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Passive ETF's are usually built to follow an index, which, in turn, follows a specific methodology for selecting and weighing assets based on some common criteria. From the largest universe of assets such as Vanguard Total Stock Market (NYSEARCA:VTI) or iShares Core Total US Bond Market (NYSEARCA:AGG), to the smallest, finest slices of "pure plays" like Market Vectors Indonesia Small-Cap (NYSEARCA:IDXJ) or PowerShares DB Precious Metals (NYSEARCA:DBP), the commonality of underlying assets is key. In fact, it's what allows the ETF issuers to present their investment case to would-be customers. Should that common bond be weak, the ETF is unlikely to survive. After all, would you consider putting your money in an ETF that invests in companies whose names start with 'X'?

That is exactly why a September 2012 SEC filing for Nashville Area ETF (NYSEARCA:NASH) was met with considerable skepticism. Who would be the target audience? Buying local may work at farmer's market, but would that hold true on the NYSE? An index based on geography is hardly new, of course, but only when it comes to countries or regions. There are no other equity ETF's in the market today based on US localities. There were two others in the past, Large Companies ETF (TXF) and Oklahoma ETF (OOK), but both closed less than a year after their launch, having failed to attract sufficient investment demand.

Regional ETF Rationale

The conventional wisdom of investing into a regional or country ETF is three-fold. First, there's the idea that the economy in that locale is at a higher growth stage than the majority of investor's holdings due to a number of factors, such as demographics trends (for instance, China or India), comparative advantage in location (Panama), natural resources (Saudi Arabia), local business and tax laws (Ireland), or Central Bank policies (Japan, anyone?) Even if the growth isn't there now, perhaps the distressed situation presents opportunities in the future (think Greece, Egypt, or Ireland a few years back). The second idea is that certain places are likely to have a comparative advantage in a specific industry, perhaps due to some of the same reasons as above, creating a strong ecosystem around it. You'd probably be looking for automotive and engineering companies in Germany, miners in Australia, and banks in Switzerland. And finally, there's the good old diversification argument, which in many cases includes currency diversification away from US Dollar.

Well, perhaps investing in US regions is not all that dissimilar. The Central Bank and currency arguments don't work, true, but they don't work for Europe either, for example. Yet a possible investment thesis for Spain ETF (NYSEARCA:EWP) is completely different from Germany's (NYSEARCA:EWG). The rest of the points above, however, can be easily transplanted. Different areas in US most definitely appear to be at different economic growth stages. While housing recovery and jobs growth are lifting South Florida and Arizona, Detroit is losing jobs and filing for bankruptcy. Texas runs a very public campaign to attract businesses. Alaska enjoys government subsidies. Many metropolitan areas are also easily identifiable with specific industries: high tech in San Francisco, automotive industry in Detroit, hospitality and leisure in Florida, biotechnology in San Diego, and financial services in New York. So the question to me is, why aren't there funds on the market focused on any of these regions yet?

About Nashville ETF

LocalShares, the new ETF provider founded by Nashville business executives, launched the Nashville Area ETF (NASH) on August 1, 2013. The ETF enables investment in a basket of qualifying Nashville area publicly-traded companies. "LocalShares has spent several years creating this concept, as well as developing our selection formula to carefully pave the way to launch the Nashville Area ETF," said Shmerling, chairman of LocalShares. "We believe that communities like Nashville provide significant value-add to the companies that are headquartered here. In middle Tennessee, these attributes include low taxes, a strategic location and a state where people have the right to work. Collectively, this is a solid group of diverse companies and we look forward to bringing them together in Nashville Area ETF."

LocalShares will use an algorithm to identify and assign weight to the companies in the underlying index maintained by the German research company Solactive, which also provides indices for most MarketVectors ETF's. In addition to geographical requirements for their corporate headquarters, the constituents would need to have a minimum of $100 million in market cap and daily volume of at least 50,000 shares to minimize liquidity risk. Quarterly rebalancing will take into consideration several criteria, including positive earnings, momentum and valuation metrics. As of close on August 5, 2013, the ETF composition was as follows:

Name

Ticker

% of Net Assets

DELEK HOLDINGS

DK

7.27%

HCA HOLDINGS INC

HCA

6.75%

TRACTOR SUPPLY

TSCO

6.08%

COMMUNITY HEALTH SYSTEMS

CYH

6.04%

CRACKER BARREL OLD CNTRY

CBRL

5.76%

GENESCO INC

GCO

4.77%

CORRECTIONS CO

CXW

4.58%

CLARCOR INCORPORATED

CLC

4.45%

AMSURG CORP

AMSG

4.43%

HEALTHCARE REALTY (REIT)

HR

3.71%

KIRKLAND'S INC.

KIRK

3.70%

BROOKDALE SENIOR LIV

BKD

3.66%

NORANDA ALUMINUM HLDG

NOR

3.63%

ACADIA HEALTHCARE CO INC

ACHC

3.57%

LOUISIANA PACIF

LPX

3.55%

HEALTHSTREAM INC

HSTM

3.54%

LIFEPOINT HOSPITALS INC

LPNT

3.48%

HEALTHWAYS INC

HWAY

3.46%

DOLLAR GENERAL CORP

DG

3.35%

VANGUARD HEATLH SYSTEMS

VHS

3.29%

RYMAN HOSPITALITY

RHP

3.26%

NATL HEALTH INVEST (REIT)

NHI

2.85%

PINNACLE FINANCIAL

PNFP

2.42%

CUMBERLAND PHARMA INC.

CPIX

0.99%

CASH

 

1.39%

The ETF charges 0.49% annual management fee after waiver. Opening day shares for NASH were initially priced at $25 per share. After rising 1.6% on the first day of trading on healthy volume of 111,000 shares, by August 6, the 4th day of trading, the shares settled at $25.06, just above the IPO and NAV prices. The average volume over the past 3 days (excluding the first day of trading) was 11,000 shares, and current AUM figure is listed at $2.54 million.

The prospectus lists a number of investment risks in addition to the usual, including geographic concentration, small-capitalization, lack of diversification, and healthcare sector risk reflecting the lion's share that this sector takes up of the ETF portfolio. The other major risk, of course, is that the fund won't get enough traction and will fail to accumulate enough assets to make money for LocalShares. The company is said to be planning more city-based indices. It remains to be seen whether the fund survives and others will follow the trend, but I'm a believer. Why? Just look at Motif Investing.

Motif Investing

Motif Investing is a relatively new online broker that allows investors to buy "motifs" - a group of up to 30 US listed equities of ETF's combined by a common theme, all for one low commission. Not only the company provides over 100 motifs, it lets investors modify them and recently allowed members to create their own motifs, complete with weighting methodologies and custom names, and share them on the site. I think of these motifs as a cheap way to create my own custom ETF.

A search through the "community" motifs shows quite a few on the geography theme. There is a motif on Atlanta area, another on California and at least two Seattle motifs. Below is a list of five market cap-weighted motifs I have created over the past several months that could get ideas flowing:

(click to enlarge)

Conclusion

The future will tell whether Nashville ETF will survive, but investors should pay attention to the developing trend. Geography-based investing is not just for foreign countries and municipal bonds anymore.

Source: Domestic Regional ETFs: A New Trend, Or A Mirage?