has a small and operationally “loose” environment where performance is highly correlated with the markets. Ideally, you want an operation run like a submarine or some form of military operation. You want the precision where everyone knows their job and there is an appropriate system of checks and balances. Discipline means that no one person has the ability to go beyond some pre-determined threshold or risk parameter. The moment they do go beyond their bounds, there must be some form of disciplinary action. Success is not so much about beating the competition, but being able to fight on the following day. The metaphor may not be perfect, but I believe it’s the discipline, or lack of, that often gets one in trouble.
• The retailization of hedge funds. Based on all of the above, I believe that retail investors may be best to avoid hedge funds and any alternative investments with significant non-market related risks. It’s a fair statement to say that selecting hedge fund managers for one’s portfolio is difficult. The problem isn’t just picking managers with good performance and hoping that their performance continues to be strong. It’s also about the qualitative due diligence required to avoid the blowups. Actually, blowup risk is actually quite low. However, many hedge funds simply close down not due to a blowup but for a large variety of reasons. Of course, the large institutional investor cares about performance, but they spend an incredible amount of resources studying the sustainability of potential hedge fund managers to be added to their roster. They want to avoid the worst case scenario: Having their name on the front page of the morning paper and their beneficiaries noting that they were involved in a big hedge fund blowup. Returns highly correlated with the S&P 500 is bad. A banana peel scenario like Amaranth and the well publicized problems at a fund like San Diego thereafter is much worse.

Many of these discussions I have presented in posts I’ve written in the recent past. The point is that for many investors (including many institutions), the decision to get into hedge funds is a tough one. What’s an investor to do in preparation for a potential bear market? If correlations among asset classes are high, than the benefits of diversification have a limited effect. As I’ve explained, asset strategies such as hedge funds are no safe haven due to a variety of risks as well as costs. Market timing by either shifting to cash or by shorting (whether truly shorting or by way of inverse funds/ETFs) is an appropriate response for those not willing to ride through a prolonged bear market. But what else?

You would think that after such a sustained bull run, Wall Street would be ramping up the product development for defensively oriented instruments. There are a lot of hedge funds coming to market, that’s for sure. Private equity has been hot as well and in this case returns have actually been quite exceptional. But when you look at the ETF space, most of the products coming on line have been linked to an asset class or sector that has shown exceptional performance of late. It’s almost like the perfect form of inverse market timing. With new funds for international real estate, infrastructure and listed private equity, you have to wonder what institutional investors are thinking. They have been invested in these areas for quite a while. The truly smart and innovative pension and endowment funds may have been invested in them for over a decade. If I were them, and I saw significant global assets being funneled into ETFs, CEFs and other instruments (not direct investments) in these areas, I might be itching to get my finger on that trigger to pull out, or at least reduce. I don’t think my argument here is for the ordinary investor to not invest in these areas. They should just be aware that there’e nothing innovative by getting exposure to these asset classes or strategies and they may in fact be a bit late.

Perhaps the easiest solution to a market meltdown is simply to reallocate one’s portfolio to cash and bonds. This leads to my final thought: fixed income ETFs. I think Canada is like a testing ground for ETFs: first ETF ever, first BRIC ETF and yes, the first fixed income ETFs. Barclays Global Investors introduced the first fixed income ETFs in the world here in Canada back in 2000. One was a government of Canada 5-Year bond ETF, the other was the same but for 10-Years. Interestingly, these ETFs did not track an underlying Canadian bond index but rather invested in one (YES, ONE!) Government of Canada bond that had a time to maturity that closely matched the benchmark bond maturity. As a result, these ETFs never held more than one security at any time. BGI simply rolled over the respective bond within each ETF, always holding the one that was most liquid. This is the origins of bond ETFs! Why no indexing but just one underlying bond? Clearly, indexing with bonds is not the same as indexing with equities and the benefits are not the same with both.

The idea of an equity index as a highly diversified means for market exposure is straightforward. With bonds, it’s just not the same. Bond indices can consist of hundreds or likely even thousands of underlying bonds however the correlations among the bonds is quite high … significantly higher than among stocks within an index. Because the gross returns among bonds are not that great, there is greater importance to costs within a bond ETF. The Canadian bond ETFs had a 25 bps MER. Even back in 2000 when the ETF industry was still in its relative infancy, I had many discussions with BGI Canada suggesting that they drop their MER somewhere below 5 bps, which I thought was more appropriate than 25bps. They never did that. But the important thing to note is that with bond ETFs, costs matter. I think that’s the number one rule of thumb when considering fixed income ETFs. By the way, you’ll be glad to know that about four years later in December 2004, BGI Canada converted the 5-Year Government of Canada Bond ETF into one that tracks a short term (less than 5 year maturity) bond index. The 10-Year Government of Canada Bond ETF was converted to track a well accepted Canadian bond index that includes various underlying government and corporate bonds. Although I easily stand by comments about diversification within a bond ETF, anything beats an ETF with one underlying position!

We’re at the point today where in Canada we have bond ETFs that cover various areas of the yield curve for government bonds as well as coverage for corporates and real return bonds, very similar to where the US iShares business was not too long ago before BGI introduced their second wave of fixed income ETFs. Incredibly, despite having raised well over $20 billion in assets in their six bond ETFs, BGI waited about four and a half years before launching this second wave. And during this time, no one came to market with competing products. I wrote back in January about Vanguard’s (still not yet to market) bond ETFs which provide lower costs but not too much more beyond that. You’ll note in that posting how I hope for expansion in the bond ETF space to push internationally but I end up being disappointed. With all the innovation in the ETF industry, what’s going on in the bond side?

I think the question is: Who would use a bond ETF? If investors are more price sensitive to financial products, they must be hyper-sensitive to the costs of bond ETFs as for reasons described earlier. Furthermore, if ETFs are bought for the benefits of diversification and bond ETFs provide little of that, then right away you have two big strikes against you. Whether right or wrong, I think that most ordinary investors can easily build their own laddered portfolio with a relatively adequate level of fine tuning to provide the income they require. Thereafter, diversifying by credit worthiness and a simple mix of government, corporates and even real return bonds will likely be sufficient for the vast majority of investors. For financial advisors and fund managers, this sort of bond portfolio management makes bond ETFs unnecessary.

Recently and over many postings, I have suggested that hedge funds are the big users of ETFs. The shift in product development towards niche sector ETFs and other highly specialized products leads well to the continued growth of both the ETF and hedge fund markets. Another strike for the bond ETFs, but I would find it hard to believe that hedge fund managers would find any interest here. If they wanted to play the fixed income markets, they would go directly into the bond market otherwise find exposures through interest rate derivatives and other derivatives such as credit default swaps.

What would I do if I were to build a bond ETF? The quick and easy answer is I wouldn’t because the solution might have to include an MER somewhere well south of 10bps. But if I had to, I’d really try to get one with simple international exposure. Think of it like the SPDR MSCI ACWI ex-US ETF (CWI) from SSGA but with bond exposure instead of equities. I think that emerging market bonds have the same potential (both in terms of risk and return) as emerging market equities. It’s unfortunate that the logistics of establishing underlying positions for EM markets within an ETF structure make it impractical. Perhaps doing something like what we see on the equity side is the next logical step for bond ETFs. Either moving towards a quasi-active state or simply moving away from pure indexing to something more like an index-plus strategy would be more receptive to investors, as long as costs still remain in check. Bob Smith of Sage Advisory Services moderated a panel discussion at a recent ETF conference and his company website describes a “Core Plus fixed income strategy” product. I informed Bob directly, both during his discussion and immediately thereafter, my thoughts on the future of bond ETFs. For reasons described above, my opinions are clear: It’s not an area that is well suited for the ETF marketplace. Not only did no one step up to challenge BGI over the past four years, a US based ETF provider focused on bond exposures actually closed down after only about a half year of operations, this all happening near the beginning of the decade. Even in the ETF space, there’s always a risk to being “first to market”! And I didn’t even get to the fact that interest rates have ridden a secular trend from highs in the early 80’s to lows only a few years ago as shown in this chart:

If investors think the trend for interest rates is down and the US will look more like Japan in terms of monetary policy, then that’s one thing. If not, and rates are to begin a long and slow climb upwards, then perhaps there’s a reason why even pension funds don’t have as high an allocation to bonds as many might guess. The macroeconomic rationale for bonds, with yields not that much higher than cash equivalents considering the risks, could be one of the more fundamental reasons why bond ETFs are not high up on the list with ETF providers.

I’ve just attacked hedge funds and bond ETFs. Two opposite ends of the spectrum but both commonly added to the equity based portfolio to dampen volatility. Clearly my intent is not to propose that these instruments have no place in the market and thus should be entirely avoided. I believe that hedge funds are an integral part of a large, well diversified portfolio where the manager is fully congizant of the role of active managers and the sources of risk and return when venturing out to certain types of active strategies. If there is a market for the ultimate “couch potato” portfolio, bond ETFs could fit nicely in there. My intent here, as in previous posts is to highlight the potential flaws in products or services that may be getting a lot of attention as an all encompassing solution.

My tone may be bearish but I am more concerned of the overall market than I am for the ETF industry. As such, I believe ETF providers should be thinking carefully about how their products, or products in the pipeline, fit in a portfolio context and how they may (if at all) help investors during major market declines. Advisors should be thinking about strategies for their client portfolios, perhaps even something once thought forbidden like market timing or tactical asset allocation … perhaps something simpler such as option overlays to help prepare for major market declines which I have repeated many, many times is something we really haven’t seen in many, many years.

Back in Toronto after spending a nice 48 hours in Miami. Too bad Tuesday was mostly cloudly but at least I had a few hours of good sun by the pool on Monday. You take what you can get when you’re based in the north. The tennis was pretty sweet as well. Best of all was hooking up with industry people who share a wealth of knowledge, experience and ideas that make me think that there are a lot of areas to talk about. This posting is long as I have had many thoughts in my head after having them circulate in my brain over the past few days. I hope to dig into several of the ideas in more detail in the near future. If you want me to really focus on anything below, just let me know.

According to the delegate list provided at the 7th Annual World Series of Exchange Traded Funds, there were roughly 350 people at this event. I won’t review all the topics covered, but you get an idea of the breadth of coverage from the conference agenda found here.

This was definitely a bigger event than the one I was at in New York three weeks ago although many have told me that the biggie is the Superbowl of Indexing held every December. I’dlike to attend that one later this year and my hope is that it really goes beyond just ETFs. But here are my thoughts on this 1.5 day event that was completed on Tuesday.

1. I get the funny feeling that this industry doesn’t really know where it’s going. That’s just my first impression after having been to two ETF related events in the US and having not been to any previous to that. I had some assumptions prior to this month. They’ve changed a bit. This doesn’t mean that the ETF providers are a bunch of monkeys who are randomly throwing ideas at the wall everyday. There is an exceptional amount of innovation being demonstrated in this field. But you kind of get that funny feeling … my spidey sense says that there may be a need for some caution as I first stated in my previous posting.

2. What I don’t like about these events (I know, sounds like this Kang guy wants to diss everyone!) is that it feels like one big “pat on the back” party. Everyone is so gung ho about ETFs with relatively little in terms of questions/analysis/criticism about anything. There were a few from the audience who asked some very good questions and I made it a point to continue to talk with them. It’s not that I’m looking for trouble or wanting to criticize anyone I can just for the sport of it but like mutual funds, hedge funds, pension funds or any sort of product or service, there are flaws. Not everything works for everyone. Sometimes a particular product or service may work for a very small number of users. Bogle is at one extreme where he says that something like SPY works for everyone and all investors should hold very broad exposure, low cost instruments. Nothing is absolute but I think he’s more right than wrong. At the other extreme is the highly niche sector ETFs or new strategy ETFs with an underlying rules-based methodology that don’t seem applicable for many investors because of specifics related to their portfolio construction process, risk tolerance, level of experience/knowledge, etc. There’s certainly a market for these funds and I’ll get to that later. Like I’ve said many times before, investors have no interest in seeing the smaller ETF players disappear. Nothing against the big names like BGI, SSGA and Vanguard but a more robust group of providers is good for the industry in so many ways. The innovation they provide is more than enough, I think, to keep the big guys on their toes and that’s a good thing. I think that most investors and product developers realize this, of course. But my point here is that these new niche/strategy ETFs need to think about how they fit in the larger portfolio construction process. I’ll also dig into that a bit later.

3. During my time in Miami, I was given the opportunity to see things at a much different level. I will in no way get to specifics but, likely due to my written work online, various index providers (or quasi-index providers) as well as ETF manufacturers approached me with questions about their investment methodology, or proposed ideas, as well as wanting my thoughts on their business model. There were many more of these impromptu meetings than I ever would have guessed. Again, I can’t talk about anything specific. But there’s a pipeline and it’s going to be flowing with new products for a while. To those who have written that things are getting out of hand with the number of new products, beware. You are both very right (there’s a lot) and very wrong (your call about too many ETFs may be premature).

4. Kudos to the many retail advisors I met and heard from at the event. They demonstrated a level of product knowledge that I wish existed here in Canada. There are those in Canada with the same level of acumen in this area, just not as many. I mentioned publicly during one of the Q&A sessions that I don’t consider myself to be an expert in the retail space. But I know enough that the fee based advisor is the ideal target market for the ETF wholesaler. Their holistic approach to portfolio construction based on the fundamentals of asset allocation lead well to the use of ETFs. Their processes are usually quite simple, although in my opinion perhaps a bit too dependent on optimizer software programs. However, I don’t know if the retail high-net-worth advisor is the main conduit for ETF sales anymore. Perhaps in the past they were, but I’m guessing not as much now. My arguments of the past have made me speculate that it’s the hedge funds and other professional/institutional traders who are the real users of ETFs and that’s why we see the large volume of trading in ETFs. The retail advisor sector may be significant, but I don’t know if they’re the biggest piece in the sales pie. But let’s just assume they’re very significant. They build their client portfolios and diversify between equities, fixed income and cash. The equities may be further broken down by any combination of regional, sector, market capitalization, style and other classifications all of which are nicely covered by the ETF universe. The fixed income component will likely have a combination of a laddered bond portfolio along with some additional bond mutual funds and/or ETFs. Perhaps some alternatives like a gold ETF, REIT ETF, or some other exposures are thrown in to provide added diversification which many may assume, rightly or wrongly so, to provide a certain degree of further volatility dampening. OK, that’s not too bad. Not perfect, but not bad. So the question now is where do the newer ETFs come into play within this mix. The strategy based funds (WisdomTree, PowerShares FTSE-RAFI, perhaps some of the more black-box based funds) can be used as either a compliment or substitute for the traditional SPY-type holdings. Everything else I see as even more of an active bet. Let me say this again this way: The moment you decide to invest in a Russian ETF, an agricultural commodity ETF, a cancer related ETF or other relatively narrow focused fund, you are attempting to behave more like a hedge fund than a traditional asset allocator. I wouldn’t be surprised to hear some arguments against this and I can guess some. First, even an asset allocator is making active bets. The decision to be 60% equity/40% fixed income versus 60%E/40%FI is an active bet. But you’ll agree that the degree of “activeness” isn’t the same. Second, there could be some arguments within a well thought out portfolio construction process for the addition of a niche ETF and I have written about some in the past. One example is adding alternative energy as a possible hedge for investors with high traditional energy (oil) exposure. A short ETF in this space like the one from MacroShares would serve a similar, although much more direct, purpose. But it comes down to the advisor/investor and their view of the asset allocation decision. Strategic asset allocation will generally not require use of these narrower ETFs but they could be used sparingly. Move to tactical asset allocation and then the argument for their use is strong. I’m not saying that narrowly focused ETFs including the ones mentioned above are not good. I’m just saying that for the vast majority of advisors who are building relatively simple portfolios with minimal active calls, these kind of ETFs will provide little value and thus will have limited use for them.

5. Therefore, the newer niche funds and strategy funds will likely have a smaller market in terms of interested investors. Furthermore and let’s face it, with more and more product, it’s getting harder to differentiate yours versus the competition. In the case of the newer ETFs, the low cost isn’t the selling point. It’s the idea. So, further to point #4 above, the newer and more narrow ETFs will have to search far and wide for their target market who agree with the idea(s). It’s not going to be based on the typical retail advisor/investor. It may not even be the large hedge funds as they will likely only use the ETF when the derivative contract for the same exposure does not exist. So who’s left? The smaller “emerging” hedge funds like the ones recently publicized in the press that are to be included in the large CalPERS portfolio. Many of these funds have investor capital of less than $50 million. Derivatives may not work all the time for such smaller funds and ETFs can fill this gap. The internal trading desks for some institutions, like pension funds, may also have use for these. After measuring the exposures among their external asset managers in aggregate, they may notice that they are over or underexposed to a certain sector or region beyond acceptable parameters. If their policy guidelines do not allow for the trading of derivatives, their only choice may be ETFs. I can knock off about a half dozen other potential targets but I’m sure the ETF wholesalers are already on the golf course with them. Bottom line: The relatively easy (it’s never easy) ETF sales and marketing effort is going to get much tougher. Even for something as elementary as fixed income ETFs - it won’t be an easy sell. I commented during the fixed income ETF session on Tuesday about my doubts for the suggested acceleration in growth in this area. After clarifying our statements after the session, the moderator and I agreed that delivering the message and leading this to sales would not be an easy task. And we’re basically talking about the treasury/bond market that is no small entity!

So where does that leave us? ETFs as an asset allocation tool has been done. It’s a saturated space with more than enough S&P 500 ETFs and index mutual funds to go around. Investors of all kinds are looking into different ways to use beta instruments. I received the usual morning email report from JP Morgan today. Here are too short excerpts:

“ETF volume is accounting for 26.92% of the $ volume traded on the NYSE and AMEX, suggesting selling of individual positions is not accelerating.”

“Accounts appear to be using index proxies like the SPY’s to hedge positions rather then selling into strength.”

So it seems like there’s a lot of defensive posturing going out there. Bogle says everyone should be using something like SPY. It seems like they are but in this case we see a lot of people using them for shorts to hedge their stock based portfolio. This is great. They are sticking to their knitting by remaining long-term in focus … that’s why they’re holding onto their positions (It says above “rather than selling into strength”). This is like what I’ve said in the past about investing in emerging markets with a methodology based on securities selection but with the occasional use of shorting EEM or VWO to hedge risks when the market tanks. So in a way investors are listening to Bogle about using broadly exposed, low cost ETFs. The problem is that they’re being creative in their use. Hey, it’s all about taking one form of risk in place of another. Isn’t that what we’re in the business of: valuing risk?

If so, then plain vanilla asset allocation strategies and portfolio construction based on that, is not enough. It’s not a bad start but for many reasons, including the increasing correlations among asset classes, investors need to consider potential extra steps. We can see this in the institutional space. This is an interesting article from the Global Association of Risk Professionals website:

The article describes strategies that institutions are adopting to allow their current processes (asset allocation, risk budgeting, manager selection, etc.) to be more appropriately in sync with their liabilities. This brings new frameworks to constrain the portfolio process:

“According to the results of Greenwich Associates’ 2006 U.S. Investment Management Research Study, the departure from traditional pension management practices is most evident in the increasing popularity of innovative products and techniques such as liability-driven investment strategies, absolute return strategies, portable alpha and net-long approaches such as 120/20 and 130/30 strategies. “Although actual usage of these products remains relatively low, there are signs that the current period might well represent the calm before the storm,” says Greenwich Associates consultant Rodger Smith.”

Absolute return strategies, portable alpha and 130/30 strategies right away brings us closer, if not right to, the hedge fund space. If not full blown “hedge fund” (whatever that means), at least we’re seeing a greater acceptance for purer active management. This is exactly what the ETF industry is trying to do. With all of the new products coming out, it is an attempt for the ETF industry to become more and more active … or less and less passive. It was never purely passive. But now even less so.

But I don’t see this as the only future of the industry. Based on what we see here from the institutional space, what the ETF industry needs to do is package ETFs in a more meaningful manner. It was repeated so many times at the conference: “ETFs are just a tool.” That’s right. So build some kind of process where ETFs are managed in a thoughtful way. We’re beginning to see this with lifecycle funds and managed programs from groups like XTF Advisors. My front page article on the latest issue of the Exchange Traded Fund Report (ETFR) talks about building your own 130/30 fund using levered ETFs. It can also be considered a play on portable alpha or a form of index plus. What about building some online platform where investors could choose their beta source for a particular asset class (something like SPY or a levered version of it) and overlay this in some manner with an alpha oriented program (hedge fund replication ETF, long/short ETF overlay, etc.)? It sounds easy and of course it very much is not. Building an effective alpha oriented program in this manner is like trying to build a stealth bomber using paper airplane technology. But it’s the concept of packaging different kinds of ETFs in creative ways that I would hope to see as the next logical step in the evolution of this industry. Active managment of beta to create alpha seems logical. Perhaps more logical than the need to have actively managed ETFs.

I’d like to put in a few short thoughts on the two panels I was involved with at the event. I moderated a discussion on alternatively weighted indices. Clearly, Srikant Dash of S&P, Steve Sachs of Rydex and Ken Marschner of UBS have that unique view from the inside that others need to discover to fully understand the scope of the situation. Although we’re seeing a massive bombardment of new indexing methodologies, it’s still too early to say that traditional market cap weighted indexing is on its knees. Whether in the retail or institutional space, the numbers are clear … in terms of assets under management, the traditional form of indexing is still strong and it will take a long time, if ever, for alternatively weighted indexes to even come close in terms of acceptance. Further proof that the spidey sense may be working with regard to newer ETFs.

The international/BRIC exposure discussion led by Tom Lydon of ETF Trends was fun. John Prestbo’s one-liners are great … hey, it’s a conference on ETFs … talk to 99.99% of the population on the subject and they’re already snoring, so thanks to John for adding some fun to the mix. Like John at Dow Jones Indexes, Corin Frost of BGI and Harmut Graf of the Deutsche Boerse clearly have the international insights based on their respective perches and was demonstrated through their comments. My views were relatively limited as I see international exposure from a Canadian perspective. It’s good to hear from an index provider, ETF manager and another foreign observer on how they see international exposure. I was happy to see that some attendees had reservations on the viabililty of the BRIC story … it’s healthy to challenge new ideas and products related to them. But the panel (including myself) seemed to be in agreement that the long term story is very strong although volatility will definitely test the strength of investors’ stomachs. If you don’t have a risk budget governing your investment process and you’re investing in emerging markets, buy the Maalox now. If you had significant EM exposure last summer then you’ve likely already restocked the meds in preparation for the next sharp decline.

Lastly, many thanks to all those that I met at the event in Miami. The overwhelmingly postitive response to my work is greatly appreciated and also humbling. As a blogger, you don’t really have all the information. You can guage how many are visiting your site and you get some commentary, but you don’t really get the real response until you’re face to face.  I appreciate the feedback and of course, highly value constructive criticism. Furthermore, if there’s an area of beta (not just ETFs) that you’d like me to focus on, please send a note. This is best possible by registering to my blog here.

Thanks again to all.

Let’s do a quick review of recent developments:

1. Tom Lydon at ETF Trends gives notice of some new SPDRs that were launched Friday covering various emerging market regions. Here’s the press release from State Street Global Advisors. From a previous posting on February 16 titled “All In All, It’s Just Another Brick In The Wall”, I argued that for most investors broad emerging market exposure could be done simply and cost effectively with maybe just two positions. On a February 14th posting titled “Is Emerging Market ETF Slicing and Dicing Necessary”, I suggested that funds focused on specific EM regions could be used for opportunistic trading including possible shorting in times of distress. And back in October 2nd of last year I argued that “More Regional Emerging Market ETFs Are Needed”. Bottom line: There must be a market for these as SSGA seems to be hitting some highly selective areas in recent months like infrastructure, international real estate and now these new emerging market ETFs. Somehow I don’t think the average investor, even the more experienced ETF-based investor would be a strong proponent for use of a mideast/Africa ETF or some combination of these emerging market funds. It’s got to be highly active professional investors like hedge funds, prop desks, mutual funds and even the internal asset allocation desks of large pension funds. Clearly, ETFs are not for mom and pop’s basic do-it-yourself retirement portfolio.

2. Next, we get news from Matt Hougan of IndexUniverse.com of a “hedge fund replicator” ETF. In fact, it is to be “… a suite of synthetic hedge funds strategies, which will use portfolios of ETFs to track the performance of the ten investable Tremont Hedge Fund sub-indexes. The group plans to offer low-cost mutual funds and separately managed accounts that will track each of the ten indexes.” So, the plan as I read it is not for ETFs with underlying hedge fund strategies but a mutual fund or separately managed account format with an underlying portfolio of ETFs that in combination will attempt to replicate the performance characteristics of certain hedge fund indices. Get it? At first, from reading the title from Seeking Alpha (”IndexIQ To Release ‘Hedge Fund Replicator” ETFs At Fraction of Cost”), you think an ETF with an underlying hedge fund is about to be released. In fact, it’s some other form of fund with underlying ETFs to mimic hedge funds. Clearly, the intersection of ETFs and hedge funds as I’ve been repeating so often over the past few months is something that will happen and in so many different ways.

3. One of the more common forms of such intersection is the hedge fund with underlying ETFs being used in an opportunistic fashion. It seems like one such new fund or mandate is popping up every day. For example, news of Morgan Stanley Investment Management’s former CIO starting up a hedge fund with other sell-side departees can be found here. According to the article, “The fund implements positions through futures, exchange traded funds, and customized baskets of securities” and will take long and short positions. Although not specifically mentioned, there will likely be use of leverage through the futures positions.

4. There are various other developments including life cycle funds that rebalance its underlying asset classes based on some pre-determined retirement date. This seems to take most of the fun out for the “do it yourself” investor but I can see a market for these. Just as ETFs will likely take a big chunk from the mutual fund market, these ETFs may do the same to the wrap market. There’s news of an upcoming natural gas ETF. Why is it that I thought of nothing but Amaranth when I read about this? This all follows ProShares’ massive set of levered and inverse ETF launches in February. All in all, this point and the three points previous to this point to the same direction: ETFs are built for active investors who are using beta as a means to obtain alpha. That could be in the form of searching for returns all over the world. It could be hedging (shorting) opportunistically. It could be used for long-short or GTAA strategies or even for some form of replication strategy. It could mean countless ways of extracting alpha.

5. I noticed this advertisement on one of the many ETF related sites I read:
No comments really. You can come up with your own.

Time For Caution

We’ve already heard from various sources that the ETF industry, at least in terms of the number of ETFs, will likely double within the next year. Who knows about the growth in assets but I think it’s fair to say it will increase even if there is a significant market decline. But are we close to the final destination? Are we there yet? I don’t think we’re even close. But only now am I beginning to question the value of new ETFs coming on line. In the past, there were a few ETFs that occasionally would give me reason to question their purpose. However, most have done well in terms of asset growth and trading volumes. I have greater reservations now about certain ETFs coming out now. There aren’t many, but I just don’t have the comfort level I had in the past. I’d like to think that the decision makers at the ETF manufacturers are launching products based on sound market research and overall business planning. That’s not where I have much doubt. I don’t want to dig into too much detail right now about which ETFs I think might not survive and the various banana peels I see or sense within the ETF industry. I’ll save that for a future posting.
Oh, and I haven’t even gotten to news of Bear Stearns’ SEC filing for an actively managed ETF.

Bottom line: I think we’re right about at the tipping point where the ETF industry has fundamentally changed. My bet is that the global capital markets don’t provide anything close to returns we’ve seen over the past four years or in the 2nd half of the 1990’s. Many may believe that, if my forecast is true, the ETF industry will lose its momentum. I believe that this sort of environment (whether flat overall or down over the next ten years) will be strong for ETFs. In a sideways or downward secular market, actively managed mandates especially hedge funds should do well. They certainly won’t all do well … in fact, the majority may not do well at all. But overall, the hedge fund industry should grow in terms of number of funds and asset size. If the hedge fund industry were to increase in that manner, as it surely would in that environment, so would use of their tools, that being primarily derivatives as well as ETFs.

I’ve focused so much lately on the small up-and-comers in the ETF space although I try to find reason to give kudos to the giants when they pull off something different. The recently launched infrastructure ETF from SSGA is one good example, but like Roger Nusbaum has mentioned, it’s really more of a global utilities fund.

So I find from the Financial Times “news” of Barclays Global Investors’ new private equity ETF that should have begun trading yesterday (Tuesday, March 20th). Something to go up against PowerShares Listed Private Equity ETF (PSP) which started trading on October 24, 2006. BGI has made a relatively small number of moves into the the alternative asset class space but like (IAU) which came after (GLD), this new private equity related offering fails to be first to market.
Somehow I don’t see this being a significant problem for BGI. Not because they’re big or because first to market doesn’t matter (I think it does). In my opinion, I doubt there will be much success for either ETF. The idea behind private equity investing is clear and a couple of people named Sarbanes and Oxley ought to receive sizeable paychecks from the industry for putting a killer headlock on the publicly traded markets. More like a choke hold that has greatly helped the private equity market to explode especially in the past couple of years. There has been so much discussion of institutional interest in private equity investing from funds like the Yale Endowment that I won’t dig too deep there.

But just because it’s good for large institutions, doesn’t mean it’s appropriate for the smaller ordinary investor. I think this is equally true for hedge fund investing. Like I’ve said in past postings, you can diversify (although it only helps you to a degree less than you might think), add hedging instruments (options, inverse ETFs, etc.) and other defensive measures such as simply reallocating with greater weights to cash. For many investors, especially smaller ones, hedge funds and private equity are unnecessary. It’s the bang for the buck that is missing primarily due to high fees and especially when involving smaller investable amounts.
So larger individual investors may look at these new private equity ETFs but would they or should they? I would probably lean more towards a fund-of-private equity funds … very similar in concept to a fund-of-hedge funds. Of course, there’s that added layer of fees, so the first question to ask is: Should I even bother getting into this area? This is the same question one would ask when entering any area such as emerging markets or inflation hedged bonds. But in these cases, as in most cases the question can be left to only one level: Do I invest in this area? For private equity, and in the context of this blog, the follow up question is more significant than the other examples given. The next question is: Is the ETF the way to go? This is a far tougher question when considering private equity versus US large caps or even emerging markets. In concept, I like the idea of a private equity ETF. But in terms of implementation, I’m thinking that there are more appropriate substitutes available.
What about institutions like hedge funds who I have suggested on numerous occasions in the past are big users of ETFs? I would be more than surprised to think of them using these instruments. If they wanted to get into the private equity game, an ETF would be the wrong end for them to be looking at.

So who would be interested in this type of instrument? I suppose the same investor who buys fund-of-hedge funds. And how have they done over the past 5 years or so? Investors haven’t had the returns shown in the marketing material when they got in, I’m fairly sure of that. I would only think that returns in the private equity space can’t possibly be sustained at the level they’ve been over the past few years. As is commonly the case, the moment you actually put your money down to a specific manager, a particular asset class or strategy … well, it’s usually the time it fails to deliver. Not to be pessimistic, but for every seasoned investor, you must have experienced that situation at least once in your life. I’m guessing a lot of hedge fund investors have had to re-examine their expectations in recent years. Damn this bull market!

I will certainly follow these two private equity ETFs and the flow of funds into both. In terms of trading strategy, I’d like to see how shorting them would affect a broadly diversified alternative investment portfolio. You can’t be long hedge funds, private equity, commodities, real estate and other alternatives all the time … well you can, but each can have a VERY long period of decline or close to zero returns. Perhaps an opportunistic short overlay of one of these private equity ETFs along with a few others could fine tune the alpha capture of an alternative investment portfolio. Just a thought.

Oh, it was only a matter of time before another private equity ETF came out. Any bets on when an ETF with some sort of hedge fund strategy (investable hedge fund index, replication strategy, something else) might come out?

Although this is technically a new blog and I consider myself to be a fairly novice blogger, I’ve been writing for a while. Maybe this exercise is simply an attempt to prove to myself that I am still technically competent. Who am I kidding … I had to hire someone to deal with what’s under the hood in this machine called WordPress (blogging software program).

I’ve been a contributor to the Seeking Alpha website for well over eight months but it seems much longer than that. It’s a great gig with fantastic traffic. I bump into people at industry conferences or similar events who recognize me by name or goofy photo. For the initial launch of my own blog, I have simply conducted a quick import of all my work from Seeking Alpha. Since I am a full time participant in the investment management industry and not in the blogging industry, the content on this blog will likely overlap with my work on Seeking Alpha. I have no idea if having my own blog will cause events leading to my involvement with other websites, newsletters or other forms of media. We’ll see. As I said, I’ve been writing for a while so somewhere in the columns to the left you’ll find a link leading you to PDF files with copies of my past work outside of Seeking Alpha.

With regard to this site and its future … who knows. Hey, it’s blogging. Have they even built MBA case studies for this yet? I won’t say I’m early or late into the world of blogging. I’ve seen that there are quite a large number of participants in this space although not too many in the area of beta, and further less still in this subset who actually manage money or investment management companies (sometimes they’re not the same). I suspect with little doubt that this will soon become a very crowded area.

What you will likely see on this site are a bunch of postings whose headings all have the term “ETF” in them. We’re clearly in the midst of an ETF explosion and so part of my job, I feel at least for now, is to keep up with developments in this space.

However, if this site is to be truly about “beta” then I must cover other instruments that allow for market exposure and this would definitely cover the derivative markets as well as index mutual funds although I’ll focus more on the former than the latter mainly because of my professional background. Closed end funds aren’t pure beta plays but I might throw them in as an exchange traded alternative when called for. Of course, underlying these instruments are indices which are also showing signs of major evolution. I will cover their progression as well. Overall, this is an evolving space with no well defined perimeter, so the universe may contain more than this.

If “beta” instruments allow for market exposure than on the other side of the spectrum is the polar opposite of “alpha” instruments. Actually, “alpha strategies” is more appropriate a term. Here we’re talking about hedge funds, the inappropriate term that it is. Alternative investments? Absolute return strategies? Well, we’re clearly talking about something that’s not your plain vanilla, long only exposure common to the ETF space … never mind inverse ETFs for now.

The synchronized growth of ETF with the hedge fund space can’t be a coincidence and I have gone to great lengths to repeatedly cover this in the past and will continue to do so.

Bottom line: The alternative investment space is getting blurry. Hedge funds invest in real estate deals, commodity markets, infrastructure projects, public markets as well as private. These all used to be considered asset classes but it’s getting harder to determine what’s what. Furthermore, ETFs exist or will soon exist for these areas which were once solely the domain of hedge funds. Perhaps hedge funds is too much of a focus. Let’s just say that active management within ETFs is a development that will eventually come to this industry. But I think it will eventually go all the way to the extreme of active management: hedge funds. But again, I think the key point here is that hedge funds are big users of beta instruments including ETFs because it’s these types of instruments that provides the multitude of market exposures that these active managers seek. Does this mean every investor can and should become a hedge fund? Hardly. But if hedge funds (or those in the broader defined alternative investment space) are significant users of beta instruments, then we must think about their impact. Perhaps more fun is simply to consider how to manage beta instruments in a “alpha oriented” manner. Hey, perhaps the way to alpha nirvana is by mastering beta. Not a new concept and it sounds a bit on the philosophical side but there’s definitely something in there worth considering. Frankly, I see many “portfolio management solutions” revolving predominately, or even exclusively, through the use of ETFs and/or index funds, especially as a replacement to mutual fund wrap programs. I don’t see why one should be limited in this fashion. More important to this website is the fact that more innovate uses for beta is what we’re all about. I’ll be digging deep, but not too deep with my blog analysis because there’s just not enough space/time to do so … plus you’re not paying me enough.

And you’re not paying me because we don’t have the kind of relationship of that between a client and a fiduciary. Oh, what a sweet segway into this short notice of the “Terms and Conditions” as well as “Privacy Policy” links both found near the top left of every page on this site. By reading this or any other part of this blog website, you’re accepting these terms and conditions and related policies. Let me be perfectly blunt here: I don’t know who you are. I know nothing of your financial affairs, present/future liabilities, portfolio objectives, nothing. Thus, I can in no way determine what is a suitable investment for you. As an extension, I can not know what is a suitable portfolio for you. Don’t take any of my blog entries as advice specific to you. If you do, and you also take the advice of people on other blogs, newspaper articles, TV shows, your dentist or the business section taped onto your dartboard, all to determine the course of action related to the ongoing management of your portfolio … well I only have one thing to say. Please send me your portfolio returns on a monthly basis, going back in time as far back as possible in Excel format (net of trading costs but use the Modified Dietz calculation to deal with cash flow issues). The efficient market theory is still a theory until we get more people like you providing good data.

If you somehow feel like the above comments may apply to you, you may want to think about finding a professional (financial advisor, palm reader, it’s up to you) to assist. Relying on a pro to deal with your health issues, legal issues and yeah, maybe even money issues, might not be bad especially if you don’t have the adequate resources (medical degree, time, etc.) to do things yourself. If this or the above paragraph is in any way unclear to you, please do refer to the “Terms and Conditions” section of this site where the legal language is oh so much more better on the eyes. I also do hope that those with a strong interest in the areas I cover register to this site to receive updates and occasional goodies. I don’t know what these goodies might be, if any, so for now consider “updates = goodies”.

Every blogger hopes to build a strong following so in return for reading my stuff, a humble request I ask in return. Pretty simple really. If you read my stuff and you like it, pass it on to someone else or even more than one person. I hope to have a function at the end of each entry to allow you (if registered) to forward the piece to someone else via email. Better yet, if you think someone will appreciate the material, send them the general link to the site.

Equally as important is the other side of the equation. If you don’t like what I write, feel equally free not to spread the word. But if you are here visiting my blog, and whether you like what you see or not, please let me know. Constructive criticism is highly appreciated as well as opinions that differ from mine. Although I see this blog as more of a hobby than a vocation, I simply hope that you enjoy and value its content and I look forward to your feedback. Send me links to news you think I might find interesting enough to post or comment on. Ask me about certain specific markets and you might even get me to make a market call. But what I find the most fun, although I have not focused too much on it in my past blog work is pure strategic thinking. How do you apply a particular beta instrument, or group of instruments in a certain situation, for a particular sector or geographic region at a particular time. That’s what my brain has been focused on career-wise for the past 12 years or so. And hopefully, for many more years to come.

Richard C. Kang

We’ve seen a lot of big numbers both on the upside and downside in recent weeks in the markets, although in percentage terms nothing so dramatic. Truly an active manager’s market. However, with the indexes up strongly today, I also see an interesting report out from “Pensions and Investments Online” giving some interesting stats on the world of indexing. Key points:

• According to Pensions & Investments’ latest survey of the leading index managers, total worldwide assets under internal indexed management by the 53 managers surveyed reached $5.17 trillion as of Deember 31, 2006. This is up 13.5% from the $4.55 trillion as of June 30 but when adjusted for market changes, worldwide indexed assets increased 2.7%. Thus, not a dramatic increase for new indexed assets. But clearly, some decent returns from global indexes.
• The two size leaders, Barclays Global Investors and State Street Global Advisors, saw somewhat strong growth in assets: BGI reported $1.695 trillion in total worldwide indexed assets of Dec. 31, a market-adjusted increase of 0.45% over the six previous months. SSGA reported $1.517 trillion in worldwide indexed assets as of Dec. 31, a market-adjusted increase of 5.7%.
• For both BGI and SSGA, the main drivers for growth were the asset classes of international fixed income, domestic fixed income and internation equities. Domestic equity saw little to slightly negative change.
• Other names mentioned from the list were Vanguard, Northern Trust Global Investments, Mellon Financial and BlackRock.
• The top five index managers all reported market-adjusted drops in U.S. institutional tax-exempt assets under internal indexed management. In aggregate for this group, the decrease was 4.6%. According to Corin Frost of BGI, in the institutional tax-exempt space “… we continue to see a transformation from index mandates to enhanced and active strategies.”
• Furthermore, Northern Trust Global Investments saw the largest drop with a market-adjusted decreases of 12.1% in U.S. institutional tax-exempt assets. According to Robert S. Gray, director of sales at NTGI, “There has been a push for riskier products in general with more of an appetite for alpha. As a result, we are seeing money flow out of beta products such as pure indexing and into active and fundamental active products,” said Robert S. Gray, director of sales at NTGI.
• One possible reason why total worldwide assets are going up but U.S. institutional tax-exempt assets are going down is that investors around the world are reducing their home-country bias and investing more around the world, according to Maggie Ralbovsky, a managing director at Wilshire Associates.
• Enhanced indexed assets again saw a significant increase in assets. In the universe of U.S. institutional tax-exempt indexed assets, enhanced assets increase by 14.8% to $449.5 billion as of Dec. 31. The leading enhanced manager, BGI, saw its institutional tax-exempt enhanced assets rise by 18.5% to $150.7 billion as of Dec. 31.
• Total worldwide exchange-traded funds also saw significant growth. Total ETFs reached $451 billion as of Dec. 31, an 18.8% increase from $379.7 billion as of June 30. Only $5.5 billion of that total was institutional.

My thoughts:

First, a few short comments:

1. I wish we had some data from other asset managers in this area, especially the newer ETF providers just to see how their growth in assets compare over the same period.

2. Frost’s comments on the recent increased focus on enhanced and active strategies over indexing is interesting. Perhaps it’s simply behavioral finance. After over 4 years of a bull market (at the time of the survey), investors have simply accepted risk taking to a greater degree. Many might say that pure indexing and passive management is the greater risk due to poor performance during major market declines. But from what I read in S&P’s SPIVA reports, active managers don’t really do that well in bad times for nearly all asset classes. Adding active managers is simply adding on another level of uncertainty.

To me, the key point from P&I’s report is that indexing is still a powerful force but is showing some loss in momentum. Where do we see growth? Fixed income, international markets and enhanced indexing. Also some small mention of alternative investments but not in the context of index implementation. Why does this sound familiar?

No surprise we are seeing a significant push of new ETF products in these specific areas. BGI has made the strongest push recently for more fixed income ETFs but I hear of other providers having something in the pipe. There has obviously been a lot of product development both in North America and outside for international exposures. Enhanced indexing? Although the fundamental weighted ETFs from PowerShares and WisdomTree might not seem like it, they’re meant to be an improvement over market cap weighted indexing. I wouldn’t technically classify them as enhanced indexing but we can see in today’s environment that investors are striving harder for “better than average” returns. I suppose it’s a sign of the VIX@10 world … note that this survey was taken as of the 2nd half of 2006.

And of course, with ETFs covering private equity, commodities, real estate and infrastructure, the area of alternative investments is also within reach for investors. It’s this area, along with enhanced (and various forms of non-market cap weighted) indexing that I suspect to find the greatest growth in the ETF industry.

This is relatively good news for mutual funds and other active managers with sizeable assets. If the trend in indexing had continued its focus on tracking the traditional, low cost, broad market-cap weighted index, someone like a mutual fund company would have to bite the bullet and accept indexing as part of their investment philosophy or else chug along and hope for the best in an uncertain environment where investors don’t want to pay for sub-par performance. But simply getting into the pure indexing space just doesn’t make sense for the many professional investors who say “we buy good stocks and we sell/avoid bad stocks” (or something to that effect). Instead of going the full 180, they can use their marketing spin to adapt a quasi-index/quasi-active approach within their current fund lineup. So, instead of seeing another Fidelity take a swing at the ETF space in the way they did, perhaps we could see something more like what Invescap did with their acquisition of PowerShares.

This sort of logic leads to what I believe is currently a very short list of acquisition targets. Frankly, the ETF provider space is still way too small for a shopping spree of acquisitions. But it wouldn’t suprise me to hear of news related to WisdomTree or Claymore being bought … just conjecture. Also wouldn’t surprise me to see a hedge fund or two get into this beating out a mutual fund. Unlike most mutual funds, hedge funds are truly in the business of alpha and hedging their bets with a little bit of beta-based returns makes perfect sense to me. Although this logic makes perfect sense to me about 5 years ago.

Anyway, from all this, we get further evidence that the direction of the indexing and ETF space is onward and upward. No signs of slowing down unless you’re focused on the traditional origins of indexing. For those focused on further innovation in this space, not only does your future look good, I think you should be preparing for a potential financial event. Only at such a point in time, if and when we see a large number of acquisitions as described here, would you see me beginning to have significant concern for the health of the ETF industry.

On Tuesday March 6th and Wednesday March 7th I attended and participated in my first ETF conference in the US. At the “ETF Evolution 2007” in New York, I learned quite a bit. The news from Amex regarding actively managed ETFs especially got me and a lot of people up and alert giving that it was near the very end of the event. Some of my thoughts after having given a week to mull things over:

First, this industry is small. Well, truthfully this event was rather small, but there are a relatively small number of participants in terms of organizations in the ETF manufacturing business. Of course there are the giants like BGI, SSGA and Vanguard. They were keeping a low profile at this event since it was about the ETF “Evolution” … and more like evolution away from what they do. I felt rather bad for the guy from BGI who was taking some shots from others in his panel where the discussion was on new ETF indexes. He seemed to take it well and I think it’s a fair metaphor for the 3 large firms. They’re comfortable now. But they have to admit that the growth of the industry is pushing against them.

What I’m talking about is the move away from the origins of classic passive investing. The broad consensus at this event seemed to be against the thought of investing in the CAPM framework. Thus, building portfolios based on market cap weighted indexes seemed to be generally out of favor to the benefit of alternative weighting schemes such as equal weighting or the various forms of fundamental weighting. Of course, market cap weighting is not dead as the push to international exposures and niche sectors usually still leads to this traditional weighting method.

I was very interested in listening to the index providers speak. They’ve had to significantly change their business model. I know first hand that the large index providers have put much less attention on the traditional business of providing benchmarking related services to pension funds – “been there, done that times infinity” … I’m pretty sure kids don’t say anything like that anymore. Instead, index providers are highly focused on building new indexes specifically tailored to ETF manufacturers. Maybe it’s not the dominant revenue generator in their business but it is an interesting shift. Just imagine going in for an interview at one of these firms. Instead of asking you about a broad US equity index, what if they instead said “So, give me a few ideas on a market exposure that you think could be engineered effectively yet sell to plug a space that needs exposure?” Sounds more like the “Give me three ideas” question you would expect from a hedge fund or prop desk. No shock then of news from most, if not all, of the big index providers about massive numbers of indexes coming on line in the near future. I’ve written in the past about Russell.

There’s been talk (not at this conference, of course) about the ETF industry looking a little “bubbly”. My only comment here is that, if true, we’re still in the very early stages. There are, at most, about a dozen small ETF providers each slowly building their niche in this space against the big firms mentioned earlier. The way I see it, we would first need to see many more new participants for me to think of this as being anywhere near bubble territory. Next, we’re starting to see merchant bank/VC type firms entering the picture to help finance startup ETF firms. But I know of only a couple of situations. There’s a lot of product out there but the numbers tossed around this one conference speak of a magnitude of new offerings that could see a doubling of ETFs within the next year. This event was quite US-centric so I will have to wait until the World Series of ETFs conference in Miami in a couple of weeks. Let’s say, that there’s a doubling in the number of ETFs globally over the next twelve months. That would certainly be interesting, but the key factor would be the corresponding values for assets under management. If we get into the same habit as mutual funds with a high proportion of ETFs versus the total assets invested in them, then I would agree that a problem exists and we could see some fund closures as a result.

However, with so many ETFs domiciled and focused on the US markets, it’s clear to everyone that the future expansion of the ETF industry will be based on international exposures. And I’m not talking just about super broad exposures like the new Vanguard® FTSE All-World ex USA Index Fund (VEU) or State Street Global Advisors’ SPDR® MSCI ACWIsm ex-US ETF (CWI). As neat as these are for those building a highly simplified core portfolio, the real demand is coming from investors who wish to be more nimble with their decision making. International exposures by region and sector still have some gaps that can be filled. We’re seeing the first shot at moving away from market cap weights in overseas exposures from firms like WisdomTree. Although shorting is a possibility as well as options (but not as robust a list as I’d like), there is still a gigantic void in terms of inverse ETFs for international exposures as another line of defense. Hey ProShares and Rydex: Before you completely super-saturate the market with a hundred more or so US-centric levered and short ETFs, what about a few for international markets?! Even an EAFE based fund and one for emerging market exposures would be nice to see. SEC hoops for these two can’t be that tough to jump through. Perhaps some locals have made their own levered/inverse ETFs for their home market. For example, BetaPro ETFs here in Canada have ETFs for both long and short exposure to the S&P/TSX 60 Index, both with 200% exposure.

I want to come back to actively managed ETFs. I’m not sure if it’s the biggest thing in the world to have this next step in the evolution of ETFs actually occur. We’re doing all right with ETFs on the passive side and closed end funds with underlying active strategies. There are flaws, as everywhere, but anyone can build a pretty darn good portfolio just with ETFs and CEFs (throw in some cash, certain futures and option contracts and then I think you really have all you need). The move to push away from market cap weight exposures is, in my opinion, the industry’s initial attempt at moving towards active management. I’ve discussed in previous posts my opinions on new rules-based ETFs and my belief that they’re not active management and thus they do not provide what I would call “alpha”, in a philosophical sense. However, if the numbers (historical backtests!) show some outperformance relative to market cap weights, then the related ETF providers will make their case for “statistical alpha”. And their case will always be strong as no one builds, and reveals, a historical backtest that sucks. People brag about their kid at U.Penn, not their kid at the state pen.

So, if what was introduced about actively managed ETFs in New York, and hopefully will be expanded further in Miami, is true and in full throttle, where will this take the industry? One participant at the conference mentioned that it wouldn’t make sense to see ETFs with an underlying hedge fund strategy as hedge fund managers wouldn’t go for the low management fees. True, hedge fund managers would see their fees cut to something probably close to a quarter (at best) of what they receive now. And I think this actually argues in favor of hedge fund strategy ETFs. If ETFs are about providing exposures to replicate the performance of a particular benchmark, region, sector or even strategy (anything from WisdomTree, Claymore’s new ETFs built with Robeco and I can name many more rules based products), then why can’t there be an ETF with an underlying hedge fund replication strategy especially considering the modern and informed investors’ loathing of fees especially if and when little value is demonstrated by the manager? Merrill Lynch, Goldman Sach and JP Morgan are three I-banks already promoting their work in this new space. A few smaller, yet still very significant European firms are equally, if not more advanced in their product development work. And their concept is the same: Build a product that replicates certain hedge fund strategies in a manner that can provide a low cost means for investing. I’m not saying that things will move this way next week or even this year. But if there’s anything we’ve seen in the ETF industry over the past few years, it’s that providers are finding ever more clever ways to introduce new and unique exposures to capital markets. Hedge fund strategy ETFs are just one example. I’m sure there are dozens if not hundreds of other ideas being considered today.

Lastly, I want to consider down markets or a potentially more serious bear market which, no surprise, was not a big topic at the event in New York last week. Let’s say we get whacked by a big one. Either something like 1987 or even worse, a longer more drawn out and painful decline. Well, if it brings us back to where we were in the early 1980’s, investors will be as unenthusiastic towards ETFs as they would be towards any other instrument as well as the markets in general.

But let’s just say that we’re in a period where we’re simply going to experience several down markets (who knows how often or the decline) very similar to what we saw last summer. Further to that, it’s almost irrelevant if the overall curve of the markets bends flat relative to the growth we’ve seen over the past few years or if the markets continue to zoom up of if it crashes. The question to ask is: Are investors well served by having a portfolio with a fairly standard asset mix consisting of a very small number of ETFs each with fairly broad exposures and focused on extremely low costs? I’m thinking about the countless “model portfolios” that hold something like ten or fewer ETFs.

I’m as big a fan as anyone of many of Vanguard’s ETFs, as well as some of BGI and SSGA’s broad ETFs which are dirt cheap. But simply adding a REIT ETF, a gold ETF and a few fixed income ETFs doesn’t make the portfolio protected. The unfortunate reality (Al Gore’s title sounds better) is that diversification won’t save your skin in today’s world. Not only are correlations among the vast majority of asset classes high, they spike at times of distress. Even asset strategies (hedge funds, private equity) don’t have the same diversification benefits they once had. I heard someone once say that diversification fails when you need it the most. This doesn’t mean that we all have to be market timers although there are various degrees of timing. When Warren Buffett says he can’t find good companies to buy and builds up his cash position, is that timing? The oracle believes in “buy and hold” but waits to buy in when the time is right. Moving into cash and potentially parking in a fixed income ETF or even a currency based ETF can be considered one form of defense.

What about sector rotation to re-allocate based on changes to the economic cycle? The new sector based ETFs could be used more for protection than for opportunistic and aggressive trading. What about fundamental based indexing? Doesn’t it just make sense that in times of market stress you would want to be more heavily exposed to companies that pay more dividends, have better earnings (assuming SarbOx is working and no one’s pulling an Enron) or are a function of a combination of various fundamentals? Of course, inverse ETFs in addition to outright shorting of ETFs is like a last line of defense.

Trade ETFs like a hedge fund and you can be aggressive with a somewhat shorter term perspective and a ton of choice. Construct a portfolio with defensiveness in mind, and there are also many ways that you can see the current ETF evolution as more of a solution than a problem.

My February 22nd article appeared with an unfortunate title that may have suggested that WisdomTree was “Moving From ETF Evolution to ETF Pollution”. As mentioned in that article, I did find it surprising that WisdomTree would introduce a new lineup of ETFs based on a new fundamental factor (earnings) when all of their previous product development had focused investors’ attentions on the benefits of dividend-based indexation. My main inquiry was whether a portfolio construction process based on earnings as the determinant for weightings within an index would provide a significant divergence in performance versus one similarly based on dividends.Not a surprise, I soon had a call from WisdomTree . Many thanks to Luciano Siracusano, Director of Research for ETF firm WisdomTree Asset Management, for taking the time to give me some of the thinking behind WisdomTree’s new product line. Luciano is no stranger to the blogging environment and here are some of the main points I gathered from our phone conversation:

If the Russell 3000 represents the broad US equity market, an indexing strategy based on dividends will provide a subset of roughly 1500 stocks or 76% of the market. Based on this, if the remaining 1500 stocks represent the remaining 24%, you get an idea of the capitalization that is left out. Of course, investors in this strategy would be still be missing out on certain big names like Google (GOOG) but it’s fair to say that you have a fairly strong value and large cap bias.

A fundamental indexing methodology that uses earnings instead of dividends would have broader representation. Clearly, you have to have earnings before you can give out dividends. But, the difference is quite significant: Using the Russell 3000 as the overall market again, with an earnings based filter, you have access to roughly 2450 companies or 95% of the market.

The earnings based methodology provides a strategy and fund that appears to be a lot more like the traditional market cap weighted index fund. Sector weights are more similar, especially compared to the dividend based methodology. Overall returns for the earnings based funds should be highly correlated to market cap weighted funds.

Perhaps the idea from WisdomTree is to use dividend based indexation as a highly defensive measure and earnings based indexation as a pure replacement for traditional index exposures. In other words, if you have a broad US equity position like SPY, an investor could consider the WisdomTree LargeCap Dividend Fund (DLN) as a potential compliment (or outright defensive replacement) and the WisdomTree Earnings 500 Fund (EPS) as a potential substitute.

The evidence on non market cap weighted indexation (equal weighted such as Rydex’s RSP, or fundamental weighted from PowerShares/Research Affiliates and WisdomTree) seems to suggest an outperformance relative to market cap weighted indexation of at least 200bps per annum on average over the long term. Dimensional Fund Advisors is in the same boat as they also have de-linked from traditional indices … although they’ve been doing it for a very long time. DFA has shown incredible strength in their asset gathering despite focusing on the mutual fund structure and not joining the ETF bandwagon. Whether they do a “Vanguard” or not, the continued interest and product development in non market cap weighted index instruments will surely continue. It’s just one of many trends away from the origins of passive management, CAPM.

Like I said in my earlier piece, I’m not sure about the future success of WisdomTree’s new earnings based ETFs. The dividend based ETFs seems to make sense and a serious down market will surely prove their worth as a diversifier. If the earnings based funds are somewhere between the dividend based fund and the traditional index fund, I wonder if enough interest can be created based on something that seems “stuck in the middle”. Frankly, I see a lot more marketing for WisdomTree versus the FTSE-RAFI based ETFs coming out from PowerShares, so I would not be surprised to see them have success with their new products. Thinking for a second about the FTSE-RAFI fundamental index methodology which is based on four factors, I wonder if WisdomTree is considering the remaining two factors or, more broadly, any other fundamental factors for future product development?

It makes me think of the FTSE-RAFI funds like a BRIC fund. It could make sense to have separate funds for Brazil, Russia, India and China for global asset allocation decisions. But what about comparing the FTSE-RAFI based funds versus WisdomTree’s focus on dividends and now earnings? For now, I understand the reasoning behind WisdomTree’s launch of the earnings based funds to go along with their dividend based funds. I don’t see much use in bringing out further product lines focusing on other fundamental factors, the remaining two from Research Affiliates (the “RA” in the rather convoluted FTSE-RAFI acronym) being book value and sales. I’m sure there are a plentiful number of academic papers to suggest other factors (cash flow?) which may also outperform the market cap weighted index and provide other tangible portfolio benefits.

We’ll see. I am sure that the marketing minds at WisdomTree are many miles ahead of me. And I am now even more interested than I was a few days ago about the future success of WisdomTree’s recent efforts.

Risk Magazine isn’t what I would consider standard reading in the financial services industry, as the last few sections of each monthly publication breaks out the math. I’m talking about equations that have few numbers and a ton of greek letters. Despite this, there is the occasional article that covers relevant industry developments for the non-quant. There is one article that discusses the recent push of products aiming to replicate hedge fund return distributions.Both Alpha Male at the blog, All About Alpha, and myself have commented on this topic and the work of Harry Kat, Andrew Lo, Bill Fung and Lars Jaeger (among others). But I find this article I find to be unique as it introduces the new term of “portable beta”. I’ve actually heard this term applied before within the context of the portable alpha framework. Basically, if you can transport an alpha engine (long-short emerging market equity, for example) on top of some beta component (S&P 500 index), it’s both the alpha AND the beta that can be transported and mixed in countless ways.

But in this case, we’re looking at research that has resulted in the application of beta in some unique and somewhat complicated fashion (combination of longs and shorts to various degrees in any number of different futures markets) in the attempt to replicate a certain hedge fund style/strategy’s performance characteristics.

There’s no argument here … the providers of these new products/services agree that what they are providing is beta, not alpha. And this is of little surprise when you see how correlated various hedge fund indices have been relative to standard benchmarks such as the S&P 500. If many (not all) hedge funds have high correlations with the broad capital markets, there’s little choice but to:

1. Be highly selective of the hedge funds one chooses in the hopes of having them deliver true alpha (at a cost).
2. Focus on gaining the beta exposures related to hedge fund investing at the lowest cost possible.
3. Do nothing and hope that the relatively high beta exposure that seems to have spread from the mutual fund industry to the hedge funds is a trend that reverses as the current bull market potentially/eventually comes to an end.

According to Steve Umlauf of Merrill Lynch:

“We do think there is alpha available out there through good fund managers. And if you can identify it and get access to it then it’s worth paying for. But if it’s just beta you’re getting, then it should be sold like an index fund - that is, in a liquid, low-cost, transparent format.”

Sounds pretty close to an indictment of the hedge fund industry from one of the big banks. Like other banks, ML must have hedge fund clients, in addition to their own alternative investment programs, so those words must have been massaged by more than a few people internally.. As an academic, Harry Kat of the Cass Business School in London has more freedom to speak his mind which he does here:

“Based on our research, we estimate that in 70-80% of the cases, a hedge fund manager’s contribution to the after-fee bottom line is zero or negative. Investors basically allow the manager to make a very good living using their money without getting anything in return. Unless one is genuinely attracted to this form of charity, in these cases it is worth replacing the manager in question by a synthetic fund.”

Harry has his own software program to go up against the big industry names so you can understand the direction he’s coming from. But like AlphaSwiss and Partners Group, you really have to wonder if the numbers used for all of these products has more of a bias based on recent data, specifically the bull market since 2002. The real question is how will these replication programs behave versus the comparable hedge fund strategies they aim to mimic?

If we are in the middle of a correction more serious than that experienced last summer, I’m afraid we will likely separate the men from the boys, so to speak. I doubt many funds with an absolute return mandate will do well. I’m not saying that there won’t be winners, I’m just betting that the vast majority will be losers. Just remember, there are a lot of hedge fund managers out there and they clearly all can’t be winners. The likely scenario will be a relatively small number of big winners with a relatively large number of “not so terrible” losers. Just my opinion.

This still leaves room for manager selection, but that sport is obviously getting tougher every day. Thus, this new area of hedge fund replication or portable beta should get broad acceptance if things continue as they’ve been. In reality, this development is just the transfer of indexing strategies to the hedge fund space but without it being the investable hedge fund index programs that were attempted a few years back with not much success. According to the Risk Magazine article, Lars Jaeger of Partners Group suggests “it is only a matter of time before more big investment banks and some of the index companies launch their own offerings in this market. Indeed, some participants predict portable beta could make up 40% of total hedge fund assets in just a few years’ time.”

It seems that anything (even hedge funds) that is considered alpha can and will be commoditized to beta in time as inefficiency becomes efficiency due to competitive forces. And this comment further confirms my thought that index providers and ETF manufacturers are catering more to the active investment crowd rather than the traditional passive investor. Index providers don’t need to promote an index for pensions to benchmark certain asset classes to … it’s been done to death and institutions are already there and may be considering moving away from that and to a portable alpha/liability driven investment framework. My guess is that the index providers are spending considerable resources in joint work with ETF manufacturers and other non-traditional work, including portable beta. They may not be working jointly on a hedge fund ETF … I’m just saying that index providers have focused a lot of their attention on ETF related business in recent years.

Getting back to the main topic, some questions that both the index providers and interested investors should consider regarding hedge fund replication strategies: Will they adequately replicate the underlying hedge fund strategies? Precision will be based on what comparison? If a particular hedge fund strategy (or strategies) does poorly in a bear market environment, will the replication strategy behave properly i.e. just as badly in that scenario? On the other hand, if replication strategies perform well in a continued bull market, will it build a strong following as investors dump high cost hedge funds that provide more beta and alpha in a rising market?

In any case, it’s getting tougher to be a hedge fund manager. It will be very interesting to see the performance numbers for February and even more interesting to see what happens in March.

Aside: VIX is roughly at 19. Looking at the short-term chart, you’d think that it’s high and it is since it’s spent many recent months closer to 10:

But if you look at the longer term chart you see that it’s actually fairly close to what would be considered it historical norm.

Like this past summer, it will be of little surprise to see asset class correlations spike up with the rise of VIX. Bonds and cash will provide some buffer but generally, exposure to beta of any sort will be painful if momentum builds. As I write this, the US equity markets are moving down but nothing like overseas markets. But you can feel the tension as investors consider the plug to be pulled. As VIX climbs higher, we move more towards an active investor’s environment. If you’re paying someone to make profitable decisions, you’ll want to make sure they’re not on vacation right now. If you are a long-term oriented investor, this is one of those times when your faith in long-term thinking will be tested. Take another look at that long-term VIX chart. We’ve recently seen historical lows with VIX spending some time below 10. Historical highs well above 40 haven’t been seen since the bottom of the bear market. Despite VIX’s recent climb, it still has the ability to move much higher.

Imagine a global market exchange that would allow investors to trade stocks, ETFs, futures and options all at one place. The CBOE Stock Exchange, known as the CBSX, will open for trading starting on Monday, March 5, 2007. CBSX is a subsidiary of the Chicago Board Options Exchange and more information on this event can be found at the CBOE website. This development increases the competition within the US exchange community; however, we have also seen similar growth in the Europe, East Asia and even in the Middle East. In the case of CBSX, the continued trend favoring electronic trading is clear: Trades will be implemented through CBOE’s electronic platform, CBOEdirect, which also facilitates trading for the options exchange as well as the Futures Exchange.

We’ll see how this new exchange will go up against Globex which handles about 70 percent of the Chicago Mercantile Exchange’s (CME) total exchange volume. The Merc announced its plans to purchase the Chicago Board of Trade a few months back for roughly for $8 billion in stock, rejoining the two financial institutions as CME Group, Inc. According to the Merc’s site the “CME continues to expect the transaction to close by mid-year 2007.” One result of this transaction would be the CBOT’s electronic trading brought onto Globex.

The CBOE’s move with their new CBSX platform is its attempt to deal with its neighbor who happens to be the 800-pound gorilla. And rightly so. The business of trading beta (ETFs and derivatives) is sure to grow. Everyone from institutional investors who have internally managed asset allocation programs to hedge funds to Joe Average are fueling growth in this area.

But what we still haven’t seen is the mass stampede of global M&A activity within the exchange community. It has certainly started but I’m guessing that we’ll see some very large acquisitions that will create global trading behemoths.

I’m not sure what the catalyst will be though. The regulators can’t force the situation but I’m guessing they would like less exchanges to keep track of and build relationships with. Perhaps it will simply be market driven should this four year bull market drive on beyond the recent bumpiness. At some point in time, people plugged into the market (shareholder of an exchange would count) will want to sell out.

What’s my point? Bottom line is the world of trading beta will get cheaper even if we see consolidation in the global exchange community. The advances in technology are progressing exponentially and thank goodness when you consider the in-step increased trading volumes. Much older and more widely discussed than the recent “anti-ETF” rhetoric, the arguments made against derivatives will certainly increase as the derivatives market continue to expand and like ETFs, in an exponential manner.>

I won’t get into the debate of whether the derivatives market is the ticking time bomb and potential weapon of mass destruction. To me, it’s just another tool like a stock or ETF. If there are concerns, they’re probably regarding leverage. Why not just pear it down?

It’s like the incredible amount of repetitive news regarding the subprime mortgage market. Every 4 year old who is learning the lessons of money knows the deal. You want to lend money to someone who doesn’t really qualify for borrowing, there’s a decent chance they’re not going to pay you. Should there be any surprise if the subprime mortgage market blows up? Come on.

Shouldn’t the same apply to the derivatives market? LTCM, Barings and Amaranth all deal with the use of leverage. Forget about rogue traders for now. If you have the exchange dealing with counterparty risk, there’s got to be a relatively easy mechanism to control the amount of leverage allowed based on the investor and what type of trading they’re involved with. I hate to say it but maybe it’ll take the regulators to step in and strongarm the situation. Maybe after one or two more Amaranths the industry will figure it’s time to strongarm themselves.

Despite all this, I’m still pretty happy as I think we’re moving closer to a world where trading beta, no matter what the asset class or instrument, in a rather effortless manner from virtually anywhere, can be achieved … with both a highly acceptable level of execution and cost.

We focus so much on ETFs in our own jurisdiction but there are many interesting instruments worth considering outside home. Currency risk aside (not in reality of course, just for the purposes of this discussion), these are the areas investors should consider when implementing their portfolio decisions. Diversification isn’t the perfect answer — aside from cash and certain bonds how have most asset classes done during the declines of this past week or this past summer? — but it’s one of many steps in protecting your portfolio.>

I’m hoping that I can trade a global list of ETFs and derivatives domiciled anywhere from my screen. It can be done now. But it can be done more elegantly in the near future. That’s not to much to ask for.