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

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

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

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

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

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

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

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

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

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

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

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

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

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

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