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With investor interest in ETFs at an all-time high, exchange-traded funds' continued dramatic growth amid the last two volatile years, and ETFs' impact on the market greater than ever, Morningstar hosted its first ETF Invest Conference Sept. 16-17 in Chicago.

Here are the blog posts from Day 1 of the conference:

ETF Invest Conference: State of the Market
Scott Burns, director of ETF research at Morningstar, launched our premier ETF Invest Conference with a "back to school" themed introduction.

Even seemingly simple ETFs have nuances that need to be understood better. More and more, advisors are realizing that the lowest cost wins more often than not.

That's one of the key advantages of ETFs. Passive investing is closing in on 30% share of all invested assets, and that number grows every day. Wednesday, Morningstar's Paul Justice and his team held a workshop that covered the "know the vehicle" aspect of ETF education, which can also be thought of as ETF 101 or 201.

The goal of the ETF conference is to understand how we invest in ETFs. ETFs have been a game-changer for advisors. They have created options that advisors could only dream of five to 10 years ago. Along with these options, they've also brought low cost, diversification, and liquidity.

But along with these options comes the responsibility to know what we are investing in, what each ETF actually does and how it actually works.

To meet our goal of education for the conference, we reached out to the large ETF firms and asked them to reach deep into their ranks to find executives who can explain ETFs to investors. By looking at the program, you can see that the ETF families rose to the challenge. We also reached out to folks who are a bit removed from ETFs, but who have investment expertise that can help us form a plan for ETF investing.

The first speaker is Dan Farley, SSgA's (State Street's) global head of investments, who is responsible for multi-asset-allocation strategies for more than $190 billion in assets. SSgA is the architect of the first ETFs out there.

Dan's presentation was composed of four parts: the state of the economy; the state of the markets; concerns about the economy and the markets; and how that all comes together into a portfolio strategy.

Here is what Foley shared in his State of the Market presentation.

Economy
Right now, we're in a stable but shallow recovery mode. Of course, there are other scenarios that could unfold, but sustainability is the most likely. World GDP should be 4.4% in 2010 and 4.1% in 2011; U.S. GDP 3.3% in 2010 and 3.1% in 2011.

Recovery in global trade is largely complete. Business confidence is at a crossroads. There are nascent signs that employment is picking up. Central banks remain accommodative. Industrial production gains are moderating--the pendulum swung too far to the downside, then perhaps too far to the upside, and is now moderating.

U.S. capacity utilization is a "very, very important data point" to look at. Right now it's about 75%, whereas the long-term average is 80%. Hiring plans, inflation, and durable goods orders are unlikely to pick up until capacity utilization picks up.

The U.S. employment picture isn't pretty. Stresses in the labor market persist. Working through the available labor pool is going to take a long time. On average, prerecession, two people were looking for every one job. Currently, six people are looking for every one available job. In SSgA's view, this imbalance doesn't go away until 2015. This overabundant labor pool and extended unemployment cycle fuels the view that it's going to be a long, slow recovery.

Employment affects retail sales. Here in the U.S., there has been a blip up in sales. Some of that is probably pent up demand. Going back to 2005, the pattern is that U.S. retail sales and world equity returns are in lockstep. It's important for consumer sales to increase to lead market returns. It's tailing off in the past couple of months, which suggests world equity returns could start trailing off.

Spending can be affected by consumer credit. Banks are more accommodative, but consumers remain disinterested. Month after month, banks are willing to make a consumer installment loan. But consumer demand for loans is still negative versus three months prior, although the decline is abating. In the long term, this is a good thing because it means consumers are shoring up their personal balance sheets. In the short term, this paying down of debt takes away from potential economic growth. Again, this supports the view for a long, shallow recovery.

From commercial point of view, banks are no longer tightening loan requirements. Banks are starting to lend; companies are starting to borrow. We see this in bank loans and in the capital markets.

There are significant amounts of new issues in the bond market. Even in the high-yield market, we're seeing new issuances. But although banks are more than willing to lend to small businesses, they're charging them for it. Spreads on small business loans are climbing, up to 4 percentage points now. The small-business credit outlook is tightly tied to their hiring plans. Because small businesses are the largest job creators out there, this credit situation is hampering a recovery. So, until this gets rectified, we're likely to have high unemployment.

Market Outlook
SSgA's view is that we will see mid- to upper-single-digit equity returns and low-single-digit fixed-income returns. The still-anemic recovery provides few catalysts for growth assets. The threat of deflation has pushed government-bond yields to record lows. The search for income continues: Corporate cash is at a record high of past 50 years, and equities still have room to move.

Government-bond yields are low. No news here. Demand for Treasury auctions is high, as investors seek risk protection and as banks look to bolster the quality of their assets.

Credits and equities provide attractive yields versus cash. We're getting to talk about dividend yields again. M&A and dividends are likely beneficiaries of the corporate cash hoard. Dividends should increase or even begin at some firms that have never paid them. Cisco announced just this week that it will have a dividend.

M&A is likely to target, as it has historically, mid-caps and small caps. Equity valuations don't look onerous. Maybe they aren't "cheap," but valuations have come down. At this point in the cycle, the earnings estimates in the forward P/E ratio are suspect. Don't extrapolate last quarter's earnings into the future. So, be careful of value traps.

As we start to dig into equities a bit, we see some differences in equity valuations. For a long time, SSgA's team hasn't liked U.S. small cap. However, it's a very different story when you look at non-U.S. small caps, especially developed-markets small caps and to an extent emerging-markets small caps.

Among non-U.S. small caps, you have cheaper forward P/E ratios and higher returns on equity. So, you're getting more and it costs less, relative to U.S. small caps. Investors have about 3% of assets in global small caps, even though global small caps represent 12% of the global marketplace.

Emerging-markets valuations are not demanding, either. Forward 12 month P/E ratios are approaching one standard deviation below their average valuation. Emerging markets are under-represented in institutional portfolios. They make up 13% of institutional portfolios, but have 20% of the market cap. Yes, people talk about emerging markets all the time. But they are still not properly represented.

Concerns
SSgA looks at four main concerns. First, sovereign debt worries emanating from Europe may come to nothing, but still they keep risk at the forefront of investors' minds.

Second, localized pockets of inflation may force independent actions by global central banks. While SSgA thinks the risk of inflation is low in our corner of the earth, in some areas it is a problem. So, in the U.S. and Europe, central banks remain accommodative, but in Australia, India, and China they are raising rates to combat inflation.

Third, the regulatory backdrop is creating uncertainty. Looking at some surveys, it's the number one thing CEOs point to, saying the uncertainty is holding them back from making decisions.

Fourth, structural deficits are hindering growth. Increases in taxes to pay debt interest lower potential growth. A burdensome rise in financing costs becomes a persistent risk.

Gold's rally discounts the effectiveness of fiscal austerity programs.

This outlook is looking at what could happen 12 to 18 months out. In the very near term, SSgA looks at how risk is being perceived in the marketplace. Looking at TED spreads, three-month LIBOR spreads, and VIX levels, it looks relatively calm. However, TED and LIBOR spreads have been rising over the past few months. Be mindful of this--they often act as canaries in the coal mine.

Portfolio Positioning
Over the past couple of weeks, SSgA has been pulling out equity risk in the portfolio. If we're in this muddle-through economy, how do we generate income? They are very focused on coupon and dividend income. They are overweight large-cap dividend payers on equities, and on fixed income, they are overweight investment grade and high yield.

Investors need to be mindful of their emerging-markets exposure. Investors often come up with a thesis that centers on demographic changes, and then buy an ETF that is dominated by large multinationals. Good idea, poor execution. Look at small-cap emerging markets to get those demographics working in your portfolio.

They've been underweight REITs for a while. They just don't see how office and retail space get filled in a slow, shallow recovery.

--Mike Taggart

Mining for Lessons After Flash Crash
Four ETF industry executives revealed the outcomes of post-flash-crash, industrywide collaboration among competitors in a panel discussion Thursday at the Morningstar ETF Invest Conference. While the flash crash itself was tumultuous, they agreed, it facilitated improved communications between the companies and laid the groundwork for the controls that will help prevent future flash crashes.

The most prominent change investors can expect, according to the panel, is circuit breakers that will halt trading if extreme activity is pummeling the market. European markets have deployed similar mechanisms as protections from wild market swings.

"Regulators are trying to be judicious and not flip switches too quickly," said iShares' Noel Archard. "It's a big, complex market, and we don't want to break something while we’re trying to fix it. But circuit breakers are a good first step."

Ben Fulton, managing director of Invesco PowerShares, said it is important for dialogue to continue among members of the financial-services community and regulators. "If there was a success story out of the flash crash, it's that it brought the major leaders of the ETF industry together," he said. "We all feel a lot better about the world today than we did May 7."

--Mike Brennan

Opportunities in Emerging Markets
In the first round of breakout sessions at Morningstar's ETF Conference 2010, David Semple, head of Van Eck's emerging-markets team, shared some of his insights into the space.

Semple's opening drive explained that contrary to popular belief, emerging markets do not afford investors an opportunistic asset class. Emerging markets account for a roughly 37% share of the global economy and have maintained growth premium throughout the tumultuous financial storm of 2008-09.

Commodities in these markets are no longer constrained by demand side drivers, as emerging markets have grown to command a majority share of global resource supply. Despite growth in the space, Semple notes that MSCI's 12% emerging-markets weighting is a marked under representation by even conservative global GDP estimates.

Sovereign debt is in much better shape than years past, and corporate debt remains low, as cash flow has exceeded capex and dividends. Van Eck is expecting free cash-flow yields of 5%-7% through 2011.

Emerging-markets payout ratios tend to be low, but there are several advantages over developed markets, like their lack of leverage-derived vulnerabilities. Emerging-markets growth remained in line with developed markets over the past decade but accelerated post-2008.

Semple noted that the emerging markets are held hostage by Wall Street fears over anemic growth, deflation, and developed-economy sovereign default in the short run. As emerging markets continue to open themselves to the global economy, their middle classes grow and their currencies look to appreciate. Moving away from the traditional mercantilist systems pervasive in emerging markets may pose difficulties, but Semple doesn't expect the boom-and-bust cycle that has traditionally plagued the space.

ETFs allow investors to tap previously inaccessible emerging markets, but Semple advises against overlooking equity- and nation- specific risks. Many of the largest holdings in emerging markets indexes are government owned and disregard the interests of minority shareholders.

Headlining national differences in the risks associated with emerging-markets exposure, Semple made note of the lack of investment options in China, leverage and political complications in Russia, and infrastructural deficiencies in India.

Semple doesn't find valuations in the space to be challenging or compelling, rather interesting, and predicts emerging markets maintaining growth premium in all but the worst scenarios going forward.

--Abraham S.H. Bailin

Micro and Macro Factors Create Opportunities in Commodities
Three veteran commodities traders opened up about the opportunities they project to emerge in the near- and mid-term future.

Gold
Fred Jheon, head of product and investment strategy for ETFS Marketing, said his firm is closely scrutinizing the possibility of gold rising in the near future due to three factors:

The devaluing of the U.S. dollar and other paper currencies. Thanks to its inverse relationship with currency, gold is the beneficiary of the struggling dollar. "Gold is being used almost as a hard currency for investors," Jheon said.

Economic uncertainty. The sovereign-debt crisis in Europe and questions about the sustainability of the runup in U.S. equities securities make gold an attractive alternative to owning equities or currency.

The Indian wedding season. A very short-term factor favoring gold is the arrival of wedding season (September through December) in the world’s largest consumer of gold. Contrary to popular opinion, Jheon said, jewelry, not investments, accounts for most gold purchases.

Wheat
Jim Green of Rosetta Capital Management said he anticipates the price of wheat rising dramatically as a result of vastly reduced crops in Canada, along with Russia and its neighbors. "We're probably embarking on one of the most exciting times we’ve had in the grain markets and livestock markets we’ve had since 1995 or 1996," Green said. Reduced wheat supplies has led to additional demand for corn, which itself is enduring far lower production than projected, driving up the price of corn, too.

Macro factors also favor the long-term prospects of grains. Grain stores are down because of increased demand in emerging markets, while global population growth will create increased demand during the next decade.

Crude Oil
While shortages have driven wheat prices up, excesses of natural gas have suppressed its prices. If this continues, said John Snell of Risk Management Incorporated, companies will eventually lower production. "Look for the chinks in the armor," he said. "We're starting to see ... less money go into exploration and production."

And while the price of coal has also dropped, some utilities providers might use more natural gas if the price is favorable. With winter approaching in the U.S., this could spell heavily increased demand if it plays out.

-- Mike Brennan

Asset Allocation and New Wave Portfolio Theory
Paul Justice moderated a panel discussion with Sandip Bhagat and Erik Ristuben on strategic asset allocation and New Wave Modern Portfolio Theory. Bhagat is Vanguard's head of equities, overseeing both passive and active strategies. Ristuben is the chief investment officer for client investment strategies for Russell Investments. The topic of the panel was to what extent new investment opportunities and techniques should be brought to bear on the staid field of tactical asset allocation. Many investors came away from the financial crisis dissatisfied with the buy-and-hold strategy that they were counting on to guide them through the ups and downs of the market.

Both Bhagat and Ristuben agreed that while the buy-and-hold philosophy is not dead, it does need resuscitation. Additionally, the alternative to buy-and-hold is not necessarily a fool-proof approach. Bhagat pointed out that if the market-timer missed just a handful of days over the course of a 20-year period his or her upside would be cut in half. Ristuben agreed that sitting on the sidelines waiting for the right time to invest can be frustrating.

Both panelists reminded the audience that buy-and-hold is only part of the buy, hold, and rebalance philosophy that they endorse. Additionally, new products and innovation in markets require that we reassess the tools available to us. For example, 30 years ago, a typical advisor might recommend a 60/40 portfolio of investment-grade bonds and S&P 500 stocks. Today, the more prudent approach considers international markets, both developed and emerging, as well as alternative investments such as currencies, commodities, and real estate. Even a small allocation to these alternatives would have had the profound effect of reducing portfolio volatility during the crisis.

For plan sponsors who are concerned with asset and liability matching, investors prefer certainty and wish to avoid any shortfall, but Ristuben reminded the audience that certainty is expensive and many plan sponsors can not afford the level of certainty that they desire. While not overly optimistic about prospects for the equity markets, they observed that the market was perhaps too pessimistic at this point and it would be a mistake to extrapolate the flat returns in stocks from the past 10 years over the next 10 years. Asset allocators need to look at long-term valuation trends, not day by day or even quarter by quarter.

-- Michael Rawson

Globalization at Mach Speed
The lunch presentation at the ETF conference was given by Gregg Easterbrook. Easterbrook is the author of Sonic Boom: Globalization at Mach Speed, and is also a contributing editor at Atlantic Monthly. The theme of his presentation was the impact globalization was going to have on the world in the decades to come.

Throughout American history, we have been predicting the eventual demise of American power in the world. In a free market economy, it is impossible to predict the direction the market will take. As an example, if you told people in the 19th century that in 2010 only 2% of people would work in agriculture, they would have said the U.S. economy must have collapsed. The loss of manufacturing jobs is analogous to the loss of agriculture jobs at the beginning of the 20th century. Manufacturing is not as important as everyone thinks. We are creating a society where very few people work in factories, and this is a good thing.

Easterbrook thinks that the world is more stable today than at any time in history. For the last 25 years, we have had basically no inflation. With the advent of new farming techniques that have dramatically increased crop volumes, people have not had to worry about feeding themselves. The world's superpowers, United States and China, are friendlier with one another than any other superpowers in world history. This has created a stable economic environment where innovation is allowed to flourish.

2010 is very early in the globalization trend. The network effects are just getting started. In this world, ideas are more important than resources. In the past most ideas came from the developing world. Emerging markets are now contributing, and the continued freedom of women in the world is dramatically increasing the world's supply of ideas.

There will be more "un-commanded institutions." These are organizations that aren't controlled by anyone. Wikipedia and the global economy are examples of this phenomenon. In the new world, people will be able to govern themselves, and there will be less need for centralized decision-making.

Easterbrook is very positive on the global economy. The biggest problem he sees is the largest national deficit. Overall, the good things happening in the world far outweigh the problems.

--Timothy Strauts

In Defense of Commodities-Based ETFs
A recent cover story by Bloomberg Businessweek--"Amber Waves of Pain: Do Not Invest in Commodity ETFs"--needlessly misdirected concerned investors away from the real issues troubling their commodities-based-ETFs, according to Fred Jheon. The head of product and investment strategy for ETFS Marketing, Jheon said the very recent surge in popularity of commodities ETFs makes them an easy target for industry observers tasked with providing worried investors with answers. The real solution, he said, is not avoiding an investment vehicle altogether but rather doing homework before making any investment.

"The confusion mentioned in that article is largely due to the holding of futures, and investors not completely understanding how those mechanisms work," Jheon said.

He said many investors get tripped up when commodities are in contango--when an upcoming contract is more expensive than the expiring contract. In those cases, the fund--and its investors--take a hit.

"That's where a lot of investors got tricked or stung," Jheon said. "Investors really need to understand how a product works before investing their money in it."

Jheon also discussed concerns some investors have that an investment in a physically backed gold ETF might be an investment in nothing--that the firm collecting investors' money does not actually own the gold it's selling. Contrasting such concerns, Jheon said the industry is very transparent. He explained that bars of gold are individually coded, and most gold ETFs post online the codes for the bars they own. These codes can be verified by the vaults holding the bars of gold.

"We try to be as transparent as we can," Jheon said. "I think having that mechanism of publishing bar codes is really a help for the average investor."

-- Mike Brennan

Panel: Alternative ETFs in the Portfolio
The session started with an introduction to the alternatives sector by Morningstar's own Nadia Papagiannis. The past decade has seen a flood of new alternative investment vehicles, both in mutual funds and ETFs. Currently, Morningstar tracks 420 total alternative funds, 182 mutual funds, and 238 ETFs. Flows are also growing rapidly, with a marked increase in interest in the sector in 2009. Alternatives can include many different investment strategies, including commodities, bear market (inverse funds), currencies, long-short funds, and others like hedge fund replication and alternative asset allocation.

Papagiannis then moderated a panel that included Adam Patti, CEO and founder of IndexIQ, George O'Connor, director and manager of BlackRock's global client group responsible for iShares product development and research, and Peng Chen, president of Ibbotson Associates, an RIA and subsidiary of Morningstar. The first topic of discussion was the broad democratization of alternatives, from hedge funds, which are the near-exclusive domain of high-net worth and institutional investors, to ETFs available to the retail investor.

According to Patti, in 1984 there were 84 hedge funds. Today, hedge funds number about 10,000. A study by Ken French showed that the typical 2+20 (2% of assets, 20% of returns) hedge fund fee takes about 4.5% off the top, a high hurdle for managers to create alpha. With the competition increasing over the past 25 years, hedge fund managers have more difficulty in justifying these fees. Studies show that about 75%-85% of actively managed mutual funds underperform their benchmarks after fees, with similar numbers for hedge funds. Other studies show that the majority of hedge fund returns can be explained as a form of 'alternative' beta, or a series of risk premia across different asset classes.

So why should investors pay 2+20 for underperformance if they can replicate those returns using commonly available asset classes? Patti's firm, IndexIQ, launched a series of representative indexes in 2007 to demonstrate the capability of using investable products like ETFs to mimic hedge fund returns. Their QAI ETF charges only 0.75%, plus about 0.30% for underlying fees, and has a good track record, especially considering that hedge fund indexes typically overstate the industry's returns--as only the hedge funds that have done well tend to report their results.

O'Connor indicated that there is no standard definition for "alternatives." He suggested investors should look at it based on the desired outcome, an addition to a typical equity and fixed-income portfolio that has low correlation, positive returns, and hopefully low volatility as well. How can investors gain access to alternatives? Hedge funds are one tool, but they can't be all lumped together as some deliver diversification, and others strive for alpha. These different objectives should have different price points. ETFs are a better alternatives tool for delivering diversification, because they are more liquid, more transparent, and have lower fees and better tax consequences than hedge funds.

Patti chimed in that he believes alpha is elusive, so portfolios should be constructed primarily with diversification in mind.

Chen explained that there are three components to hedge fund returns: alpha, beta, and fees. A historical study showed that 60%-65% of hedge fund returns can be explained by some form of beta, while 20%-25% was fees. The remainder was alpha or undiscovered beta.

The next topic was allocation to alternatives. Chen said that the first decision investors must make is deciding where they want returns to come from, beta or alpha. He agreed with Patti that the average investor is better off using beta, because it has lower fees and is more diversified. In a typical portfolio composed of 60% equities and 40% fixed income, a rough estimate of the desired allocation to alternatives is 20%. O'Connor estimated the range of allocation to alternatives to be anywhere from 2%-30%, again depending on the definition of alternatives. Patti estimated the range to be 10%-30%.

-- Alan Rambaldini

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Foreign Small Caps Are Cheap: Notes from the Morningstar ETF Invest Conference 2010, Day 1