Many observers of the ETF industry have commented on the thinner slices to sector exposures provided by fund manufacturers in recent years. My take is different. Although there are some “sectors” that are indeed quite narrow, many new fund offerings are more “thematic” in nature. These include water, alternative energy and infrastructure and are more broad that they are, in my opinion to be considered asset classes themselves. Of course, some would consider this issue semantics but that’s for the final user to decide within their own investment process. Certainly, many institutional investors look at infrastructure as an asset class. I don’t know if I would consider water to be an asset class … actually, I don’t … but it certainly is broader than a sector and can be considered thematic in nature.

At the end of the day, I am interested in finding things (call it a sector, call it a theme, I really don’t care) that help in the overall risk-adjusted return potential for any given portfolio. I think Van Eck is a firm that thinks the same way. Steel company exposures (through their Steel ETF, SLX) may not be a diversifier for many, but I could see it as one for many unique types of investors. The same could be said for their Environmental Services ETF (EVX), their Gold Miners ETF (GDX), their Global Alternative Energy ETF (GEX) and their new Russia ETF (RSX).

To take RSX as another example, for an investor with a need for emerging market exposure outside of what they likely already hold (China, India, EEM) and with a strong commodity bias, this fund makes sense. For someone like a Canadian or Australian, it likely doesn’t make so much sense.

But now I’m getting word of some new ETF product development in the Van Eck pipe as seen from this recent SEC filing.

What have we here? (Think Lando when he first met Leia for all the fellow Star Wars geeks out there.) Here are some of the more interesting excerpts:

Market Vectors—Global Agribusiness ETF and Market Vectors—Global Nuclear Energy ETF (the “Funds”) are distributed by Van Eck Securities Corporation and seek to track the DAXglobal^® Agribusiness Index and DAXglobal^® Nuclear Energy Index, respectively, each of which is published by Deutsche Börse AG (“Deutsche Börse”).

More specifically on the Agribusiness ETF:

MARKET VECTORS-GLOBAL AGRIBUSINESS ETF

Principal Investment Objective and Strategies

Investment Objective. The Fund’s investment objective is to replicate as closely as possible, before fees and expenses, the price and yield performance of the DAXglobal^®® Agribusiness Index.” Agribusiness Index (the “Agribusiness Index”). For a further description of the Agribusiness Index, see “The DAXglobal^® Agribusiness Index.”

Principal Investment Policy. The Fund will normally invest at least 80% of its total assets in equity securities of U.S. and foreign companies primarily engaged in the business of agriculture. Companies primarily engaged in the agriculture business include those engaged in agriproduct operations, livestock operations, agricultural chemicals, providing or transporting agricultural equipment, and providing or transporting ethanol/biodiesel, and which derive at least 50% of their total revenues from such activities. This 80% investment policy is non-fundamental and requires 60 days’ prior written notice to shareholders before it can be changed.

Indexing Investment Approach. The Fund is not managed according to traditional methods of “active” investment management, which involve the buying and selling of securities based upon economic, financial and market analysis and investment judgment. Instead, the Fund, utilizing a “passive” or indexing investment approach, attempts to approximate the investment performance of the Agribusiness Index by investing in a portfolio of securities that generally replicate the Agribusiness Index.

The Adviser anticipates that, generally, the Fund will hold all of the securities which comprise the Agribusiness Index in proportion to their weightings in the Agribusiness Index. However, under various circumstances, it may not be possible or practicable to purchase all of those securities in these weightings. In these circumstances, the Fund may purchase a sample of securities in the Agribusiness Index. There also may be instances in which the Adviser may choose to overweight another security in the Agribusiness Index, purchase securities not in the Agribusiness Index which the Adviser believes are appropriate to substitute for certain securities in the Agribusiness Index or utilize various combinations of other available investment techniques in seeking to replicate as closely as possible, before fees and expenses, the price and yield performance of the Agribusiness Index. The Fund may sell securities that are represented in the Agribusiness Index in anticipation of their removal from the Agribusiness Index or purchase securities not represented in the Agribusiness Index in anticipation of their addition to the Agribusiness Index. The Adviser expects that, over time, the correlation between the Fund’s performance and that of the Agribusiness Index before fees and expenses will be 95% or better. A figure of 100% would indicate perfect correlation.

The Fund will normally invest at least 95% of its total assets in securities that comprise the Agribusiness Index. A lesser percentage may be so invested to the extent that the Adviser needs additional flexibility to comply with the requirements of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), and other regulatory requirements.

Because of the passive investment management approach of the Fund, the portfolio turnover rate is expected to be under 30%, generally a lower turnover rate than for many other investment companies. Sales as a result of Agribusiness Index changes could result in the realization of short or long-term capital gains in the Fund resulting in tax liability for shareholders subject to U.S. federal income tax. See “Shareholder Information—Tax Matters.”

Market Capitalization>. The Agribusiness Index is comprised of companies with market capitalizations greater than $150 million that have a worldwide average daily trading volume of at least $1 million and have maintained a monthly trading volume of 250,000 shares over the past six months. The total market capitalization of the Agribusiness Index as of [ • ], 2007 was in excess of $[ • ] billion.

So we now have a competitor to the up to the PowerShares-Deutsche Bank agriculture ETF (DBA). A quick review from its website gives us this description:

The PowerShares DB Agriculture Fund is based on the Deutsche Bank Liquid Commodity Index – Optimum Yield Agriculture Excess Return™ and managed by DB Commodity Services LLC. The Index is a rules-based index composed of futures contracts on some of the most liquid and widely traded agricultural commodities – corn, wheat, soy beans and sugar. The index is intended to reflect the performance of the agricultural sector.

With all the focus on metals and energy, diversifying into agriculture is a reasonable move for investors with the size to spread their allocations out even further. Those who lean more towards a Jim Rogers philosophy will look to DBA and/or this new Van Eck offering as more of a strategic (I would say tactical) bet.

And like applying a GLD/GDX combo for exposures to both the gold bullion price and gold miners, a similar DBA/new Van Eck combo makes sense here. For those implementing a position to a specific commodity, I think this dual positioning is ideal and the tilting between the two positions can be a significant source of alpha in the long-term (in my opinion). If only this were also available to the commodity I’ve been commenting on recently and for quite some time: uranium.

More specific to the upcoming Nuclear Energy ETF from Van Eck:

MARKET VECTORS-GLOBAL NUCLEAR ENERGY ETF

Principal Investment Objective and Strategies

Investment Objective. The Fund’s investment objective is to replicate as closely as possible, before fees and expenses, the price and yield performance of the DAXglobal^®® Nuclear Energy Index.” Nuclear Energy Index (the “Nuclear Energy Index”). For a further description of the Nuclear Energy Index, see “The DAXglobal

Principal Investment Policy. The Fund will normally invest at least 80% of its total assets in equity securities of U.S. and foreign companies primarily engaged in various aspects of the nuclear energy business. Companies primarily engaged in the nuclear business include those engaged in uranium mining, uranium enrichment, uranium storage, providing equipment for use in the provision of nuclear energy, nuclear plant infrastructure, nuclear fuel transportation and nuclear energy generation, and which derive at least 50% of their total revenues from such activities. This 80% investment policy is non-fundamental and requires 60 days’ prior written notice to shareholders before it can be changed.

Indexing Investment Approach. The Fund is not managed according to traditional methods of “active” investment management, which involve the buying and selling of securities based upon economic, financial and market analysis and investment judgment. Instead, the Fund, utilizing a “passive” or indexing investment approach, attempts to approximate the investment performance of the Nuclear Energy Index by investing in a portfolio of securities that generally replicate the Nuclear Energy Index.

The Adviser anticipates that, generally, the Fund will hold all of the securities which comprise the Nuclear Energy Index in proportion to their weightings in the Nuclear Energy Index. However, under various circumstances, it may not be possible or practicable to purchase all of those securities in these weightings. In these circumstances, the Fund may purchase a sample of securities in the Nuclear Energy Index. There also may be instances in which the Adviser may choose to overweight another security in the Nuclear Energy Index, purchase securities not in the Nuclear Energy Index which the Adviser believes are appropriate to substitute for certain securities in the Nuclear Energy Index or utilize various combinations of other available investment techniques in seeking to replicate as closely as possible, before fees and expenses, the price and yield performance of the Nuclear Energy Index. The Fund may sell securities that are represented in the Nuclear Energy Index in anticipation of their removal from the Nuclear Energy Index or purchase securities not represented in the Nuclear Energy Index in anticipation of their addition to the Nuclear Energy Index. The Adviser expects that, over time, the correlation between the Fund’s performance and that of the Nuclear Energy Index before fees and expenses will be 95% or better. A figure of 100% would indicate perfect correlation.

The Fund will normally invest at least 95% of its total assets in securities that comprise the Nuclear Energy Index. A lesser percentage may be so invested to the extent that the Adviser needs additional flexibility to comply with the requirements of the Internal Revenue Code and other regulatory requirements.

Because of the passive investment management approach of the Fund, the portfolio turnover rate is expected to be under 30%, generally a lower turnover rate than for many other investment companies. Sales as a result of Nuclear Energy Index changes could result in the realization of short or long-term capital gains in the Fund resulting in tax liability for shareholders subject to U.S. federal income tax. See “Shareholder Information—Tax Matters.”

Market Capitalization. The Nuclear Energy Index is comprised of companies with market capitalizations greater than $150 million that have a worldwide average daily trading volume of at least $1 million and have maintained a monthly trading volume of 250,000 shares over the past six months. The total market capitalization of the Nuclear Energy Index as of [ • ], 2007 was in excess of $[ • ] billion.

Perhaps the whole green ETF thing has gone a bit far in the past year but, a bit surprisingly, this would be the first pure play on the nuclear energy story. I have commented recently on uranium as have so many other industry watchers in recent months after having seen the commodity double in price in the past four calendar years … it’s up roughly 70% so far this year according to the chart found here.

I just said “pure play”, but it’s important for prospective investors to consider the 50% and 80% values quoted in the above descriptions. That’s 50% of the revenue of an underlying holding must fit the required parameters and 80% of the fund’s assets is to be invested in companies whose primary business operations are in the field of agriculture or nuclear energy respectively.

I don’t want to comment too much on this nuclear energy ETF as I don’t have enough information at this time. But here’s the problem I foresee: There’s just not an even spread of companies involved in the nuclear energy business. Let’s take uranium mining for example. It’s Cameco (CCJ), a very small number of competitors who are close in terms of size and a large number of small cap, if not micro cap, producers. Having an ETF based just on uranium miners would be a logistical nightmare and investors would have to accept a few stocks dominating the fund. An equal weighted ETF for this sector would make sense except for the fact that the thinly traded smallcaps/microcaps would provide an interesting (to say the least) situation for the market makers of the fund. I could see hedge funds getting into that game on the other side. We can only hope that there is a more robust mix in other related businesses mentioned in the prospectus namely uranium enrichment, uranium storage, providing equipment for use in the provision of nuclear energy, nuclear plant infrastructure, nuclear fuel transportation and nuclear energy generation.

In the past I’ve mentioned both Cameco and Uranium Participation Corp (U) as appropriate uranium plays. This new nuclear energy ETF would be an even more appropriate holding in the place of Cameco and with recent uranium derivatives on the market, exposure to the price of uranium itself allows for more complete exposure (and inverse through shorting) than in the past.

No word yet on fees as well as other details on these upcoming Van Eck ETFs.

I’d say that of all the ETF providers, it’s the news out of Van Eck that gets me the most interested and I always look forward to finding out what’s next from them.  Nothing too fancy … just new exposures, but I like it!

No, not that The Guess Who although now I can’t get the song American Woman out of my head. News from MarketWatch today of Vanguard about to fire another shot across the bow and as usual, it’s more of a shotgun approach than a rifle. It’s broad access to the international space with nothing new but the same old EAFE exposures we’ve had from ETFs like EFA. But unlike BGI’s offering with a 35bps MER, this new fund from Vanguard (VEA) will sit at 15bps.

Vanguard already allows investors cheap international exposures to Europe and the Far East (VGK and VPL respectively) both at 18bps but this new ETF will allow international exposure in one position. With the ETF world having focused in recent years on the narrowest of regions and sectors, we’re now seeing quite a few product launches for broader international exposures.

For example, SSGA now has three ETFs allowing for very broad international exposures:

• The SPDR S&P World ex-US ETF (GWL) covers most of world outside of the US market. The underlying index is the S&P/Citigroup BMI World Ex US Index. This ETF has roughly 670 holdings and has an MER of 35bps.
• The SPDR S&P International Small Cap ETF (GWX) does the same as CWI but limits holdings to small cap equities. The underlying index is the S&P/Citigroup World Ex US Range < 2 Billion USD Index. This ETF has roughly 500 holdings and has an MER of 60bps.
• The SPDR MSCI ACWIsm ex-US ETF (CWI) is very similar to CWI in most respects except the underlying index is the MSCI ACWIsm ex USA Index. This ETF has roughly 680 holdings and has an MER of 35bps.

These SSGA funds allow for some (although not much) exposure to emerging markets while EFA and Vanguard’s new offering do not. Focusing on the large cap exposures (GWL and CWI) from SSGA, in general, you’re getting greater diversification from these compared to the BGI and Vanguard offerings which both track the MSCI EAFE Index. According to the iShares website, this factsheet for EFA shows that the three top country exposures are the UK (23.11%), Japan (22.29%) and France (9.46%). A total of about 55% in these three countries. Based on the SSGA website, GWL and CWI have the same top three countries but with decreased weights. Both GWL and CWI have about 45% in these three countries. I don’t see that significant a divergence among these funds in terms of general country and sector allocations.

Of course, many investors will want to make their own decision on how to split the developed and developing world within their portfolio. SSGA has recently launched a broad emerging market ETF (GMM) as well as five regional emerging market ETFs but with all of them at a 60bps MER, they like EEM (75bps) are relatively expensive compared to Vanguard’s VWO at 30bps. I think it’s worthwhile to explore the SSGA site to dig into their new emerging market ETFs as it allows investors to implement asset mix decisions within the emerging markets space and I’ve discussed this area a few months back here. SSGA’s emerging market ETFs weren’t available until the middle of March 2007 so they weren’t a part of that February posting but as you can see from this chart, the four broad emerging market ETFs track closely with a few times when the month-to-month return difference is rather significant.

I should also note that Vanguard has a competitor to SSGA’s GWL and CWI in their Vanguard FTSE All-World ex-US ETF (VEU). According to Vanguard’s website, VEU holds about 1,500 stocks (overkill?) yet is quite similar in terms of asset mix to the international funds from SSGA. Again, I find the same top three country exposures for its underlying index as the UK (17.3%), Japan (15.7%) and France (8.6%). But SSGA’s funds are at 35bps and VEU is at 25bps. In general, it looks like Vanguard is the cheapest with the broadest international exposure. Was there ever any doubt?

VEU began trading earlier this year so this chart goes back as early as will allow analysis of it versus the other broad international ETFs I’ve mentioned above (Note: SSGA’s GWL was not available until April 20, 2007 so I’ve excluded it here just so that it won’t be a one month chart).

A tighter group but again some spread in time. I don’t want to comment too positively on the good performance of Vanguard in both charts above, but if international exposure is a long-term hold for you, then the effects of fees and the benefits of diversification should allow consideration for Vanguard’s VEU and VWO as core holdings.

Many may disagree, but on top of these two core holdings, I would overlay some active tilting using a VGK/VPL combination for the developed world as well as SSGA’s new emerging market ETFs for the developing world.

Although based in Toronto, I focus so much of this blog’s content on the US marketplace simply due to the massive amount of industry development in the area of ETFs and derivatives. Of course, there is also news in this space that comes out of Canada, Europe and other regions of the world, but for some reason, I don’t seem to get the same amount of information flow.

In recent months I have spoken at ETF related conferences in the US but since beta (and alpha) are global beasts, I’m trying to gain some added exposure outside of the US. So, in a bit of self promotion, I’d like to comment here on two events I’ll be speaking at here in Toronto.

The first is the Canada Cup of Investment Management scheduled fo June 12-13. Here’s the link to the event’s website. But before I comment on the conference, I thought it might be interesting to give some insight to the history (albeit short) of this conference as I attended the first one in 2002. That conference was called “The Canada Cup of Indexing and Related Products”. If you follow this link, you’ll see that five years ago the world, or at least Canada, had a sophisticated view of the beta world. Of course, if you read the names of the speakers, you’ll note that this was a primarily institutional event although there were many sessions for the retail adviser/investor audience. For retail advisers/investors interested in the ETF/indexing space, I highly recommend that they try to attend these types of “institutionally oriented” events to keep up with what is happening at the leading edge.

In time this event has morphed into the Canada Cup of Investment Management. When this name change occurred in 2004, the byline was “where active and passive management meet”. So it wasn’t a complete departure from beta and this agenda from the 2004 event still shows the focus on indexing and ETFs and related products. In other words, I’d say that it was at around that time in 2004 when indexing became rather mainstream. It makes sense. It was at about that time when BGI and SSGA began to see the beginning of a new wave of competition in the ETF industry. It’s only been in the past year and a half when things have begun to grow rather exponentially.

Coming back to 2007, we have the following agenda for the coming event. I provide the links to the agendas for these events to give you the following insight:

• the list of sessions gives you an idea of what are the hot topics of that time.
• you get a general direction of the trend in the industry and the perception of beta and alpha as drivers of portfolio performance.
• people - who are the experts of what
• new asset classes and strategic thinking

You’ll note that I moderate a discussion on, what else, ETFs (Tuesday, June 12, Track B, 1:45pm) and speak again later that afternoon (3:00pm) on how financial advisers can think about building model portfolios based on what institutions are doing. Both are pretty broad topics and I’m excited about the speakers who I will be working with.

The second event I am involved with is the Hedge Funds World Canada conference (October 9-11, 2007). This event is quite a few months away so the agenda is incomplete in terms of the speaker listings however it does give an idea on the broad topics to be covered. Many may believe that the hedge fund industry in Canada is limited to stock pickers going long and short while focusing on a small group of industry sectors such as oil & gas, gold and uranium. Although there are many who specialize in the commodities complex, this conference agenda shows that the talent pool in Canada is quite broad although perhaps likely not as robust as in the US and Europe … it’s just a matter of time I believe.

I think it’s interesting that the Canada Cup of Investment Management is an event that has a significant level of content related to beta (indexing, derivatives, ETFs, etc.) based on its history, whereas Hedge Funds World Canada focuses more on issues related to alpha as opposed to beta, and rightly so. Everyone has been talking about the separation of beta and alpha over the past several years but it has been common to see philosophies and methodologies pop up recombining the two. Portable alpha is the most common term thrown around.

Perhaps it may be in the group of sessions on the first afternoon of the Hedge Funds World Canada event where this type of discussion will bring some new thinking in this area. The last three sessions of day one of this event fall under the broad heading “Alpha Beta Portfolio Construction”. Note that I’ll be leading the discussion for the first panel discussion on how beta relates to alpha. Here is what’s shown on the latest version of the online agenda for the afternoon section:

ALPHA BETA PORTFOLIO CONSTRUCTION

Panel session: How does beta relate to alpha?

· Beta sources – identifying the sources and choosing benchmarks

· The availability of exotic beta

· Getting comfortable with derivatives – financing costs, leverage and liability

· Rebalancing

· Liquidity

Panel session: Identifying alpha

· How to identify alpha in a hedge fund

· What is true alpha vs alternative beta?

· Hedge fund replication

· The combination of alpha & beta; implementing a 130/30 strategy

New opportunities from new strategies: Hedge fund replication and alternative beta

· Alpha and beta: an ever more blurry line

· What aspects of hedge fund should actually be replicated?

· A review of four different replication approaches

· The prospects of hedge fund clones

Not one mention of portable alpha. That would not have been the case over the past few years. Instead, 130/30 funds and hedge fund beta (commonly termed as alternative beta) are front and center. I have commented on the growing field of hedge fund replication strategies in the past with these postings:

· The Latest In ETFs Makes Me Think: “Are We There Yet?”

· Index Providers: Commoditizing Alpha To Portable Beta

· Merrill Lynch Releases New Hedge Fund Replication Index

· Hedge Fund Replication Strategies: What’s Under The Hood?

· Harry Kat And The Art Of Replicating Hedge Fund Performance

As a practitioner involved in the inclusion of alternative investments and hedge fund programs within a broader portfolio, and more generally also as an asset allocator, I find the evolution of ideas within this area to be both exciting and yet leading to many broad philsophical questions. Where will this lead in terms of the way the largest of defined benefit pension plans think about beta and alpha? Will they think of the asset mix problem differently in the future? I can list other broad questions but the devil is in the details and although many large institutions have already implemented 130/30 type programs, I wonder how hedge fund replication strategies will fit into the mix. For those interested in digging deeper in this area, a further source of information is All About Alpha, a blog I’ve mentioned before also based in Toronto. By the way, Alpha Male, the blogger at AAA will be leading the discussion during for the 2nd panel right after mine.

Update! Last month I commented on some developments here in Canada that saw a closed end fund converted into an ETF. I asked if that was the beginning of a trend.

Maybe not a massive trend, but I now see that First Trust is doing the same with one of their closed end funds. It’s the First Trust Value Line® 100 Fund (FVL) and here’s the press release discussing the conversion. First Trust must really be commended for providing A LOT of information on their funds online.

Unlike the Claymore conversion in Canada that has a truly active manager with a classic active management mandate, the First Trust closed end fund seems to fit the model of other rules-based “quasi-active” ETFs such as their own new AlphaDex funds as well as the IntelliDex and fundamental weighted (FTSE-RAFI) funds both from PowerShares.

The question is if and when we’ll see more traditional closed end funds converting into exchange traded funds? Furthermore, if by doing so, would we hopefully see a minimal spread (premium/discount) between the funds’ market price and the underlying net asset value.  I’m sure that many investors who have exposures to the various country specific funds and thematic funds (infrastructure, for example) on the NYSE would be interested to see a structure, if possible, that would reduce, if not eliminate, this problem with closed end funds.

I’m fairly sure that a part three in this series will follow quite soon.

It can be viewed quite simply. Derivatives are used by many as a hedging vehicle. A crop producer as well as the buyer on the other side. Bank and interest rates. Portfolio manager and a stock index. Gold miner. I can go on for a while. But of course, there’s always someone on the other side willing to take that bet.

This blog has focused, in my opinion, too much on the ETF industry. The derivatives industry has a similar story of excess, abuse and a picture that is not all rosy despite many participants in the capital markets focusing solely on the positives and rightly so. Don’t get me wrong … I’m pro beta (it is The Beta Brief, right) and that means pro-ETFs and pro-derivatives. However, that’s not pro in the absolute.  Because a very small number in this space manage to cause considerable confusion and/or distress, that’s the real shame.

This is an interesting posting on HedgeCo.net called Derivatives, Mutual Funds and Pensions.  The author, Susan Mangiero, starts with this eye popping opening sentence:

Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That’s a lot of zeros - $400,000,000,000,000.

I’m not sure if that would be a value approximating the global total of all derivative contracts if we were to take a mark-to-market measure at some point (24 hour markets so there is no close), open interest or some other measure. But $400 trillion is pretty much the biggest number I think I’ve ever seen in this industry. The US public debt figure is the only number I can think of that gets into trillion dollar territory. If the derivative markets increase by another $100 trillion, we can say that it’s at roughly half a quadrillion. I kid you not.

Mangiero refers to a recent article by Eleanor Laise of the Wall Street Journal and here’s a short intro to the piece:

Funds’ use of derivatives — which Warren Buffett once called “financial weapons of mass destruction” — is growing as the instruments become easier to trade and as mutual funds aim to stand out in a crowded field. More automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds. And with more than 8,000 mutual funds on the market, many managers believe it’s not enough to match a market index. They want to beat the market — and derivatives often help.

So mutual funds use derivatives. Is that surprising? Mutual funds might be dinosaurs, especially compared to ETFs and hedge funds, but that shouldn’t stop mutual fund managers from doing their best to manage risks. For funds with significant international exposures, shouldn’t they use forward contracts to deal with foreign exchange risk? I would hope so. Again, I can think up many situations where derivative contracts would be applicable for fairly simple mutual fund mandates.

But according to Laise and highlighted by Mangiero is the fact that “automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds” and that “mutual funds aim to stand out in a crowded field.”

The list of questions Mangiero provides in her posting makes sense and I believe she has the good intention of having investors focus on risk management when determining if their mutual fund holdings are prudent for their situation considering the possible use (and potential abuse) of derivatives. However, I think that in general, mutual funds don’t get involved in derivative markets for anything other than the most basic of hedging strategies such as the FX hedge mentioned earlier. They just don’t have the incentive (compensation wise) to be opportunistic with derivatives in the same manner as hedge funds. This doesn’t mean that the type of investigative due diligence suggested by Mangiero is unnecessary … I think it is necessary, especially if there is evidence that the manager makes tactical/opportunistic decisions using derivatives or the wording on the offering documents is unclear (sometime purposefully to allow for maximum leeway). I just think that for most ordinary investors, this concern regarding the mutual funds they hold may not apply.

For pension funds, it’s a bit different because the external managers they use are expected to come with an added level of sophistication. It’s in the institutional realm that Mangiero makes this point clear with this lead up to the list of questions:

“… a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager.”

So derivatives can be used for hedging, defensive posturing and prudent risk management. Of course, because of the requirement for someone to be on the other end of the contract, there must be a speculator. It’s this end that I believe worries many including securities regulators and other capital market watchdogs. And this brings us back to hedge funds. LTCM, Barings/Leeson, Amaranth … they’re all about derivatives and a lack of risk management in their application. Issues of leverage and the bravado that led to such massive bets should be thrown in there as well as they are surely key. I know Barings wasn’t a hedge fund but so wasn’t Enron … or were they? I’ve mentioned in the past of the convergence between various alternative investment strategies and asset classes such as hedge funds, private equity, real estate, infrastructure and commodities. What also has to be considered are more traditional situations like a bank or energy company whose operations, if fully explored could resemble more of what a hedge fund looks like than what you may believe.

If true, then regulation/oversight on hedge funds (only) in regard to derivatives use would be unfair. The issue of risk management over the derivatives industry isn’t an easy one. It’s been discussed for so long and I’m wondering if “the powers that be” are waiting to see what happens during and after the next LTCM situation gone fully nuclear. A scary thought.

The first line of defense is always at home.  Knowing the ingredients and recipe of what’s being cooked (or more importantly, what you’re eating) is in your best interest.

Just a quick comment on the new global water ETF from Claymore that should provide some competition for PowerShares. I commented on this topic back in December with a post on a new global water index but instead of that leading to a follow up offering for PowerShares (the index in that case was developed by Palisades Indexes who was behind the work on PHO), we have Claymore working with S&P on this competing fund (ticker symbol CGW traded on the AMEX).

More news on today’s launch here and here.

For specific news related to water specific equities, take a look here.

But more on this new offering from Claymore:

It’s an incredibly sad fact that globally there are more than one billion people who simply do not have access to safe water. Shocking numbers but when you consider that roughly double that number lacks adequate sanitation, you begin to understand the rationale and necessity for infrastructure investments. It’s not just about uncorrelated returns but providing the basics of life to the world. If it is indeed true that about three million people die annually simply because of inadequate access to safe water supplies, then this type of infrastructure is not a “nice to have” but a certain “must have”.

From a business sense, it’s self evident that as developing countries become wealthier they will first look to bring these “must have” necessities to their populations which makes water the world’s most significant untapped commodity. Where there is demand, global companies will capitalize. Today, companies have the capability to derive new sources of water and deliver it to those places that will pay for it. The size of this market must simply be enormous, especially when considering that despite the earth’s surface being 75% water, only about 3% of the world’s supply is drinkable, let alone available for modern irrigation.

Although this isn’t the first water ETF, one of the major points of differentiation between this new ETF and that from PowerShares is its global exposure. For the Claymore offering, its underlying index, the S&P Global Water Index ETF, has the following properties as cited from the BusinessWire press release linked above:

The index is comprised of 50 equity securities selected from a universe of companies listed on global developed market exchanges and based on the relative importance of the global water industry within those companies’ business models. The index is designed to have a balanced representation from different segments of the water industry consisting of the following two clusters: 25 Water Utilities and Infrastructure companies (water supply, water utilities, waste water treatment, water, sewer and pipeline construction, water purification, water well drilling and water testing) and 25 Water Equipment and Materials companies (water treatment chemicals, water treatment appliances, pumps and pumping equipment, fluid power pumps and motors, plumbing equipment, totalizing fluid meters and counting devices) based upon Standard & Poor’s Capital IQ (”CIQ”) industry classification.

Companies included in the Index have market capitalizations ranging from US$250 million to US$25 billion and the Fund will normally invest at least 90% of its total assets in common stocks and ADRs that comprise the Index. The Index is rebalanced annually.

Recent product offerings which could loosely be defined as thematic sector funds (infrastructure, real estate and now water) have been globally oriented ETFs and it just makes sense – for the broad spectrum of investors, why focus these themes on just the US market? If it’s all about diversification, then that should be geographically as well as based on sector/themes. Furthermore, regarding the global exposures:

• CGW’s regional breakdown: 28% US, 20% France, 16% Japan, 14% Britain (PowerShares is 84% US). However, it’s important to note that many of the positions in the PowerShares offering, although primarily but not exclusively consisting of US domiciled securities, have significant operations (and revenues) generated internationally.
• CGW invests in sixteen countries (versus six for PowerShares).
• CGW is the first Global Water Index ETF to invest in foreign ordinaries (PowerShares and provides some of their international exposures through ADRs).

My comments here have been limited to comparisons with PHO. However, Roger Nusbaum has recently discussed another ETF offering from First Trust that is to provide water exposure. From his posting here as well as from other sources, my understanding is that this ETF (not available yet) is quite similar to PHO in that it more domestically focused. The chart Roger has provided on that posting , comparing PHO and the underlying index for the First Trust offering, seems to confirm this. If, for whatever reason, you want to focus more on domestic markets, than the PowerShares or First Trust offerings may be better suited for you.

And having held PHO since its inception would have not been a bad call as here’s its chart since inception versus the S&P 500:

Looks a bit like a high beta stock compared to the S&P 500. But after having glanced at the portfolio holdings of PHO, I decided to try this graph again but against the Nasdaq:

No suprise, they track quite well. Looks like PHO is more of a bet than a diversifier, especially for investors heavily weighted in US equities. I look at thematic sector plays as diversifiers. And I would look to the global water ETF to provide better diversification properties than PHO (not difficult based on these charts).

Another important factor when looking at this new Claymore offering is its strict focus (pure play) on water. On the PowerShares website, for example, you’ll see the list of holdings for PHO here. I’m not entirely sure how health care fits into water exposure but a more important point is that conglomerates like General Electric can not be considered a pure play on water. Frankly, GE should already be well exposed in core equity holdings. It’s a minor point, my focus on GE which is less than 2% of PHO, but the point is valid … when you want a water ETF, you want a water ETF.

This is the same point with the recent global infrastructure ETF from SSGA. It’s as much a utility ETF as it is an infrastructure ETF. With all the slicing and dicing of the capital markets based on sectors, it gets a bit “dicey” with these thematic offerings. Understanding the list of ingredients as well as the recipe helps in can often be helpful in avoiding an upset stomach.

News today from the Associated Press about an early start to this year’s storm season. It’s a subtropical storm, not even a tropical storm never mind a hurricane, but with all the craziness in weather patterns in recent years, you can never be too cautious or prepared. On the investing side, this gives us (investors keen enough to read this blog!) some lead time before the official start of hurricane season which is June 1st.

First, some background reading on weather derivatives:

This article from Canadian Investment Review is from back in 2002 so you can see that weather derivatives are really not that new as an asset class. The article was written by Jason Wei, a professor of finance at the University of Toronto. This is a powerpoint presentation from Wei and Melanie Cao of York University. It’s even older but gives some deeper understanding of how the weather derivatives markets evolved to that time, the types of instruments available and the basic strategies for use.

One of the big problems cited from that time was the lack of investor interest and the resulting issue of liquidity. With hedge funds actively participating in the weather derivative markets especially over the past few years (along with re-insurance/catastrophe bonds due to the spike in extreme hurricane activity), this is not as big an issue. The purpose of these documents is simply to give an idea of where this quite esoteric area of investing came from. I mean, if you tell your friends that your recently established investment is dependent on the heat in Baltimore, you won’t get that funny look?

Now, let’s focus on where we are today. Here’s the link to the Chicago Mercantile Exchange’s weather derivatives website. In the opening paragraph near the top, I found the last sentence quite interesting:

This sector of hedging and risk management products represents today’s fastest growing derivative market.

Fastest growing derivative market. Well, I suppose the other broad areas of equities, interest rates, currencies, commodities and real estate have built well established markets in this space so weather derivatives, despite being around since 1999 (at least on the Merc), are still the new kids on the block. But perhaps it’s also the added focus from the press on the global warming issue and personalities like Al Gore that have moved environmental finance forward as part of a broader solution to what is clearly a massive problem.

Once you arrive here to this site, you’ll see a list of weather contracts, many of them related to temperature but some that I think are quite interesting like the ones for frost and snowfall. Here in Toronto, we’ve been experiencing summer-like weather for the past week and a half. We have no spring or fall here, just a long winter and about four months of summer. I exaggerate but unless you live up here, you just won’t get it. The idea of profiting over the cold months sounds appealing. The idea of profiting from times of heavy snowfall can somewhat compensate any northerner’s aching back after shoveling their driveway. A snowblower would make sense but I’ve just discussed the massive environmental problem, right?

But, of course the reality is that there are many industries who rely on these derivative instruments for serious hedging needs. Think of a utility whose electricity usage spikes up during a heat wave. And, of course, there are the hedge funds on the other side willing to take their bet. Again, one of the popular areas in this field is in hurricane futures which is one of the instruments listed on the CME website. According to this section of the website:

The CME Weather Product group has added CME Hurricane futures and options on five U.S. defined areas - Gulf Coast, Florida, the Southern Atlantic Coast, the Northern Atlantic Coast and the Eastern U.S. The underlying indexes will be calculated by Carvill, a leading independent reinsurance intermediary in specialty reinsurance that tracks and calculates hurricane activity. These contracts will begin trading March 12, 2007 for the 2007 hurricane season that begins June 1.

You would think that this type of recent product development would be getting a lot of press, but I just don’t see it. Good for me and my little blog but if this was an ETF? Sheeesh! There’d be coverage left-right-and-center. Probably most of it would talk about how the industry was yet again finding another thin slice of the market to exploit with an ETF product offering.

But hey, weather is an attractively uncorrelated asset class and I’ve discussed at length and in too many occasions about the fact that this investing world is troubled by highly correlated asset classes leading to synchronized, and due to the multiple compounded herd mentality, sharp down markets.

There’s a lot on the CME website and from the previously cited CME Weather Products main page, the tabs for Education and Resources should provide more than enough background before you begin to implement. Just don’t think that you’re ahead of the curve by exploring of actually entering into this market. Take a look at this chart showing, no surprise, another market with recent explosive growth:

This global liquidity thing … it’s really something. If there’s a market for something out there that isn’t getting a ton of attention and money, it’s a rarity. Domestic automobiles and not much else, I think. This chart cites its source but I found it from this good article from Financial Engineering News. The article is interesting as it gives a nice story as to who is interested in these instruments and why.

For me, someone interested in the asset allocation problem, I’m interested in understanding how plugging something like a weather derivative will affect the overall performance of a globally diversified asset allocation program. As someone also interested in underlying beta risks in multi-strategy and fund-of-hedge fund mandates, I’m keen on knowing if these instruments are useful ingredients in a recipe to provide the appropriate short overlay to offset unwanted long market exposures.

Many different reasons to consider these new products. For many who are simply fascinated by the strength of recent hurricane seasons, perhaps a visit to the National Hurricane Center website might provide evidence to entice them into the new hurricane futures market. To each their own, but I can’t stress enough the need for uncorrelated investments and this area is one of the few that requires investor attention.

With recent news of uranium futures contracts available through NYMEX beginning yesterday (May 7th), I was looking for a price chart for the spot price just to get my bearings on its rise which has been well publicized. It really is funny … go to Google, above the text box, choose “Images” and enter “Uranium price” for your search. You’ll get a LOT of uranium price charts all going from the bottom left to the top right. No surprise. But you’ll open one chart, say this one and you’ll think that the price is somewhere around 85.

The heading says that the data is up to February 2007, so your first guess is that this is a fairly up-to-date chart to start with. But then, through the same list of findings from your Google search, you also will find this chart:

Basically, this second chart only covers the rightmost section (roughly 1/5th) of the first graph. More importantly, this chart adds another couple of months which end up being significant as the uranium spot price has spiked even higher from around $85 to $113. That’s a 33% return in two months. That’s amazing but having this occur after a doubling of its price every calendar year for the past several years is actually quite scary. Kudos to anyone who jumped on uranium early (pre-2004) but a bigger and surely envious “congrats” to anyone who’s held on up till now.

From early April to early May, the price has remained quite flat around $113 and the second chart above (as with most short-term charts of uranium) shows that there are several instances where uranium prices will remain quite level for a period of weeks, if not months.

My point is that uranium has been rising (and rising and rising) over the past several years and to even have a 2-month old chart (geez, even a 2-week old chart in many instances) is playing with stale data.

Of all the news and commentary on this new futures contract, I found this article to be most insightful. It covers a lot of ground in a short read but similar to many of my posts, it goes into potential problems with this new derivative … just some things to think about before you dive in.

Also of note, NYMEX has teamed up with UX Consulting (provider of the 2nd chart above) on this derivative instrument and UX’s website is a great source of information for uranium in general as well as latest price charts … so you won’t have to go Googling for the latest chart.

With the way the ETF industry is moving, you’ve got to imagine that there are a lot of eyes on the launch of the uranium futures. The UPI article above discusses the issue of holding the underlying commodity. There are more than a few hurdles to deal with for an ETF launch for direct exposure to uranium prices. I’ve mentioned this in a few posts in the past but up here in Canada, the Toronto Stock Exchange lists Uranium Participation Corp (U) which might be the easiest way to gain exposure.

I titled this posting “Uranium Mania” simply because of the incredible parabolic curve of the price chart. The move to derivatives can, and likely will, help provide greater access to this market as would an ETF. I’m guessing that quite a few ETF manufacturers (and it’s not at all difficult to guess who they are) are watching developments with the new futures contracts and already have their business development people sniffing around to get a sense of demand for an ETF. News of an ETF would definitely bring us closer to a mania and it’s not difficult to forecast the final stages of the climb if this were to happen.

I’m thinking of an instrument (or instruments) that allow for upside and downside exposure to uranium prices that would best be accepted by the marketplace. Again, if you’ve been following this industry, a very short list of ETF developers come to mind.

But until then, for uranium plays it’s either:

1. Stock selection with big producers like Cameco and a small number of relatively large competitors but a large number of very small producers.

2. Uranium Participation Corp (and the added FX risk for non-Canadians)

3. Uranium futures with more information here

Good luck out there. Don’t get burned (sorry … bad one).

Recent market action in the US has made me think of what was going on about one year ago. Here’s the 2-year chart of the S&P 500:

A lot of market participants were prepared for what happened in May and June of last year. We weren’t the only ones with put options in play at that time. The run up from October plus a string of key indicators seemed to make a clear case for protection. In highsight, this graph above seems to make the drop in the first quarter of this year something even more foreseeable. Take a look at that (basically) straight line up from mid July to late February. If only life were that certain … well, an uneventful life isn’t great either. Whether it was the Chinese market’s sell off or any of a few dozen other reasons, that was a market that needed to let off some steam.

I have commented on VIX many times in the past. On the left margin of this page you can click on the “VIX/Volatility” link at the bottom of the categories list to find other postings that also refer to VIX. Here’s the 2-year chart of the S&P 500 with VIX overlaid:

And VIX in isolation, again for the past 2 years:

We’re not back to the historical lows of 10 but don’t let this graph fool you. 14 is not the historical average. Here’s the longer term chart from Yahoo Finance:

In this seventeen and a half year chart, 20 looks more like the longer term average. Note that when the markets fell (and fell hard) in late February, VIX spiked up to just under 20. It’s an understatement to say that we’re in a low vol environment.

Total speculation here but a pattern nonetheless: Note how VIX seems to have a longer term trend bringing it from the plus-20 range to the 10-15 range, like it did from 1990 to 1995. Likewise on the upside, VIX took a few years to go from the 10-15 range (1995) back up above the plus-20 range (1997-98). The downside trend from early 2003 to 2005 is another example. There’s no denying that there is significant “volatility of volatility” like we’ve seen from 1998-2002 and from early 2005 to now. These would seem to look like periods of a “sideways” trends on this longer term chart. The question now is if an upward movement of VIX would again happen in a 2-3 year period taking it from the 10-15 range back up to range in the plus-20s. My guess is it’s just a matter of time before VIX makes that climb up and I think it will be sooner rather than later. This is actually an area where I have been reading up on and if you search online, there are a surprising number of market participants and academics who discuss the longer-term views/forecasts of VIX.

Now, the 2nd chart above shows that in the shorter term, spikes in VIX coincide with sharp drops in the broader US market. However, the longer term chart above does not have the same pattern. Here’s the same long-term chart with the S&P 500 overlaid:

Note that I had to switch from a log-based vertical axis to a linear based axis to make the chart more easy to read. The key here is that in the shorter term, VIX and the S&P 500 can (but will not always) move in opposite directions. They move in opposite directions in times of extreme market movement. However, in the longer term, for example during the bull market of the late 1990’s, we can see that VIX and the S&P 500 can move in tandem. It’s all about the implicit volatility as measured based on prices of S&P option contracts but I won’t go into the math of Black-Scholes.

The follow up question then is how do you feel about this chart? S&P 500 (and just about every indicator for just about every asset class) is near or at historical highs. VIX is close to historical lows. The rubber band is being pulled tighter and reversion to the mean is providing some significant pull.

Let me be blunt: The S&P 500 is now somewhere above 1500 where it hasn’t been since September 2000. I see it’s closed today just under 1510 so it’s roughly 18 points short of its record close of 1527.50 back in March 2000. So another 1% rise ought to do it. Being up roughly 6.5% year-to-date, another 1% seems easy.

In addition, I’ve seen A LOT of commentary on this online but I’ll add it here anyway: The S&P 500 has gone up in 23 of the past 26 trading days — the longest such streak since 1944. Well, if you add today, it’s now 24 of 27 days. A hockey team with 24 wins in the past 27 games would be considered “on fire”. A boxer with a 24-3 record would likely be the title holder. But this ain’t no sport. 24 ups in the past 27 days should bring a cautionary “spidey sense” to investors.

[UPDATE/CORRECTION: According to this article from CNNMoney.com, the run of 24 ups in the past 27 days for the Dow 30 ties a record from 1927. I think this stat will be repeated SO many times in the next few days … and imagine if Tuesday is another up day!

Just a string of facts. A possible time for tactical measures? A boy scout would call it preparedness. I think that options should already be in play … if you’ve been invested in the S&P 500, then you have about a 6.3% return since the end of March. Some of that return could finance some put options for even a partial hedge.

So, next question (I think we’re up to number 3 now) is whether now is a good time, especially with volatility near historical lows, to buy some portfolio insurance?

The follow up to that is whether you want to go even further and set triggers for shorting futures or purchasing inverse ETFs. I’m still thinking tactically here. You have to do the same with your own philosophy of asset allocation. Are you more long-term oriented, thus focused on strategic asset allocation, or do you have a shorter-term perspective? If the latter, then you’re already thinking about tactical measures, if not implemented already.

Why not a few more charts? Everything below is charts for ProShares’ inverse ETFs showing performance since their respective inception date. Here’s the inverse and double-inverse for the QQQ:

Here’s the inverse and double-inverse for the Dow 30:

Here’s the inverse and double-inverse for the S&P 500:

Here’s the inverse and double-inverse for the S&P Mid Cap 400:

Here’s the inverse and double-inverse for the S&P Small Cap 600:

Here’s the inverse and double-inverse for the Russell 2000:

We can see from the first four charts that it’s been tough to go against the market. The small cap market, through either the S&P 600 or the Russell 2000 have only been available in an inverse ETF for a short time and there seems to have been little interest in them as shown by the trading volumes for the bottom two charts. My feeling is that all of these inverse ETFs, including the small cap exposures will begin to see increased trading volumes in the coming weeks. There is already a significant level of short interest according to communications from the sell side and we know that fund flows are coming out of equity funds and into bond funds. So, perhaps like about one year ago, investors are preparing for the storm.

This posting is not a recommendation for any of these inverse ETFs. For those of you looking to protect/hedge existing positions, only you know what you hold whether it be mega caps (you’re likely looking at DOG or DXD) or a tech heavy portfolio (consider PSQ/QID). Also note that ProShares also has short exposures to value and growth tilted indices as well eleven sectors. For these cases, all are for domestic indices and all have 200% short exposure. For those of you looking for something in the ETF space beyond these such as international exposures, you’ll have to consider shorting ETFs. I am absolute amazed at how long it’s taking other ETF participants (Rydex) to get into the inverse ETF space. I see a parallel here to the GLD/IAU situation in gold ETFs. If Rydex doesn’t get in here soon, they’ll “pull an IAU”.

Final note: If we’re basically talking about market timing here and all of the above seems pointless, you can simply take some profits and thereby build a cash position to buffer downside volatility!

In the vast majority of my posts, I comment on some sort of industry event whether market related or product related. At times, I might throw around some industry jargon without much thought as to who’s reading this on the other side of the wire. I have always assumed that anyone interested to peek into “The Beta Brief” knows what beta is all about. On more than one occasion, I have commented on the difference from what I believe to be “philosophical alpha” versus “statistical alpha”. There is no such dichotomy in beta. It’s just the market. Well, even that is being rethought and I’ll get to that at the end. But to simply define beta as “the market” may be considered as being too vague so I’ll try to take small steps in providing greater clarity on the field of portfolio theory and, more specifically, beta.

Warning: Once you start digging deeper into the following readings, you’ll quickly see that a basic understanding of algebra and statistics is required. If you’ve taken any sort of college level stats, you’re fine. One of the main things you’ll have to understand is regression analysis. Basically, by plotting one set of sample data (say, returns for a stock in a particular month) with another set (say, returns for an index in each corresponding month), you can plot the corresponding points on a Cartesian plane, the x versus y graphs that you likely spent a lot of time playing around with in high school. If there is any sort of pattern between the two groups (not necessarily proving causality) then this will be provided mathematically with a “best fit” straight line. From, high school algebra, we know that the formula for a straight line on the x-y graph is:

y = mx + b [Equation 1]

You may have also learned a variation of this which is:

y - y1 = m * (x - x1) [Equation 2]

which can be manipulated to solve for m as:

m = (y - y1) / (x - x1) [Equation 3]

In equations 2 and 3, the “number ones” should be subscript but I hope you get the point. The x1 and y1 are the x and y coordinates for a specific and unique sample used in the regression analysis. I recall first learning of slope (m) as rise over run, or in algebraic terms “delta y over delta x” which is mathematically shown in equation 3.

This is the most basic of introductions. The key is that it’s equation 1 that we’re trying to find based on a sample set of data. For our purposes, it will usually be returns data for a securities and index. But all you really have to know is that m (the slope) is your beta value using regression analysis. The intercept of the best fit line to the vertical (y) axis is your alpha value and is represented by the letter “b” in equation 1. The calculations involved in regression analysis are important to understand but thankfully, in today’s world, anyone with a spreadsheet program can calculate beta and alpha on their own. For example, MS Excel has a built in “Data Analysis” program and within it is a regression analysis program.

Now the theory. And it goes way (WAY!) beyond the above. Here’s a small list of free online sources of information related to portfolio theory and, where possible, specific discussions related to beta. If you know of more, please send them in as part of a comment to this posting. Thanks.

For the most novice investor who has never read anything on portfolio theory, these might be a good place to start as they’re rather short so they’re easy to digest in one short sitting:

These are all taken from the same source, RiskGlossary.com, which covers many terms in portfolio theory, but I have arranged these in order that I believe provides a logical sequence of order:

1. Portfolio Theory

2. Capital Asset Pricing Model (CAPM)

3. The Market Portfolio

From #2 above (on CAPM), it introduces the term “Systematic Risk” as:

Systematic risk is the risk of holding the market portfolio.

#3 above briefly discusses the term “Market Portfolio”. This then leads to …

4. Beta

According to this, beta “measures the systematic risk of a single instrument or an entire portfolio”.

The above material is written in as concise a manner as I believe is possible. For a more expansive and thorough explanation, consider this lecture which covers a large area of portfolio theory including a discussion on beta.

This lecture is part of an eight part introductory investment theory course at Yale’s School of Management. The entire set of course notes are available online here. You can thank me for forwarding this to you, but an infinitely bigger thank you needs to be offered to Professor William Goetzmann and the Yale School of Management for having this all available for free to the public online.

I was also able to find this useful treasure trove from the MIT website. For those so inclined to dig deep into various fields of academia, you can literally get lost in time with MIT’s OpenCourseWare website. Pertaining to this blog, you will find this set of lecture notes for a class simply called “Investments” worth reviewing.

Class #6 covers CAPM and discusses beta. For those so inclined (and with at least some college level math), it’s not a bad idea to go through lectures one through seven for a thorough review of portfolio theory. For those who are not so confident in their mathematical abilities, I’d focus on the notes from Yale carefully and do your best following up with those from MIT.

At the beginning of this post, I mentioned that “beta is the market”. The problem is that the traditional form of beta, based on CAPM, is being distorted by new developments in the indexing world. Such recent developments have brought forth terms such as exotic beta and alternative beta. I don’t want to dig too deep into this but I believe these terms still need time to get a general level of acceptance in terms of standardization. Not all individuals in the industry agree on their definitions. I have always seen exotic beta as the beta for any asset class that is considered to be beyond that of the stock or bond markets so this would include real estate beta and commodity beta. Alternative beta is any form of duplicable return process and truly straddles the line between pure beta and pure alpha. For example, are the new fundamental weighted indices used in WisdomTree and PowerShares’ ETFs truly beta or some alternative beta? Similarly, many hedge funds, in this case I am specifically questioning those that are mandated to a beta-neutral objective, have returns which are not entirey driven by alpha but also by traditional beta (CAPM) as well as alternative beta. I know, this new world of “funky” beta can be confusing so I will only now refer you to two other bloggers who have already ventured into explaining these areas … very well I believe. I will likely revisit this discussion as it’s an important one not only for The Beta Brief but for the ETF and hedge fund industries on an ongoing basis.

Here is one hedge fund participant and blogger’s attempt to define and analyze these betas.

This blog also gets into exotic beta.

Happy reading!