I’ve made comments recently arguing against bond ETFs. Some of my arguments are really more about the rationale towards low bond allocations in one’s overall portfolio due to the existing, and projected, interest rate environment. Part of it is also the seemingly significant list of weaknesses of bond ETFs versus equity ETFs. I’ve discussed enough about the latter so I want to make a short comment on the former.

Yale University’s Endowment Fund is a top performer in its peer group and the envy of the institutional investing world. I’ve mentioned it by name several times on this blog as have countless others on the web. David Swensen and his group are respected as much for their forward thinking investment philosophy and methodology as their fund’s performance. On the Yale website, the annual reports going back to 2000 are publicly available. Each report shows data as of the last day of June in that year and in each report, the asset mix of the that year and the previous four years are shown on a table near the front of the document. From these annual reports, I’ve put together an asset mix table for this one endowment fund going back eleven years:

Where do I begin?

One observer might say David Swensen is a revolutionary thinker in the institutional investing CIO space. Another might call him a lunatic or at least risky. I think it would be fair to call Swensen risky … in the institutional space, doing anything out of the ordinary and actually implementing an innovative plan would be considered by most to be risky. For example, a 12.5% allocation to fixed income as far back as 1996 with increased bearishness leading to an almost non-existent 3.8% in the latest annual report? Isn’t the purpose of a bond portfolio to provide yields and reduced volatility in the overall portfolio program?

Oh, by the way, when I said “risky”, I meant risky to one’s career. No one in the pension or endowment world wants to take on too much undue risk. They just don’t get compensated (as an employee) in the appropriate way for risk when volatility is nice on the upside. However, risk works two ways of course and if volatility is to the downside, it’s their job that’s on the line. Being close to the median is safe for your livelihood but is it good for the plan? It’s not just Yale but several innovative funds that have led to significant philosophical changes in the industry.

Taking a look at other asset classes, we see that Yale’s endowment fund also looks bearish on US equities having slashed its allocation to this asset class nearly in half over the eleven year time period to a level far lower than what most funds would ever consider to be reasonable. On the other hand, I believe that the foreign equity component would be deemed as reasonable by most investors although the variability in the allocation to this asset class as shown in the table only proves that Yale has been an effective market timer.

If the traditional asset classes of fixed income and domestic stocks have been greatly trimmed, it has been to the benefit of the “real assets” section of the portfolio which includes real estate, oil & gas as well as timber. Interestingly, Yale has had a nearly constant allocation to absolute return strategies (hedge funds) and private equity. In addition, hedge funds have been kept within a range of roughly 20-27% with private equity at roughly 15-25%. Clearly, this fund is a big fan of alternative investments with nearly two-thirds of the fund within this broad classification in the past few years.

Perhaps, if it weren’t for the fund’s great performance, Swensen might have long been considered as an excessive risk taker or worse. Fortunately, in addition to the returns, Swensen’s book Pioneering Portfolio Management provides great clarity in explaining the broad thought process that has underlined the philosophy and methodologies at this fund.

This is only one example of an institutional investor, albeit a very significant one. Bringing this back to the discussion of fixed income investing, you only need to see this chart of long-term interest rates to understand that Yale may have been thinking about reducing its bond exposures well before 1996. In fact, if Yale was a true maverick, the evidence should have led them to reduce these exposures about ten years earlier as shown in this chart.

But clearly, over the eleven year period covered in my table, there was enough evidence from the markets to see that interest rates were moving in one direction on a global scale. Although it’s easy to see this in highsight, the trend was unmistakable as of 1996 so this justifies the low 12.5% allocation to bonds by Yale at that time. Further decreased allocations since then were reasonable as the interest rate decline continued on a global scale to 2006 as shown in this chart:

And so here we are in 2007 with interest rates in a state of limbo (slightly inverted curve over a not so insignificant period of time) and the Fed having held short-term rates constant for longer than many may have thought when it stopped raising rates last year.

But depsite all of the above, there’s been considerable discussion lately over fixed income ETFs. After what seems like a “black out” period, suddenly we’re seeing new products and more in the pipeline. Could it be with all the talk of yield enhancement focus in products related to infrastructure, real estate and other asset classes, ETF providers are thinking that it’s time to restart the bond ETF assembly line? Considering all this and looking at the line graphs above, you (the bond investor or bond ETF provider) have to think a bit like a market timer and perhaps try to call the bottom of this long-term rate drop. The way the US dollar is going, investors must be thinking about rising rates. With the way the housing situation is playing out, the logic is for rates to drop further. The second line chart above is further evidence of globalization so the added wrinkle of determining if the synchronized fall of interest rates globally will continue is another piece to this puzzle.  There are more than enough economists commenting on this and, like them, I feel as though I’m providing way too many questions and no solutions at all. In fact, my only point here is to highlight whether bond investments (ETF or otherwise) are to be a significant component to the overall globally diversified portfolio. Yale, as well as many institutional investors, seems to think not. The recent ramp up of fixed income ETFs seems to show otherwise.

It all depends on:

1. Your income requirements and comfort with volatility that you expect from your portfolio, and
2. To what extent you believe bonds will be (or not be) able to facilitate these roles for your portfolio, and
3. To what extent you believe other asset classes or strategies are effective replacements for bonds within your portfolio.

No analysis today. Just a reference to this article from the GARP (Global Association of Risk Professionals) website regarding real estate related risks.

For those looking to hedge real estate “beta” the best you could do today is some combination of derivatives, for example property derivatives out of the UK and Case-Shiller housing futures in the US, as well as maybe some of the real estate/REIT ETFs. Currently, the real estate ETF area is actually quite thin, especially considering the heavy bias towards REITs. The same can be said of real estate derivatives which have been around for a while but not in great numbers. This will change soon according to this:

That is one reason why real estate derivative markets — the lynchpins for hedging — are almost here, he exclaims. He goes on to list a number of indices either in the development or planning stages by such groups as National Council of Real Estate Investment and Fiduciaries, Standard & Poor’s (residential and commercial), and Real Capital Analytics, and for particular markets or sectors such the IPD Index for London, a new hotel index and Hong Kong real estate index.

“Everyone and their grandfather and sister will have an index,” laughs Edelstein, “so there will be plenty of opportunities for hedging.” On the buy side, the derivatives potential comes from demand by pension funds and other institutional investors, foreign investors, REITs, portfolio investors and even hedge funds. On the sell side, lenders, institutional owners, CDO (collateralized debt obligation) and CMBS (commercial mortgage-backed securities) managers as well as hedge funds, speculators and REITs can derive some benefit from derivatives.

And the reason for all this interest in real estate investment hedging? Answers Edelstein, “there is more risk now than there was five years ago.”

More risk? Clearly. I’ve shown many charts in the past few months and the concept of new highs is something that we haven’t seen in such amounts since the top in late 1999, early 2000. Today, we again can see this on a price chart of any real estate related ETF versus the broad market indices, except in Canada and a small number of regions.

Getting back to product development we can see that, just like the ETF industry, this shows that the derivatives markets are continuing to branch out in the global marketplace. Depending on your point of view, this will appear as expansion to narrower and unnecessary niches or more unique and interesting niches . Another example is in the area of timber, and here’s this notice also from GARP about derivatives for wood pulp.

You could say this is an offshoot of timber, but it could of course fit somewhere in the broader commodity complex. It’s interesting how, despite being perceived as fully saturated by many, the beta industry continues to punch out new products. A recent posting of mine regarding new metal ETC offerings from ETF Securities conforms with this.

Many industry participants in the ETF space may not be aware of what is happening in the derivatives industry. For example, not only can you get exposures to various interest rates through futures contracts but you can also get exposure to inflation. There’s a multi-faceted inflation-indexed fixed income play in there and that’s a fairly typical global macro trading strategy.

Bottom line: There is a big push of new products in the derivatives industry under way globally and its momentum began earlier than that of the ETF industry. It’s not getting a lot of attention except in certain parts of the institutional world. I don’t think it’s as big (or certainly, as well publicized) as the ETF industry but it is unfortunately getting the attention of many naysayers with crystal balls forecasting some impending doom. Derivatives, hedge funds … and even ETFs. They spell doom! Hardly. If the risk is in the use of leverage, that’s the one and only true risk. However, just like Amaranth (the biggest and worst case we’ve seen thus far), we’ll always have participants on the other side of the trade. Regulation will likely be increased over time with greater international cooperation from the regulatory community. However, it’s the market and its broad array of participants who I believe will keep things in relative equilibrium.

For me, derivatives play an essential role for many market participants. For some who see them as market exposures to have on the long side, perhaps even with certain levels of leverage, that’s fine. But others see them also as hedging instruments to offset unwanted exposures. In today’s world where hedge fund investments cross over to any and all other asset classes, it’s key for these managers to have the appropriate tools to properly control and maintain the adequate level of “beta” they require. It’s not an easy task, but without these new instruments, “difficult” is an understatement.

A recent article in the April 21st issue of The Economist provides a decent review of the ETF industry today. You’ll be able to read it online here. It’s a nice bit of commentary so I will add only a little of my own.

In the recent past, I would have thought that ETFs in aggregate were a fairly niche sector of the financial services industry. If, according to this article, the US-based ETF industry is at roughly $450 billion, it’s still less than 5% of the $10 trillion mutual fund industry. So, it’s not really the size but more of the growth that has gained this industry some attention. With attention comes some negative opinions of course, and there was a reference to “valuations that recall the dotcom bubble” but that was a reference to WisdomTree’s stock price over anything else.

I think that there are very many investors who know very little about ETFs and very few investors who know a lot. What I mean is that many investors might have heard of Spiders or Cubes, and possibly even traded more than just these, but they likely don’t have a clue of the underlying structure of the ETF that makes it different from a closed end fund or mutual fund. That lack of education, and thus full understanding, is the same with hedge funds and anything else in investing, I suppose. Maybe it’s just the circles I revolve in, but I believe that many people (even the most ordinary of investors) are picking up more on ETFs. The coverage of the pros and cons of ETFs in a mainstream periodical like The Economist leads me to believe that this will continue as the ETF industry expands.

Time Magazine ran this article on ETFs in the July 24, 2006 issue as well. I know that here in Canada a few national magazines (not specifically focused on business or investing issues) have also covered ETFs in one manner or another and I would guess the same would be true for many other countries. Despite this, I think we’re still early in the ETF industry’s growth cycle.

At a recent conference, I spoke privately with many industry insiders about the slow acceptance of ETFs in Canada relative to the US. The view from others was that it’s the same story in the US. Someone commented that if you shouted “ETF” in the middle of Grand Central Station, no one would know what you were talking about. I personally think that’s a big exaggeration, but it is sometimes difficult as an “insider” to determine what the pulse of something is on Main Street. Coverage like these stories in broad market publications leads me to believe that only in the past 12 months have ETFs started to gain real market acceptance. Thus, the quote from Deb Fuhr of Morgan Stanley forecasting ETF assets reaching $2 trillion may in fact be quite conservative. Many would agree that the size difference compared to the mutual fund industry would also confirm this.
Now, if there’s a cover story on Time or The Economist related to ETFs … then we have a different situation. I seriously doubt that will happen any time soon (in the next few years) but when it does, you’ll start hearing more than just negative words about the industry and its participants … you’ll hear about investors shorting the stocks of ETF providers. My feeling is that there will be many more front cover stories talking about hedge funds, private equity, real estate and even mutual funds over the next while leaving the ETF industry alone to quietly continue to grow.

Just received this mass e-mailing from ETF Securities out of the UK:

ETF Securities creates world’s first exchange-traded precious metals platform backed by physical metal

• 5 new physically backed exchange traded commodities (ETCs) to be listed on the London Stock Exchange (LSE)
  
• Platinum, palladium and a precious metal basket ETC to be made available to ordinary investors for the first time ever
  
• Silver offered for the first time outside of the USA
  

The global pioneer in exchange traded commodities, ETF Securities, is set to bring another world first to the London Stock Exchange with the listing of a range of physically backed, precious metal, exchange traded commodities (ETCs). See the attachments above to review the full press release and fact sheets. For our full product list follow this link: http://www.etfsecurities.com/en/document/etfs_document.asp#product

For more information please visit our website: www.etfsecurities.com

Note that instead of providing attachments as stated above, I simply refer you to the ETF Securities website and in particular this page. With all the chatter of a platinum ETF and palladium ETF … well for those interested, these are exchange traded commodities and they’re traded on the London Stock Exchange.

I didn’t find the description of the precious metals basket clear until I read this on one of the pages of their website:

For the first time ever, investors can now trade all four major precious metals (platinum, palladium, silver, gold) individually or as a basket, on the London Stock Exchange.

Another interesting innovation.

Today I put some focus on hedge funds and although my blog is called “The Beta Brief”, you will likely know by now that I have an interest in the use of beta within the hedge fund arena.

I saw this story, regarding the debunking of various hedge fund related myths, on Hedgeworld.com (registration required but it’s free). It summarizes and comments on a paper by Ed Easterling of Crestmont Research which can also be downloaded via the Hedgeworld website.

By the way, there’s a lot of interesting information on Ed Easterling’s corporate site including graphs and charts which normally don’t get put online for the viewing public. Good stuff.

I won’t comment too much on Easterling’s “debunking” of hedge fund myths. Hedge funds are relatively new to the broader investing world. Frankly, I believe that the vast majority of individual investors should not be anywhere near hedge funds. It’s not just chasing returns and the probabilities related to both 1) picking a hedge fund manager and 2) that manager being successful during your time of investment. That’s part of the fund investment problem and investors in that realm should understand the statistics involved within this process. More importantly, it’s also the issue of costs related to hedge fund related instruments with small investable amounts. Large institutions can negotiate costs down somewhat but retail investors are often paying MERs that would be considered absurd by most standards.

Even worse are hedge fund programs wrapped in a principal protected note structure. Often with an underlying “fund of hedge funds” mandate (of course with a great real track record) these investment products are built simply to allow smaller investors in with small investable amounts. But not only are the investment management and performance fees high but the costs for engineering and financing a guarantee structure make the problems even worse. Often times, I see historical graphs in marketing material for these products showing decent returns but with incredibly low volatility … the hallmarks of a good, well diversified multi-manager hedge fund program. And this makes me wonder: Why wrap such a program within a principal protection structure? You wouldn’t put that added cost and complexity to an underlying money market mandate. Many times there’s a tax advantage argument put forth in such structures but clearly, it’s because of the various “myths” associated with hedge fund investing and the risk of complete annihilation of one’s investment. However, a properly diversified program would likely not need such protection unless they had a handful of Amaranth-like situations that all happened at or near the same time. I wonder if Nassim Taleb would call that a purple swan with white polka dots?

Due to the fact that hedge funds are relatively new to individual investors and their advisors, it’s not surprising that we have a long list of hedge fund “myths”. But I think it’s important to note that we’re not in the same space we were a few decades ago. It’s a different hedge fund industry with an incredibly more saturated environment - with so many participants investing in so many markets with countless strategies each with its own little twist.

All I’m saying is that hedge funds are not for everyone (especially in the retail space) and the decision to go in or not requires a different skill set than one would normally consider in the fund selection process. It certainly requires enough resources (especially time) to fully process this decision.

Thus, the decision for many investors (even many institutions) to get into hedge funds is not easy. I hear stories from 2006 and 2007 of institutions thinking of pulling fully out of hedge funds if not decreasing allocations significantly. It’s certainly not the trend, far from it. In fact, Aaron Siegel at InvestmentNews has an article today on the record inflows into hedge funds in the first quarter of 2007. The numbers really are quite amazing:

The hedge fund industry posted record inflows of more than $60 billion during the first quarter, bringing total assets under management to $1.57 trillion, according to data released today by Hedge Fund Research Inc.

This record inflow is a big jump up from the same period last year:

The net inflows reflect a 295% increase over the fourth quarter of 2006, when the industry recorded $15.7 billion in new fund flows, and was equal to nearly half the record $126 billion in assets gathered in 2006.

I’m wondering if this is simply a large timing bet. If investors are worried of the lengthy bull market we’ve experienced and the relatively quick recovery to new highs that the markets have shown in the summer of 2006 as well as over the past few months, then it would make sense to see big inflows into hedge funds as a means for defensive preparation. We have not seen a lenghty, drawn out bear market in a while so it will be interesting to see how the hedge fund industry (and various hedge fund indices as guages, faulty or not) perform during such a time. I am confident that there will be a good number of hedge funds (single strategy, multi-strategy and otherwise) that do well but as many including Easterling have mentioned, it’s not just raw numbers but the meeting of client expectations that causes some discomfort after the fact, and thus further confusion within the hedge fund industry.

News of the coming actively managed ETFs has grabbed most of the attention in this young and growing industry over the past several months. The AMEX gave some details of an underlying structure for such ETFs at a conference in New York in early March. Even prior to that there were some media reports on this issue including this from John Spence at CBS MarketWatch. I have posted my views several times on rules based “strategy” ETFs and how I believe that they’re not really actively managed, although there are some that have very strong arguments. But what I’m talking about in this post is an actual actively managed ETF. No index tracking. An active manager making stock selection decisions on the underlying portfolio just like for a mutual fund. I sound like a broken record but again, the innovation comes from Canada.

First some background. On Thursday, April 12th, I attended a luncheon seminar organized by The Toronto CFA Society (their derivatives committee, in fact) to a full room of I’ll guess around 120 people. The first speaker was Howard Atkinson, President of Horizon BetaPro ETFs. BetaPro has a long and a short exposure set of levered Canadian equity ETFs linked to the S&P/TSX 60, the dominant large cap equity index in Canada. The underlying advisor for these funds is the same as those for the ProShares line of ETFs in the US. Howard is best known for leading the BGI iShares (formerly iUnits) group in Canada before recently moving to BetaPro and is also the author of “The New Investment Frontier” which is already in its third version. To me, it’s THE book for anyone (Canadian or not) on ETFs. Of course, there’s a big home bias in this book, but it still gives the important basics such as the underlying structure of ETFs (as well as other forms such as HOLDRs), the history and some stats on current funds … although with the pace of product development this book was already obsolete with the ETF-specific data even upon going to print … a problem with all ETF publications including the annual Morningstar ETFs 100. For every book out there, you really have to have an associated website to keep things up to date. To credit Morningstar, and despite concerns I have with regard to their analysis of ETFs, they do have a website with a section specifically covering ETFs. I didn’t say their ETF website was a good one or not. Frankly, I’m not a subscriber to their service so I can’t say whether their ETF-specific analysis is of any value or not … nor did I in my posting which I just referred to. If someone is a subscriber to their service and wants to comment on it here, please do. There are quite a few sites that have databases with a decent amount of ETF related information (they’re free but clearly not as robust as you’d find on a Bloomberg terminal) and many of them are listed on the left column of this blog’s main page under “ETF Information”.

Getting back to the presentation: Like much of his book, Howard’s presentation covered in broad terms the basic topics of history and underlying structure. More importantly, he discussed the confusion today about ETF liquidity as well as related discussion of “true value”. He also quickly went through some recent offerings and the different strategies that can be applied with ETFs.

The second speaker was Peter Haynes, Managing Director of Index Products/Portfolio Trading (Institutional Equities) at TD Newcrest also here in Toronto. I focus so much on the markets and beta related instruments outside of Canada that I hadn’t familiarized myself with the local ETF specialists and researchers on the sell side (thanks Howard for the names!). Peter is one of these few specialists and considering that he was one of the people working on the first ETF ever on the planet (TIPS in 1990 and HIPS in 1993 which eventually merged in late 1999 to become what is now the iShares S&P TSX 60 Index ETF), you could and should say that he’s pretty much been in the ETF business as long as anyone. Peter’s session focused more specifically on the Canadian ETF marketplace and the providers. He also had comments on the institutional use of ETFs and a behind-the-scenes look from the dealer’s side. In all cases, for everyone in the institutional space as well investment dealers with an ETF inventory … it’s all about risk management. No surprise there.

The big surprise, for me at least, was when Peter started to speak … in a rather “matter of fact” tone … about the first actively managed ETF. According to a slide from Peter’s presentation:

“In early March [2007], conversion of FIE.UN from closed end fund (CEF) to ETF resulted in the first North American Actively Managed ETF. Street (other CEF providers) are watching FIE asset retention carefully.”

I did some poking around and thanks to Andrew Leinwand of the Toronto Stock Exchange’s (TSX Group) Structured Products & ETFs Division we have this prospectus available on SEDAR for the Claymore Canadian Financial Monthly Income ETF (ticker FIE on the TSX).

By the way, “SEDAR” is the System for Electronic Document Analysis and Retrieval, a filing system to provide access to most public securities documents and information filed by public companies and investment funds with the Canadian Securities Administrators (CSA).

I couldn’t find a way to link to the pdf file directly through SEDAR so here’s how you go to download the prospectus.

1. Go here:

2. In the text entry box under “Investment Fund Name” enter [Canadian Financial Income] but of course without the brackets.

3. Under document type, choose [prospectus] then click [search].

You should get four matching results, the top one being the English language prospectus. The prospectus is actually for two ETFs. The second ETF listed is a fundamentally weighted fund with Research Affiliates as the underlying advisor. Claymore has anchored itself firmly in the fundamental camp in Canada with multiple offerings based on this indexing methodology from RA. But the purpose of this posting is to focus on the Claymore Financial Income Fund (abbreviated as FIE in the prospectus). The third paragraph found on the first page of this prospectus reads more like a description for a mutual fund than for an ETF with a clear objective related to active management. It reads:

FIE’s investment objectives are to maximize total return to its Unitholders, consisting of distributions and capital appreciation, and to provide its Unitholders with a stable stream of monthly cash distributions of $0.05 per FIE Unit. FIE’s net assets, together with borrowings under its loan facility, are invested in a diversified and actively managed investment portfolio consisting primarily of common shares, preferred shares, corporate bonds and income trust units of issuers in the Canadian financial sector (the “FIE Portfolio”). MFC Global Investment Management (Canada) acts as investment advisor to FIE.

I’ve emphasized the text with regard to the fund’s objectives. There’s no mention of tracking an index but rather maximizing total return. It also mentions the underlying investment advisor as MFC Global Investment Management, part of the global financial conglomerate Manulife Financial. If the part of this being an actively managed fund wasn’t clear, two paragraphs down is this passage we find this:

MFC Global Investment Management (Canada) (the “Investment Advisor” or “MFC Global Investment Management” or “MFC Global”), a division of Elliott & Page Limited, a Manulife Company, acts as the investment advisor to FIE and actively manages the FIE Portfolio on behalf of FIE. MFC Global, one of North America’s largest and most experienced asset managers, and its affiliates provide investment advisory and portfolio management services to institutional clients and investment funds and, as of September 30, 2006, had over $230 billion in assets under management.

Again, I put in bold text the key phrase. Also note that on page 5 within the “Prospectus Summary” section, under the “Investment Approach” subsection, the document gives greater detail on the degree and scope of active management applied within the fund.

But from the second quote above we again see quite clearly it states that the investment advisor “actively manages the FIE Portfolio on behalf of FIE” (as if the third party investment advisor would be hired to passively manage the fund?!), although it’s not very sexy in that the fund’s investment universe are securities in the Canadian financial sector. Funny, with all the talk of Bear Stearns’ SEC filing for an actively managed ETF, in this case it’s about active management within money markets. For those interested in doing some comparison shopping, here’s the link to the Bear Stearns prospectus. I found this link from Matt Hougan’s article on IndexUniverse (registration required but it’s free) with early news on the filing.

I would be wrong to not highlight the fact that this Claymore ETF has a 100bps management fee. That 100bps fee seems to fit the smell test … this guy’s actively managed. The fundamentally weighted ETF has a management fee of 65 bps and I don’t consider it nor other rules based strategy ETFs to be actively managed. By the way, here’s the chart which shows that it’s only had a few days of trading and despite it being an interesting development, clearly it’s not that interesting when you consider the trading volume:

One more note: I just received the latest “ETF Worldwide Guidebook” from Deb Fuhr at Morgan Stanley along with the usual set of additional guidebooks. Page 44 of this guidebook has a listing of Canadian ETFs including the Claymore Canadian Financial Income ETF although it only lists the name of this fund not any additional detail such as ticker symbol or cost (TER). But it does again confirm the fact that this actively managed fund is classified as an ETF.

The ETF industry seems to be taking baby steps into active management … and that’s a good thing. A lot of people (in Canada at least) are looking at these late events and are eager to be second to market. I’m eager to see the response from outside Canada once I post this story. Despite all the comments about the importance of being first to market in the ETF industry (think GLD versus IAU), there’s little point in being #1 and swinging for the fences when you have no clue what to expect.

But this makes me think of all the news in the US of actively managed ETFs and the dawn of a new age [Please note that when I talk of an “age” in the ETF timeline, we’re talking about a year, ok?] So, there was some news of an actively managed ETF out of Germany (some say it’s not) and now we have this CEF to ETF conversion that could potentially lead to other CEFs switching sides. Will we see a mass migration of this sort? More importantly: Why hasn’t this news in Canada made headlines elsewhere … actually, I don’t think it really made headlines here either. Why is that?

This would seem like the forgotten, or somewhat undiscovered passage for the move towards truly actively managed ETFs. Or maybe not. Perhaps, like Peter Haynes had said, there are many other participants in this market watching developments here in Canada as well as in the US. And if so, then there could be some very interesting further developments in the closed end fund/exchange traded fund world. As a review/primer for those unclear about the difference between CEFs and ETFs, I bring this excerpt from a recent article on the Morningstar website:

Most individual investors never deal directly with an ETF the way they would with a traditional mutual fund. Individuals and financial planners buy and sell ETFs among themselves via a broker. In this way, they are similar to closed-end funds. But the similarities end there. Closed-end fund shares can trade at large premiums or discounts to the net asset values of their underlying portfolios. ETF discounts and premiums tend to be much smaller, though, because ETFs can do something closed-end funds can’t: continuously create and redeem shares in-kind. This means that the ETFs exchange fund shares for baskets of their underlying securities and vice versa.

This in-kind creation/redemption process creates an arbitrage opportunity for large institutional investors and market makers, known as authorized participants, who deal directly with the ETF. This helps keep ETF premiums and discounts narrow. When ETF shares trade at a discount to the NAVs of their underlying holdings, the APs buy the ETF shares and sell the underlying securities. If the ETF shares trade at a premium, the APs buy the underlying securities and sell the ETF shares. In the process of taking advantage of these arbitrage opportunities, the APs drive ETF market prices and NAVs close together.

That was from Dan Culloton. In addition to this article being well written in my opinion, by linking to this Morningstar webpage, I also wanted to show that I’m not completely … almost, but not completely … anti-Morningstar. Let me be clear: I’m not so sure of the value of someone telling me “this” mutual fund is better than “that” when a strong majority of these funds are closet indexers. Not all, but a very good number of them. I’m even less sure of the value when applied to ETFs. Furthermore, the star system, to me at least, seems to be the absolute perfect example of the phenomenon of “chasing returns”. I wonder if anyone has ever run a mandate where long positions were established for funds with the top ranking and shorts were established for “no stars” (if there is such a thing as no stars)? I know, that would be stupid but I’d just be interested to see the results. Backtests are only shown for successful backtests. If there is none for this “strategy” (I use quotation marks for obvious reasons), then we probably know why. End of rant.

Back to CEF to ETF conversion story. I’m hoping that this posting leads to a lot of discussion and if so, I hope to follow up with some Q&A with various analysts in the ETF space. I’d like to get some reaction on this particular fund conversion process and their outlook on the future of actively managed ETFs both here and in the US.

In essence, the closed end fund story is quite simple. Just like any index can be traded on an exchange through an ETF, so can a mutual fund (so to speak because it’s actively managed and has a net asset value) be traded on an exchange as a CEF. The well publicized flaw of CEFs is the spread between the CEF’s market price and the underlying fund’s NAV thus if the conversion to ETFs appropriately deals with this, as it should, yet also makes economic sense for the fund provider, this could lead to a significant number of actively managed ETFs on the market. But there’s a big “IF” in there. With all the uncertainty of this, I’m thinking that if this was such a great idea, it would likely have already been done. I’m guessing it’s simply an issue of going through the regulation process and if so, that’s fine. What’s the rush, right? But then, this makes me think of a long list of additional “IFs”:

• If a mass conversion of actively managed closed end funds to ETFs occurs, what are the ramifications to the other participants in the ETF industry, in particular the mutual fund industry, but also to the broker/dealer community, and heck just about everybody?
• If developments lead to a robust and growing actively managed ETF industry, would this further confirm my feelings of a divergence in the ETF space: low cost broad market cap weighted index exposures at one end, and pretty much every else with a higher fee attached to it on the other end.
• If this were to happen, then suddenly the new infrastructure and real estate ETFs (among many others) brought to market recently would have more direct competition from relevant CEFs that become converted. Same with many other asset classes and sub-categories. I wonder what the mutual fund executives think of this? Not another dagger. Certainly, many will have to adapt: Hey Morningstar, you’re back in business! I hear a sigh of relief from mutual fund analysts everywhere as active management truly makes it way to ETFs. Caveat: remember that it’s “IF” such developments occur. Just kidding … there’s really nothing for mutual fund (or active management) analysts to worry about. The financial services industry was built for active management and it’s just a matter of time before the ETF industry gets pulled in.

Last “If”: If John Bogle didn’t like the direction the ETF industry was taking in 2006, you have to wonder what he thinks about it now.

Why am I picturing floodgates being opened?

On my post from April 2nd, I’d mentioned discussions I had with the press on recent developments in the ETF industry further to the World Series of ETFs conference in Miami. From those discussions, there have been some recent articles available on the web which I’d like to share.

I’d like to start with a quick reference to Abnormal Returns, a blog of blogs so to speak. For those like me who have their list of favorite sites and blogs to read daily and weekly, some things slip through the cracks. Who am I kidding? It’s the web … lots of things get missed as there’s just so much stuff online. Abnormal Returns is one of a few sites that produces a linkfest in the investment space to minimize slippage. It’s great because it provides a daily list of interesting articles and blog postings. By the way, two other sites that provide a linkfest, although not available daily but a few times a week, are Charles Kirk’s The Kirk Report and Barry Ritholtz’s The Big Picture. Both are part of my “Blogroll” along the left margin on the main page of this blog.

As an aside and in advance, my apologies for the self-promotion as articles mentioned here all make reference to me in some way.

Thanks to Abnormal Returns for an April 10th top line link to an article I wrote for InvestmentNews titled “Hedge funds and ETFs: Strange bedfellows” which briefly outlines what I have focused on over the past month of postings on this blog - the convergence of the ETF and hedge fund industries and how despite being at opposite ends of the investment spectrum they seem destined to overlap in so many different ways.

Also on InvestmentNews is this April 9th article called “ETF Industry Chugs Along With New Products” written by David Hoffman whom I have spoken on several occasions over the past year and first met in New York at the ETF Evolution conference in early March. David quotes several ETF insiders (including myself, but I consider myself to be more of an outsider looking in) about the move towards greater degrees of active management in ETFs. This will easily be the primary focus of debate in the ETF space for the remainder of 2007 if not for some time thereafter.

John Spence of CBC MarketWatch who provides significant coverage of news related to ETFs has an April 8th story titled “Trouble in ETF Paradise?” that specifically comments on the World Series of ETFs conference in Miami. Like David Hoffman, John gets opinions from many industry participants and puts added emphasis on potential problems that may occur in the future. While some focused on what needed to be done, others were quite critical and with some good reason. However, I found it strange that someone from Morningstar had such negative comments on new products in the ETF space such as:

“True, we haven’t seen any true scams yet, but we have seen plenty of really, really bad ideas that no prudent investor would touch.”

“All this speculative dross won’t end in a pretty way.”

“While I’d expect most long-term ETF investors will get well diversified, low-cost funds and do just fine, those who enter the casino side of the ETF world will get burned.”

I had to read it again before I figured out that these quotes were from Morningstar’s director of mutual fund research. It’s kind of like being an analyst for coal stocks or a cigarette ad agent … tough place to be. The mutual fund industry isn’t dead or dying but clearly the ETF industry is making a dent. Morningstar has recently been involved in producing research on ETFs and it’s with the newer ETFs that I would think that this group would want to spend a lot of time and resources. They must be hoping that their mutual fund research counterparts are wrong in their opinions.

Of course, as per the title of his article, John also mentions a few current situations where communication breakdowns (among other things, I believe) have caused some discomfort between investors and ETF providers.

My small contribution in this article is as follows:

Richard Kang, an independent consultant for hedge funds and index providers, noted that the push toward fundamental indexing is a byproduct of investors’ greater appetite for risk. “Just like any other part of Wall Street, ETFs are trying to be better than everybody else,” he said.

I still see it as odd that many observers find it surprising that the ETF industry is pushing into a more actively managed orientation. It’s like active management is bad. Or that participants in an industry who are generally (but certainly not all) smart and possibly even over-achievers would dare to try something different. This is an industry about ideas and innovation. And about pushing product. And about making money even if sometimes the investor isn’t. Just telling it like it is. Put all this together and it’s inevitable that the industry will evolve in the way it has, four or five year bull market or not.

And despite my comments, I still see the push towards active management as still some form of beta, not alpha. That sounds incredibly contradictory but, in my opinion, what the ETFs are doing is commoditizing alpha which to me is beta. To me the only true alpha is in the form of a hedge fund or active strategy where their methodology is not repeatable by competitors in an effective manner so as to profit from this knowledge or skill. So call it quasi-active management or whatever you want, but I think the ETFs coming out to market (perhaps for a very few that truly provide what I think may be defined as alpha … and I’ll have to come back to this in a later post) are in some grey area between the classic form of market cap weighted indexation and some form of purely active management.

What the press doesn’t seem to get but I think the ETF providers fully understand is that this recent move will clearly result in a significant divergence in the industry of low cost providers versus relatively higher cost niche product providers. That’s a good thing. The Vanguard types will be happy at the one end and the XShares types will be happy at the other end. Those “stuck in the middle” will quickly have to figure out where they want to go. I don’t think many will be caught in this middle ground. In fact, if anyone is, it’ll likely be BGI and SSGA. They’ve got size so it’ll likely take some time until they become compelled to make such decisions. However, we’ve seen some recent examples of movement in the form of fee cuts. John Spence reported in this article back in January of a drop in expenses for (SPY) (not significant for many) bringing it closer (within about half a basis point) to iShares’ (IVV). It was a small step but with so many overlapping ETFs, especially in various areas of the US equity asset class and sub-classes, I’m hoping for more.

And John mentions, like dozens of others in recent weeks, of Bear Stearns’ move with an SEC filing for an actively managed bond mandate within an ETF structure. This will continue to get a lot of press as the concept of full active management in an ETF has been discussed for years now.

Lastly, some local coverage … by local, I mean Canadian … from Jonathan Chevreau at the National Post. One of a very small number (maybe three) in the Canadian mainstream press who regularly mention ETFs. His April 10th article “Specialized ETFs Have Drawbacks” covers Claymore’s continued assault on the Canadian frontier. I use these words since their products are quite aggressive (in a good way) in that they truly aim to cover new territory. And considering the relatively small number of ETF offerings in the Canadian marketplace and the relatively small numbers in terms of assets under management, Canada really is still a frontier market in terms of ETFs. This despite Canada being a place of innovation in the ETF space. First ETF. How about the first multi-asset-class ETF in the world? Claymore’s new Global Balanced ETF will provide exposures in at least three asset classes: stocks, bonds and cash. I would think that for the vast majority of investors who use ETFs, they think of them as tools and want to make their own decisions in terms of allocation between these broad asset class. But, there must be some, like balanced mutual fund investors who would think otherwise. Despite the ominous tone of his title, Jonathan actually doesn’t have a lot of negatives aside from comments from Bogle that I think we may have heard already. I don’t totally disagree with Bogle by the way as shown in my comments in this article, but there’s a broken record being played here.

The article also mentions the new Claymore S&P CDN Preferred Share ETF (ticker CPD on the Toronto Stock Exchange) which is the Canadian counterpart to the new BGI offering, the iShares S&P U.S. Preferred Stock ETF (PFF). The index research people at Standard and Poor’s have been busy (Srikant?). For more information on the underlying indices, go here for the Canadian index and here for the US index.

As an aside, these S&P links are common to a parent site covering S&P Alternative Indices. You really have to go to this site and see what they have listed. Exposures to different types of real estate indices, commodity indices and even various hedge fund indices. MSCI/Barra, FTSE, Dow Jones and others all have various forms of alternative indices, and like S&P have many more in the pipeline. We’re definitely not in Kansas (or traditional index land) anymore.

With an oil sands ETF and a BRIC ETF as well as broad coverage funds that use the FTSE-RAFI fundamental indexation methodology over traditional market cap weights, Claymore is clearly trying to be that niche specialist in Canada compared to the more established BGI with its broader coverage ETFs. And the article even mentions an upcoming global water ETF from Claymore as well!

Jonathan also has a blog called “The Wealthy Boomer” and it is a worthwhile destination for the do-it-yourself investor as well as retail based financial advisor. Although there are many aspects catered specifically to the Canadian investor (like specific tax issues, for example), others will find the general investment discussions very informative. His April 10th posting “Will Retiring Boomers Prefer ‘Preferreds”?” goes a bit deeper into the pros and cons of a preferred stock ETF than his newspaper article. I’ve mentioned in recent posts of the search for yield and the difficulty in promoting the use of fixed income ETFs. This is another example of the market leaning away from bond exposures (not worth the return versus cash considering the risk) and attempting to find yet again another acceptable substitute to provide yields.

There were a few other reporters I spoke with recently and I hope to refer you to articles they write in upcoming posts. You may have noticed that my posts have been fewer and further between than in past months. Baby number two should be arriving any day now … and the problem is that I’ve been saying that for the past few weeks. As if I were the one pregnant or something! Anyway, in preparation for this, over the past several days I’ve been working on some rather lengthy posts that I hope to complete soon and then possibly ease back with much shorter posts (compared to what I’ve provided in the past) over the coming months. This is still a hobby for me, not a full time job and the amount I get paid from this blog (total revenue of $0 thus far) fully qualifies this as such. I actually had a few people at the recent conferences I attended ask why I don’t charge admission to this site. Flattering but no way. I’ve contemplated advertising but to be honest, I love the complete independence I have right now. I hope that it shows in my writing and I hope you find true value in that. If this is all true and good, I can think about revenue generating later assuming this site has a significant following. For now, I guess I simply don’t want to actively manage certain aspects of this blog right now. Ironic how that fits with the title of this post.

Further to my posting back in January giving details of Vanguard’s low cost (they are kind of like the Walmart of the ETF industry, right?) fixed income ETFs, we get news today of four new offerings:

The four corresponding ticker symbols respectively are BND, BSV, BIV and BLV.

There’s no doubt that the appeal for these new ETFs (well, for Vanguard in general) is the low cost. But my feelings on bond ETFs still lead me to believe that the diversification benefits of an indexed bond holding aren’t really that great, especially compared to that among equities within a broad equity index. If having minimal tracking error to a particular bond index really matters to you (then you are likely an institutional investor), then some form of index holding matters. But if you are an institution, you’re clearly not using an ETF or ETFs for your fixed income exposures … well I suppose you could be, but if your board of trustees knew this you should be cleaning up your resume.

Unless you’re a complete novice who can’t build a laddered bond portfolio (or acquire an advisor who can do this), then bond mutual funds or perhaps these bond ETFs should be one of your final options to gain fixed income exposure.  It’s almost like the opposite as what might be done on the equity side where you might have a core group of ETFs with stock selection as a “satellite” strategy.  For fixed income, a laddered bond portfolio could be the core and fixed income ETFs could be used as “satellite” positions.  That might not make sense on a first read especially with regard to the use of bond ETFs.  However, I think that we will see a breakthrough in this space where more actively managed fixed income ETF mandates appear as investors continue to push the limits to extract more yield from their portfolios in what is a tough, low-yield world.

Let me start by saying that I received three calls today from the press. On the one hand, I’m happy that the blog is getting some attention and with further coverage in the mainstream press, I am very eager to see how my readership at “The Beta Brief” grows (fingers crossed). However, everybody wants to talk about the greater focus on “active management” in the ETF industry. Is it that surprising?! It’s neither bad or good. The industry is simply evolving based on its inner economic conditions, changes in the overall market environment and the resulting changes in the behavior of investors. There will be a continued push away from the classical passive form of index investing but, on the other hand, we will likely continue to see a very high proportion of ETF assets remain in the traditional, relatively lower cost funds like SPY, QQQ and the offerings from Vanguard.

With the recent downside market action and resulting spike up in VIX, I like many market participants am eager to see if this will be a relatively short “V” pattern with new highs being quickly re-established. Here’s a 10-year chart of the S&P 500:

As you can see, since early 2003, there has not been any serious drawdown and down markets were quickly erased with new highs in a matter of months. The growth versus inflation story both in the US and globally seems to have many investors feeling not too worried but not entirely care free. It’s the incredible resilience of the global markets to a continuous assault of significant events that has me wondering what does it really take to shock this bull market? Mideast turmoil and its effect on the energy markets hasn’t done it. An all out war (albeit short) in Lebanon in addition to conflict in Iraq and Afghanistan seems almost like a non-issue now. The UK subway bombing is an example of an even more “focused” event that shocked the market but in such a meaningless way in terms of severity and length. Closer to home in the US, despite a White House adminstration that seems destined to be the ultimate case study for grad school management programs (G.W. Bush was the first US president to have earned an MBA, right?) with a chain of foul ups too long to mention, the markets have shown a nearly straight line upwards. However, G.W. Bush assumed office in early 2001 when the S&P 500 was at around 1350. Just a simple observation, but if you include distributions (as opposed to just a price based calculation using the above chart), the US market has provided close to cash equivalent returns over the Bush presidency. Somehow I think if Gore won the election back in 2000, there wouldn’t have been too significant a difference in market performance although that’s certainly highly debatable. Well, I think there’d certainly be less laughs on the late night shows … I doubt Lieberman (or Edwards if Kerry won in 2004) would have done anything like shot someone in the face, but the Democrats are also damn good at screwing themselves with ease. The market was already on its way down and no matter who won the election back in 2000 nothing would have stopped the bear market. September 11th brought a quicker drop but spiked back up only to continue the downward trend until we hit bottom somewhere in the later half of 2002.

But now we’re at a completely different time. We’re near (S&P 500) or past (Dow 30) previous highs. And what interests me now is what remains highly resilient during the moments - even if they’re relatively short - when the market seems to release some steam. Hopefully, this kind of analysis not only finds good defensive performers in mini-corrections but in serious market declines as well. First, let’s take a shorter term look at the S&P 500:

We can see last summer’s market decline as well as the turmoil over the past month. In between is one of the smoothest bull markets I’ve seen. I think it’s too short to be considered a cyclical bull but at seven months, it was a fairly nice long run of about as straight a line as a market could have, and with a rate of ascent that makes it that much more incredible.

However, you plot some sectors over this chart and you see that there are areas that are even more incredible over the past year. With all the press related to commodities, one might guess that the oil & gas sector would have been a good place to put assets over the past year but all it’s brought is its usual high level of volatility:

At least it looks relatively uncorrelated to the S&P 500 so for asset allocators with an eye for diversification (not for Canadians, Russians and other oil producers of course) there looks like an argument to hold a certain portion of one’s portfolio here. What about gold & silver?

Pretty much the same story. Low correlation. With bigger drawdowns than in the oil & gas sector over this period, again the idea is to add some of this but not too much. It’s somewhat uncorrelated so it can dial down a portfolio’s overall volatility, but add too much commodities and watch your volatility skyrocket!

Obviously, something less gut wrenching is utilities:

No surprise, utilities are one of the classic defensive sectors. Compared to the broader market it often timeis has a lot less volatility and, in fact, over the recent year’s chart looks like a really well run hedge fund. I’m not joking. Look at the behavior of the Dow Jones Utilities Average over the months of May/June 2006 as well as over the past 5 weeks in the chart above. During these times of market stress, the DJUA was relatively flat or slightly upwards (last summer) or strongly up (recent weeks). Otherwise, during other times it looks kind of like the index but on a month-to-month basis you don’t see a high degree of correlation. Unfortunately, the comparison of DJUA with hedge funds only goes so far as you can see in this 10-year chart:

Unlike nearly all hedge fund indices (as bad as they are as benchmarks I use them as the only decent source for comparison), you can see that the DJUA did not protect investors from the bear market of 2000-2002 in any way better than the broader market S&P 500 Index.

Still, my point is that utilities is one of a few areas where it clearly has been going strong even in comparison to the S&P 500 during this bull market. And, of course, as a defensive play it seems to do relatively well even in times of distress. Recent commentary has suggested that the new infrastructure ETF from SSGA, the SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII) is actually a global utilities fund in disguise. For review, refer to my previous posts covering infrastructure here and here. Some of my comments from those posts seem to suggest that infrastructure, like many areas that have shown new product offerings in the ETF space, have shown too great a rise and that investors might be wise to show restraint and wait for better valuations and a lower point of entry. Price action over the past few months have proven me wrong overall as shown in the following chart which includes several infrastructure oriented ETFs and CEFs:

All of these funds involve Macquarie and although they have different mandates you can see that they generally move in tandem. For example, although the S&P 500 had a modest increase in the month of March, all infrastructure funds in the chart above had a strong month except for the first week. Perhaps I was correct earlier this year when I addressed concerns of the recent strength in infrastructure oriented funds. The sharp declines in late February in line with the overall market seem to agree with this. However, their incredible concerted rebound was frankly unexpected. I would have thought that any rise would be in line with the broad markets, not the sort of out performance shown in the chart above.
Therefore, and perhaps not surprisingly, infrastructure and utilities are quite similar in that they have demonstrated an ability to deliver favorable performance in the good times, but more importantly, when the broad markets are not as strong. And the immediate corollary to this for me is the attention given to fundamental indexation whether through PowerShares or WisdomTree. Like other alternative weighted index methodologies, the focus is on value over growth. No one would argue that utilities are a value play, but so too is infrastructure with the stable income generated from its business operations (airport, highway, port, water service, etc.).

Lastly, I have seen some very brief commentary on the transports. Here’s a 3-year chart comparing the Dow Jones Transportation Average to the S&P 500:

Over 1 year, the S&P beats the DJTA. Over 2, 3, 4 or 5 years, the DJTA wins. Regardless of commentary relating to transports as a leading indicator, I can’t see this an anything more than a high beta version of the broader market. And in today’s environment, for the defensive oriented investor, this or an ETF in this space is likely one to avoid. Look how it behaved last summer, over the past month and in other times of market declines. But perhaps technology or in the chart below, internet stocks, are an even better example of a purely cyclical play … the perfect opposite of the defensive sector play:

This example goes too far to the other extreme but it clearly makes the point to differentiate how far apart a defensive sector like utilities looks compared to a cyclical sector and versus the broader market. Some may think of transports as a possible defensive play but in times of market distress, if you felt nervous about the S&P, transports would make you manic! Speaking of transports, I’d like to write about freight derivatives at some point. I continually neglect the derivatives market as there’s just so much happening in the ETF space but it’s just so interesting to see the continued innovation in the derivatives markets (property derivatives, housing derivatives, economic derivatives, weather derivatives). Some more for the “to do” list.

Bottom line: For investors concerned about providing an adequate level of defense for their portfolios, some sector tilts may provide greater diversification benefits than geographically based asset allocation. Rather than allocating more towards EAFE or even emerging markets, investors may look to areas like utilities, infrastructure and other sectors that may have a better chance of sustaining past earnings levels or at least have minimal downside effects to general operations when the overall global economy softens. With concerns of greater correlations among asset classes and asset strategies, sector “bets” (yeah, it’s an active decision that may be right or wrong) are one of the more tried and true methods available to any level of investor. Clearly, some sectors are better than others for defensive maneuvering. If sector rotation is to be fully explored as a viable strategy, thank goodness for the recent delivery of sector oriented ETFs brought to the market by ETF manufacturers and especially the relatively younger providers who have brought some very interesting niche funds to the marketplace.