A down market would do this.  That is, bring out a debate on the benefits of hedge fund-like investing.  With indexing and ETFs, one would think it’s all about gaining exposure to markets (hopefully on the upside) and reducing or eliminating exposure when required as a defensive measure.  You can call that effectively tweaking the asset mix or full out market timing.

However, today’s ETF industry is one that has evolved.  With inverse ETFs, any investor can now literally “build their own hedge fund”.  Shorting and the use of options requires a margin account which is not a big deal but now as long as one can open a trading account of the most basic kind, there’s not much to it to gain short exposure.
So this brings me to an email I received today care of Google Alerts which is a pretty amazing service.  You can basically tell Google to email you when anything new appears on the web related to a specific search.  Of course, for this blog something like “ETF” and “exchange traded fund” would do it.  The bad side to the service is you can easily have a big pile of emails in your inbox.

Anyway, here’s what I received today:

So on one side we have Bill Schmick and the other is John Bogle, the latter care of Tom Lydon at ETF Trends.  With Schmick and Bogle, it seems more appropriate to consider this debate as David and Goliath.  Although I understand Bogle’s comments regarding the newly filed Direxion ETFs with 300% market exposure, let’s be real … their appeal will be limited.  There will be no domino effect with new or existing ETF providers following up with leverage of 400% or higher.  If by chance they do, shame!  I’m certain market forces will simply laugh such products off the street.  Let me be clear:  Investors of all types will generally pass on Direxion or anyone else who goes down the path of even higher leverage than what we seen in the ETF marketplace today.

Is there demand for extreme leverage?  Of course.  Hedge funds play this game all the time.  Part of the basic reasoning is simply to juice the returns of strategies that don’t have the same bang they once did (crowded markets).  But these market participants use the derivative markets where they can better fine tune their required exposures, not simply some multiple of 100.  And of course, we know the difference between the returns provided from futures markets compared to the “daily return” limitation of levered/inverse ETFs.  Truly sophisticated investors will understand when to use levered/inverse ETFs and when to go to the futures market, swap market or other market for their required exposure needs.  So Bogle’s worries about extreme levered ETFs, I believe are in themselves, extreme.

Schmick on the other hand seems quite reasonable in his comments.  Unlike Bogle who might find some degree of the sector ETF universe unnecessary, I would side with Schmick on the benefits of sector ETFs for defensive strategies.  It’s unclear what Bogle would deem as “reasonable” as opposed to “absurd” in sector ETFs but I’d guess that the lineup from HealthShares would be the example given for the latter.  Since assets in this family of ETFs is relatively small, the point is moot.  But whether it’s the exposures provided by HealthShares ETFs or other rather new and esoteric areas like nanotech or cleantech, there are many reasons why investors implement sector based exposures, defensive or otherwise.  I wouldn’t want to take that away from them.  Market forces will take away the undesirables as required.

To reiterate what I’ve said many times before: In today’s highly correlation markets, diversification is the first line of defense but can only get you so far in addition to shifting the asset mix to increased cash holdings when markets decline for a prolonged period.  Sector rotation is one of the few defensive strategies left to investors.  The use of put options as an insurance policy to be bought in extreme up markets is another good one.  The use of inverse ETFs to join in on the momentum on the downside thereafter is good as well.  It would seem that the most classic of index/ETF proponents would want to stick with the strict buy-hold, rigid asset allocation philosphy which is fine.  But not for everyone.

A tough stomach is required in times of distress.  I’d hope that in today’s market (not meant to mean short-term oriented “today”), investors do not make rash decisions and completely overhaul their game plan.  My cynical views on active management and hedge fund performance still lead me to believe that there’s something to be learned from Bogle and those in his camp including not just Vanguard but DFA.  However, I think that investors, either with or without financial counsel, should consider what degree of non buy-hold thinking applies to their portfolio.  How much deviation from the policy asset mix should be allowed?  What alternative asset classes and strategies should be considered if any, and at what price?

The risk, as I see it, is that much of the most classical portfolio theories and methods we read in textbooks are based on a time when we didn’t have all the information or the tools to properly handle the information.  Today it’s different.  Sure, we have the tools to compute with greater speed and power than the early days of Markowitz and Sharpe.  These tools can even fit in a thin letter size envelope.  But despite all the information out there, it’s tough to manage it effectively so as to lead to a more thoughtful, elegant and even effective portfolio.  Until ETFs came around.
Maybe the new “active management” of investing does not revolve around picking managers but allocating among beta exposures.  That’s what institutions like CalPERS are doing by internalizing passive mandates (by first reducing active exposures where there’s more beta than alpha to be had).  I’m not trying to lead this thought to the “All ETF portfolio” but something rather close to this, with a healthy balance of traditional and alternative exposures, access to developed and developing markets, customized for income requirements and volatility tolerances.  Clearly, this thought process would seem to be elegant and “true to form” as just described if implemented mainly through ETFs and similar instruments.  15-20 positions might seem like a lot but without passive exposures, a more traditional “old school” portfolio built under the same premises would likely hold a couple of hundred securities at a minimum.  I’m assuming that someone who wanted some inflation indexed bond exposure wouldn’t just buy one bond.  Same with emerging market equities.  Or US small cap.  Or REITs.  Or even non-ETF related possibilities like hedge fund … well, maybe if it was a fund-of-funds but for some investors, even one of these might not be enough.

In my previous blog post (whoa … two posts in one week … easy there), I focused my attention on diversification.  That’s definitely what ETFs are about despite all the recent product development on narrow sectors and relatively small countries.  But ETFs are first and foremost about innovation.  This is good because it gives anyone access to ideas (water as an asset class), new regions (frontier markets) and a wide variety of capital markets that may not be as easy (logistically, cost wise, etc.) for many investors to reach.  This is also bad because the risk is that the ETF industry focuses too much on ideas rather than the true economic need for capital to be allocated in that “idea”.  I don’t see the ETF industry going down this latter path similar to the dot-com craze however, as in everything, a healthy balance is all that’s required.  Somewhere between Schmick and Bogle - they likely aren’t even the extremes on the spectrum - is the right balance for each and every investor.  Dictating what’s right and what’s wrong, limiting choice by not allowing for certain products (ETFs, hedge funds or whatever) and thus not allowing investors to choose where they lie on that spectrum in NOT the answer.  ETFs provide choice by allowing access in a meaningful and efficient manner.  The allowance for choice will be dictated by the user as in any market.

A couple of weeks ago I was invited by the guys at “The Market Traders” to join in on their weekly roundtable podcast as one of three guest panelists.  If you check out their site, you’ll see that they’re big on commodities.  Possibly a bit more of a speculative bent to their site with ads that make me think that it’s a place where stock pickers come to congregate.  However, I was surprised to find that I wasn’t the only one commenting on ETFs and my fellow panelists didn’t really spend a lot of time discussing specific stocks although a few ETFs were mentioned (not just by me).

We basically comment three times:  Once on energy, the second time on the US dollar and finally with thoughts on areas of the market that we like.  Some who have followed my writings and have become accustomed to the way I do things might be a bit surprised by my final comments.  I basically state in explicit terms how I don’t believe now is a time to think like a traditional asset allocator.  I don’t think now is the time to stick to the “60%-equity/40%-fixed income” strategic asset allocation model.  Frankly, to have a “buy-hold” mentality all of the time requires a stomach of immense fortitude.  (What you are hearing now are people from Vanguard and DFA squirming in their chairs.)  Does that mean I’m leaning towards market timing?  On the spectrum, I don’t think I’m at the far end which is market timing, but I’m certainly not at the buy-hold end.  I’d like to think that the “strategic asset allocation” process which I think is so important (cool with that Vanguard/DFA?) should, in this environment as well as others, be allowed to deviate in two ways:

1.  Allow for some tactical asset allocation.  That may mean allowing min/max constraints for asset classes to deviate even more from “home” or what may be defined as the policy allocation.  That may also mean allowing the asset allocation shifts (rebalancing, delaying implementation of cash equitization, etc.) to happen a little more frequently than normal.  This allowance for tactical decisions could actually mean several things but generally I’m saying that I believe some allowance for deviation from standard asset allocation protocols is warranted.

2.  Allow for exposure beyond the traditional asset mix.  This means to make sure that alternative investment exposures are in place.  Is it too late today for gold, oil, agriculture and other commodities that seem to be getting all the attention these days?  They’re volatile (and I believe, getting more volatile) but their diversification properties are undeniable.  Caveat:  I’m talking about exposure to the commodities via ETFs, ETNs or derivatives, not indirect exposure via equities (like gold producers).  I don’t think it’s too late to get into infrastructure and other inflation hedging asset classes and the only question is how much of these alternative asset classes is warranted as a buffer to the core of traditional asset classes (stocks/bonds/cash)?

Buy-hold philosophies for multi-asset class exposures made a lot of sense for anyone from the period of 1980 to now.  The only major hit was 2000-2002.  The big question I ask myself is whether we are still in this secular up market or did that end one year ago.  In other words, are we in a sideways or down market that has the potential to be anything as bad as the 2000-2002 bear market?  My sense is that for broad regional market exposures like the S&P 500 the answer is likely to be yes.  However, for various sectors and foreign exposures, I feel confident the answer will be no.  We’ve come out of an environment where nearly everything did well fueled by a world of cheap money.  That doesn’t mean that the pendulum will swing causing nearly everything to plummet.

A very important consideration is also the role of private equity and hedge funds given my comments above on the importance of alternative investments.  I can’t stress this enough:  As much as I am a fan of passive instruments, I’ve never said that one should completely disregard active management.  Is it hard to pick the successful managers ahead of time?  Yup.  Do they cost a lot.  More than ETFs and mutual funds but if you’re finding non-correlated returns, they should cost more.  The key question in today environment is what proportion of your portfolio do you want to allocate to market risk and how much to manager risk?

That one takes a bit of time to sink in once you really think about it.

Then you have to ask yourself, is it possible that regardless of which way I choose, it’s likely that the result will be very similar?  In other words, you put all your money in one of two possible portfolios:  All ETFs or all hedge funds … and the result is both go up or both go down!  Of course it’s possible that these portfolios go in opposite directions but that’s what we would expect and that’s why we assume the active-passive proportion decision is important.  But if they go the same way, then we’re likely to lose faith in what we were promised by someone.  The passive route promises very little.  The returns are what the markets provide.  It’s the active route that promises quite a bit more … sometime more than what was provided.  The real bummer is allocating significantly to private equity and hedge funds hoping that they will provide a buffer to the traditional core portfolio of more liquid positions but not reaching that result.  In other words over-promising and under-delivering.

Today’s deleveraged environment provides opportunities but an ever changing landscape for investors travelling the PE/HF path, some good and some bad. We hear of pension funds allocating more and more to many alternative asset classes and strategies.  I wonder if they are pleased or disappointed with their results.  Are the fees worth it?  Are managers providing alpha?  Is the illiquidity constraint more than they bargained for?  Were they too late in making asset mix shifts?  Have they improved their asset/liability situation?

Everyone is talking about credit problems (mortgage, auto, credit card) and the various tentacles of the US economy that are breaking down.  My sense is that it could be as dire as some are stating but the press is likely doing a decent job of sensationalizing the story.  But what about the pension landscape?  Low interest rates plus negative market returns of the past 12 months are bringing us back to the asset/liabiility mismatch situation we first saw during the market slide of 2000-2002.  Are these funds doing so well with their portfolio returns that the relatively low interest rate environment is not causing havoc to their books?  Is this yet another cause for concern for the US financial “infrastructure” landscape?  So many questions and I only wish I could provide simple yes or no answers.  Then asset allocation would be like ordering a pizza.

Despite the volatility we expect to find in international markets and especially in the so-called “developing and frontier markets” (I’m very much not liking those names anymore) there are so many reasons not to have anything but minimal exposure to the US whether it be equities, fixed income or dollars.  Fareed Zakaria’s commonly cited view that one must notice it’s not “the fall of the US” but “the rise of the rest” is important.  It’s important for investors because there’s a parallel to a shift in asset allocation that will surely happen … and it’s already started.  Just how much is an appropriate allocation to the emerging markets?  Defining what is or is not an emerging market or frontier market or even developed market would help in answering this.  But just as important, I believe that the simple move away from “home biased portfolios”, driven by an acknowledgment that intelligent/selective global diversification, is a necessary move in what is likely no longer a simple long-term up market.  Diversification may not be what it used to be, but along with compound interest, it’s one of the very few free lunches we investors have.

Put another way, imagine you are one of the sovereign wealth funds that the press and politicians seem to enjoy commenting on these days.  Recent allocations of these funds to western financial conglomerates (investment banks in need of capital and quickly) is a move to use some of their US dollars to buy relatively cheap assets that will provide some yield (surely negotiated to be better than what others are getting) as well as a buffer to their home grown commodity exposures.  I spend a lot of time thinking about what else is on their shopping list to diversify themselves away from existing commodity and US dollar related risks.  It’s the same exercise any investor should have with their portfolio and the positions held within it.

I’m surprised that it’s only now that we’re starting to hear the term “contagion” used more often in the financial press about the current predicament seen globally and especially in the US. Over the past couple of years, I’ve mentioned in passing to different people my concerns regarding the economic outlook of the US. The way I see it, the typical American consumer (”super consumer” may be more appropriate) who is feeling the noose tighten from their mortgage obligations could soon make decisions that would have an effect on other forms of credit. Car payments are one area. We’ve seen GM trim operations yet again and with good reason … why would any sane person by a Hummer? I doubt that the typical buyer of an H2 has child seats in the back row and strollers folded behind them. That large demographic of young families would likely buy a minivan, smaller crossover or wagon. I can see the benefits of a pickup truck for many buyers but there’s a large group of models from the domestic automakers that simply have to go given that their target market is so small. High gas prices is just the final reason to adapt and the rationale for GM to make such maneuvers now while the Japanese and Korean automakers seemed to figure this out at least 5 years earlier gives good reason for top management in Detroit to be given the boot. Perhaps management wanted to take action long ago but government incentives and strong union action simply delayed the inevitable.

The real credit concern I have for Main Street however is when mortgage and auto related obligations lead to greater use of credit cards as a safety net. Maybe it’s just me but “credit card” and “safety net” are opposites. About as far apart “opposite” as Stephen Hawking and Homer Simpson despite their link to quantum mechanics. Yet, what are their options? Bank loans will be clearly harder to come by. Methods of the past such as home equity loans are no longer available. We’re quickly in a different world. The pressures to consume will have to be restrained but I’m no sociologist and I only wonder if the real fear of “losing it all” will curb spending patterns. I foresee trouble with auto loans affecting the domestic auto industry as similar problems with credit cards would affect Walmart, restaurants, leisure/gaming/travel and so many components of the economy. Banks will try to stimulate spending just like homebuilders are now pushing “buy one house get one free” deals. At the end of the day, I think it will be market forces that hit the consumer with the final blow of reality. Unfortunately, I feel like mortgages are just the beginning. It could be the first of many domino trails that fall in sequence and all we can do is watch. It’s the growing social fear that should help in increasing the average savings rate even a little which I think is all we need … nothing too drastic. Or maybe I’m just keeping expectations in check.

As an aside, I should add that the consumerism of North America is clearly growing globally to other markets. It’s not just Dubai but major centres all over the emerging world be it East Asia, the Mideast, Latin America or Russia/Central Eastern Europe. We’re hearing constant reminders these days of rising food, fuel and housing prices globally and this includes the developing world. Yet there is simultaneous high growth in the sale of luxury goods. Hand made Swiss watches, Italian cars/motorcycles, designer handbags, cigars … the necessities of life I suppose. Or you’d think that by visiting these regions. There are some neighborhoods in large North American cities dominated by high end automobiles. However, I’m always surprised at how this pales in comparison to what I can only say are the new centres of influence around the world. Dubai was a bit of an eye opener but now I’m interested in seeing what Moscow is like. Of course, the spread between the “haves” and “have nots” is very significant in the developing world but it’s surprising just how wide the disparity is. But all things eventually swing back the other way. The typical middle class US consumer will learn to adapt just like the typical Japanese worker figured out that the concept of lifetime employment with one organization is over.

So what other areas of the credit space will hit the everyday consumer not just in the US but for the growing “big spender” global citizen? Like auto loans and credit cards, each of these other potential chain of dominos are all part of a growing credit contagion that would have far reaching implications to the capital markets. To what degree and for how long, no one can say now and the economists will have to build new models to figure this out. I wonder if the parallels to the depression era will continue and be a basic assumption in these models.

Since this is “The Beta Brief”, I’d like to link the above commentary to the industry of beta oriented instruments. Both the ETF and derivative markets will have to be less US centric and gain further access to international markets and especially the developing world. Perhaps we’ll see the same result of redundant product offerings. With all the unnecessary, overlapping exposures in the ETF space that are especially focused on the US equity markets I can only assume that many of these funds will close down or merge. At this point, the recent closures at Ameristock of five Treasury bond ETFs in addition to those from Claymore a few months earlier are a telling sign of the excess of product growth that has been a defining story in the relatively short ETF saga. Well, it’s actually about 15 years. But if the writings of Fareed Zakaria and Mohamed El-Erian give insight into the future significance of the US economically and politically, the real attention of investors … and ETF providers … should be internationally. In the US, there are just about enough ETFs available to establish any sort of international diversification by region/country, sector, market cap or theme with very few holes remaining. However, we certainly don’t have that full availability of products in other jurisdictions. It may never get to be as crowded elsewhere as it is in the US now. It’s just a matter of time before the ETF industry expands in a more robust way to other parts of the world.

The current volatile environment with strong up days like yesterday (June 5th) but with even more down days does not seem like the best of times for passive instruments except perhaps for levered long and inverse exposures … basically, derivative markets and ProShares ETFs (I know, there are other providers now with levered long and inverse ETFs aside from ProShares and Rydex). The past year has been the time for hedge funds. Like the bear market of 2000-2002, we should see many hedge funds, but certainly not the majority of them, perform well but many investors in them come away somewhat unsatisfied. My guess is the final result in this downturn will be even less palatable for the vast majority of investors in hedge funds. Of course, those that do find success will have it big. It’s black swans and higher moments to the extreme. But I wonder if the strength in the ETF market which took place since 2003 was the result of investor dissatisfaction with the performance of active managers during the preceding market declines. And if so, will there be the same result at the conclusion of this rocky period?

The chart above would provide a more useful picture if the vertical axis was logarithmic. However, we can see that the current market declines of the past 11 months or so are still relatively small in comparison to what occurred earlier this decade. The same is true for the DJIA and the Nasdaq as well as international markets.

Who knows what the maximum drawdown will be from the highs of July and October ‘07? I’m starting to think that we might be in a longer term sideways market where the S&P bounces somewhere between 1,200 and 1,600 for a few years with continued high volatility … again, hedge fund heaven. If we have anything close to this scenario in our highly synchronized global market - well, actually anything other than a strong bull market like we saw from early ‘03 to mid ‘07 - then this should be a great time for active management as opposed to passive. In this scenario, passive management will be seen as something for old “has beens” and we’ll hear the same arguments against indexing as we heard in 2002. However, I think that the ETF industry has become, and will continue to be, less about buy-hold and a Vanguard-like philosophy but rather about the use of passive instruments within active strategies. Deb Fuhr (formerly of Morgan Stanley … anyone heard where she’s headed?) recently came out with a report noting that hedge funds are the 2nd biggest users of ETFs after financial advisors. Clearly, the active trading of ETFs, like it’s been in the derivative markets, will be hot and I see a growing list of managers of all types employing the use of ETFs in addition to single securities. I’m surprised how many managers I find today who use ETFs only within highly active mandates.

Funny enough, I hear these managers asking for more product related to foreign exposures and more niche offerings. It’s exactly where the industry has been headed in the past couple of years. We can see evidence of this with the continued success of ProShares and their move to foreign markets. Their levered long and short exposure funds are catered to the active investor. For those of you who are wanting some similar instruments that access certain commodity markets, ProShares manages ETFs for Horizons BetaPro here in Toronto providing long and short exposures to gold, oil, natural gas and agricultural grains. [Note: This isn’t a recommendation in any way. Just pointing it out to you.]

Like the Asian contagion of ten years ago, this is a time of serious crisis providing opportunity for the most active of active managers to shine. The long-term oriented investor will have to conduct a serious gut check to determine how their asset mix pie will deviate, if at all, should they consider the next five years or so to be anything but an up market similar to the past five years ending this past December. Another term making the rounds in the financial press recently is “depression”. Since I don’t see the US economy or the world as a whole going down to that degree (one of the reasons for my view of a sideways market over the next few years) the only form of depression I find applicable today is that related to mental health given the fear and then realization that the “American Dream” for many might be delayed and unfortunately for many more in the middle class, quite unattainable. This sad situation applies globally due to the spread of this credit and liquidity crisis beyond the US. However, the real key problem is the US. Fareed Zakaria’s article notes that the global shift we see today is less about the decline of the US and more about the rise of everyone else. His argument make sense given its lead in innovation, among other advantages, that come out of the robust economy that is the US juggernaut. But it will be the resiliency of the US consumer (along with their government and central bank to assist them) and their ability to adapt to this credit/liquidity crisis that will determine the course of things to come in the next few years.

For the most basic investor, the simple hedge might be increased allocations to international and especially emerging market exposures via decreased US exposures. That likely won’t be enough though and the importance of alternative investments, skill in picking successful active managers ahead of time and the ability to wrap this within an effective risk protocol might be what’s required. It’s a tough world.