With 2011 just around the corner, the curtain is closing on yet another year of tremendous expansion in the ETF industry. With inflows for the year at close to $100 billion, total ETF assets will recently eclipsed the $1 trillion mark for the first time. From a product development standpoint, 2010 was a record year; more than 200 new ETFs hit the market, and the pipeline has continued to fill with new ideas.
Some of the exchange-traded products debuting in 2010 are direct competitors to existing funds; Vanguard, for example, launched a suite of ETFs linked to popular S&P and Russell benchmarks that undercut similar products from competing issuers on a cost perspective. But for the most part innovation continued to be the name of the game in the ETF industry in 2010, as the majority of new launches were first-to-market products that opened up new asset classes and investment strategies for investors. Below we count down some of the best new ETFs to hit the market in the past year, touching on a number of different asset classes. The list was based not on performance or other quantitative metrics, but rather on an assessment of which new products gave investors more tools to use in the asset allocation process. Each of the funds highlighted below (which are presented in no particular order) offer compelling investment theses that could be appealing to a wide range of investors, and provide unique exposure not previously available in the ETF wrapper:
1. Emerging Markets Local Debt Fund (ELD)
An increased interest in red-hot emerging markets has been one of the overarching themes of the past two years, as investors have shifted exposure away from developed economies burdened by high unemployment and mounting budget deficits and into developing economies that continue to expand at an impressive clip. This trend hasn’t been limited exclusively to equities, as record low interest rates has prompted a search for yield that in many cases ends in emerging markets.
Emerging markets debt ETFs are nothing new, but the first products to offer exposure to this asset class have focused primarily on dollar-denominated issues. ELD (and (EMLC), a similar fund launched this year by Van Eck) offer exposure to debt of emerging market issuers that is denominated in the local currency, which has the effect of diversifying exposure out of U.S. dollars.
An equity portfolio consisting entirely of U.S. stocks likely wouldn’t be recognized as diversified, yet when it comes to fixed income exposure, many U.S. investors stop at the borders. For those looking to beef up the yield on a fixed income portfolio, ELD could be worth a closer look; the weighted average coupon is more than 7%, and the SEC 30-Day Yield is north of 4%.
2. Cambria Global Tactical ETF (GTAA)
The active ETF space has generally been slow to develop, with investors hesitant to embrace these hybrid securities for exposure to domestic equity markets or fixed income. But there have been some bright spots among the active products brought to market in 2010, and GTAA is one of them. This fund is the result of a partnership between AdvisorShares and Cambria Investment Management, the firm run by Mebane Faber and Eric Richardson. Faber is perhaps best known for his 2007 paper A Quantitative Approach To Tactical Asset Allocation, in which he laid out a quantitative market timing model designed to manage risk in various markets and deliver equity-like returns with bond-like volatility and drawdown. Along with Richardson, Faber co-authored The Ivy Portfolio, an influential book that offers average investors insights into tactics that can be used used to mimic the impressive returns posted by endowments at Ivy League institutions. After delivering impressive returns during the recent recession, the strategy is now available to all types of investors in a package that includes all the benefits of the ETF structure.
GTAA is the first truly global asset allocation ETF; it maintains the flexibility to invest in ETFs across various asset classes, including domestic and international bonds and stocks, commodities, currencies, and real estate. GTAA follows a trend-based model across these asset classes, and will either be invested or be defensive through a cash position for each depending on certain metrics. For investors who buy in to Faber’s strategy and are willing to trust his management skills, GTAA might make sense as a core holding for those looking to take a less active role in their portfolio.
3. Rydex Emerging Markets Equal Weight ETF (EWEM)
As the tremendous surge in ETF investing has transformed indexes from hypothetical measures of performance to investable assets, the construction and maintenance methodologies behind benchmarks has become more intense (and rightfully so). A fair amount of focus and research has focused on the various strategies for determining the weightings given to each component of a benchmark. In the equity arena, the vast majority of assets are in products linked to cap-weighted benchmarks–indexes that give the largest weightings to the companies with the largest market capitalization. Cap-weighted benchmarks have a number of advantages, including easy (read: cheap) maintenance. But because of the direct link between stock price and weight assigned, there are also some potential pitfalls – the most significant of which is a tendency to overweight overvalued stocks and underweight undervalued stocks.
One alternative to cap-weighting is equal-weighting, a methodology that gives an equivalent allocation to all components of an index. In addition to breaking the link between stock price and weighting, this strategy will generally provide greater diversification than cap-weighted products by ensuring that the portfolio is not dominated by a small handful of mega cap stocks. While the difference in weighting methodology may seem minor, the impact on total return can be significant; through November, the S&P Equal Weight ETF (RSP) was up about 12.5%, or more than 500 basis points better than the cap-weighted SPY. RSP and SPY hold the exact same stocks (components of the S&P 500); the only difference is in the weighting assigned to each.
Given the tremendous interest in emerging markets–as well as the relatively straightforward argument for embracing equal weighting strategies–it is no doubt a positive development that investors now have an alternative to the cap-weighted EEM and VWO.
4. Lithium ETF (LIT)
Achieving exposure to commodities through stocks of companies engaged in the extraction and production of the materials has become a popular investment strategy, one facilitated by a surge in the number of products included in the Commodity Producers Equities ETFdb Category. ETFs have also been a popular option for investors looking to capitalize off of a shift in domestic energy policies, with options offering exposure to all types of alternative energy sources. LIT is at the crossroads of these two trends, backed by an investment thesis that focuses on an increased demand for an important metal already used in a wide variety of “next generation” technologies.
Lithium is one of the lightest metals, and when processed has the potential to store electric energy more efficiently than virtually any other material. Because efficient energy storage is required for all types of green energy products – ranging from electric cars to wind power – demand for lithium is expected to gradually climb as the energy equation shifts away from crude oil and towards renewable sources.
Lithium, a highly reactive metal, isn’t traded on any commodity exchange. And most companies engaged in the extraction and production of lithium are either mega caps that derive only a minor portion of their revenues from lithium or junior miners who aren’t necessarily close to production. LIT is linked to an index that includes multiple points along the supply chain; exposure is split between miners, companies that produce lithium, and firms that sell or manufacture lithium batteries. In this manner, LIT offers a creative way to invest in a hard-to-reach corner of the market that could be a major source of growth going forward.
5. BulletShares Corporate Bond ETFs
Bond ETFs were slow to gain acceptance among investors, in part because of these securities result in a very different investment experience than holding the underlying assets. Whereas individual bonds have a maturity date at which capital is returned to investors, most bond ETFs operate under an indefinite timeline; proceeds from maturities of underlying holdings are reinvested (or assets are sold when they move out of the related index). An investor could, for example, buy the Barclays 1-3 Year Treasury Bond Fund (SHY) and hold it for 20 years. If the same investors purchased the underlying holdings of the fund, the assets would convert to cash over the next three years as the bonds reached maturity.
One of the most innovative new products in the fixed income ETF space is not a single fund, but rather a suite of target end date corporate bond funds from Guggenheim (launched when the firm was still Claymore). The BulletShares products are each linked to an index consisting of investment grade corporate bonds maturing in a certain year, ranging from 2011 (BSCB) to 2017 (BSCH). As the underlying securities mature, the assets of the fund gradually shift to cash, which is distributed to to shareholders. So the BulletShares products are bond ETFs that act more like bonds, but still provide the immediate diversification benefits of ETFs by offering access to a basket of securities.
BulletShares don’t make sense for every investor, but they represent a powerful tool in the toolbox. These ETFs can be especially useful for investors managing a portfolio against future liabilities – everything from a family sending a kid to college in five years to a billion dollar pension fund planning for future obligations.
iShares also launched a line of target maturity date bond funds in 2010, offering exposure to municipal bonds expiring between 2010 and 2017. Guggenheim has a suite of BulletShares products in the junk bond space in the works; those could debut in 2011.
6. United States Commodity Index Fund (USCI)
Commodity ETFs have had an up-and-down ride over the last several years. After bursting on to the scene amidst praise for democratizing an asset class that has the potential to both enhance returns and smooth volatility (the Holy Grail for most investors), this corner of the ETF market quickly encountered some rather serious growing pains. Some investors began to express frustration with performance, noting that the returns generated by certain products often varied considerably from a hypothetical return on the spot price of the underlying resource (the most visible, and perhaps most illogical, critique came from BusinessWeek, which issued a blanket warning against investing in commodity ETFs).
This “performance gap” is of course the result not of a flawed product, but rather of the nuances of a futures-based strategy. When it isn’t possible to invest directly in commodities (the physical properties of crude oil make a physically-backed model difficult to construct), returns will depend not only on changes in spot but also on the slope of the futures curve. When markets are contangoed, funds that “roll” holdings on a regular basis can incur a roll yield that eats into returns – essentially running against the wind.
Enter USCI, a broad-based commodity fund linked to an index based on boatloads of research on commodity markets performed by a team of Yale professors. The idea is relatively simple: identifying commodities for which inventories are low. K. Geert Rouwenhorst Rouwenhorst, one of the academics behind the index, says:
This is something that follows from economic theory, in particular the theory of storage. When inventories are low, users of commodities may be willing to pay a premium for owning a spot commodity relative to futures prices in order to avoid facing a ’stock out.’ This premium is sometimes called the convenience yield, and can lead to a backwardated futures curve.
USCI screens a universe of 27 potential commodities, first selecting the seven resources showing the steepest backwardation or most mild contango and then rounding out exposure with seven more contracts based on momentum factors. The result is a dynamic, broad-based commodity basket that has delivered some rather impressive early returns. USCI debuted in August, and in the relatively short period since has crushed more established commodity products such as DBC and DJP.
7. Small Cap International ETFs
As the ETF industry has grown, funds offering exposure to nearly every major world economy have popped up; we now have multiple Indonesia and Poland ETFs, an Ireland ETF, the Vietnam ETF, and even a Colombia ETF (which just happens to be among the year’s best performers). Many of the “first generation” of international equity ETFs consist of mega cap stocks–collections of the largest publicly-traded companies from the particular country. Because these mega cap stocks are generally multi-national companies that generate revenues from around the world, they aren’t necessarily driven by changes in local consumption and the health of the local economy (Coca-Cola (KO), for example, is listed in the U.S. but now generates the majority of its earnings overseas).
Many investors have turned to small cap stocks as a better “pure play” on international economies, a shift facilitated by a wave of new small-cap specific international ETFs. Among those that launched in 2010:
- Canada (CNDA)
- Australia (KROO)
- India ((SCIN), (SCIF))
- Latin America (LATM)
- Taiwan (TWON)
- South Korea (SKOR)
8. PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB)
This fund wasn’t a new addition in 2010, but the PowerShares junk bond ETF got a major makeover during the summer. PHB was one of a handful of ETFs to switch indexes during the year, dropping a Wells Fargo benchmark in favor of the RAFI High Yield Bond Index. Many investors have become familiar with the RAFI methodology as an alternative to cap-weighting in the equity space, but PHB is the first fixed income ETF to embrace this strategy.
The RAFI methodology makes PHB different from other junk bond products, many of which give the largest weightings to the the largest issuances of high yield debt. To some investors, focusing on companies that maintain the most significant debt burdens doesn’t make much sense as an investment strategy, as companies with larger debt burdens will generally have a harder time repaying obligations. The index underlying PHB takes a different approach; weightings in RAFI indexes are determined not by the size of a debt issue or market cap, but by fundamental factors. In the case of the RAFI High Yield Bond Index, potential component securities are scored on four factors: book value of assets, gross sales, gross dividends, and cash flow – each based on five-year averages. As such, PHB will gravitate towards debt of higher quality companies with stronger cash flow metrics.
There is, of course, some tradeoff between risk and yield. Generally, the yield on PHB will be slightly less than those of JNK and HYG, the other junk bond products from State Street and iShares. PHB is essentially a ‘high quality’ junk bond ETF, falling somewhere between LQD and JNK on the risk/return spectrum. For investors looking to beef up returns without shifting too heavily into risky assets, this fund could make sense as middle ground.
9. Emerging Markets Consumer Index Fund (ECON)
Emerging market exposure has become an increasingly important portfolio allocation in recent years, and many investors have embraced ETFs as an efficient way to access stocks of the developing world. As mentioned above, the most popular emerging markets ETFs are dominated by mega cap companies that don’t necessarily exhibit a strong correlation to the local economy where they are listed. Another bias of many emerging markets ETFs relates to the sector allocation; because the largest companies in most countries are banks and oil companies, cap-weighted indexes tend to be heavy on energy and financials, while going light on consumer and technology sectors.
The case for the emerging markets consumer sector is a relatively simple one: as people move from rural areas of China, India, and other emerging markets into cities and take up non-agricultural employment for the first time, the middle class is growing at a tremendous rate. As quality of living rises and the newest members of the middle class are armed with disposable income for the first time, demand for autos, electronics, travel, and other discretionary items will continue to skyrocket. This demographic shift will of course translate into additional needs for energy commodities and banking services as well, but the heart of the very compelling emerging markets growth story relates to a growing consumer sector. Yet many investors who rely primarily on EEM or VWO for international exposure (these two ETFs have about $90 billion in aggregate assets) have little invested in emerging markets consumer companies, making ECON an interesting complementary option.
10. China A-Shares ETF (PEK)
Staying with the theme of rounding out exposure to emerging markets, the first U.S.-listed ETF to offer exposure to China’s A-Share market finishes off this year’s list. U.S. investors with China exposure in their portfolios likely have used N-Shares (companies listed on U.S. exchanges, including the NASDAQ, New York Stock Exchange, and American Stock Exchange, but that have their main business operations in mainland China) or H-Shares (companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange and denominated in Hong Kong dollars). Historically, there have been restrictions placed on A-Shares, securities are traded on the Shanghai and Shenzhen Stock Exchanges in renminbi, the currency of mainland China (sometimes referred to as the “yuan”). But in recent years, these restrictions have begun to ease; in 2002 Beijing launched the Qualified Foreign Institutional Investor (QFII) program, which allows approved foreign institutional investors to access the A-Share market. There are now more than 100 approved QFIIs.
A-Shares account for close to three quarters of China’s equity market, meaning that the introduction of PEK has made a huge portion of arguably the world’s most important economy available to investors. Moreover, Chinese companies listed in the U.S. or Hong Kong tend to be more mature firms that operate globally. The A-Shares market, on the other hand, is more likely to include younger Chinese companies that are driven by domestic consumption, and as such may be more of a “pure play” on the Chinese economy.
The exposure to the A-Shares market isn’t the only thing about PEK that is unique. The fund’s issuer (Van Eck) isn’t a QFII, so the underlying assets are not actual A-Shares but rather total return swaps. As such, investors are exposed to the credit risk of the swap counterparty (in the case of PEK, that counterparty is Credit Suisse). In addition, this ETF has recently been trading at a pretty significant premium to its net asset value, the result of insufficient supply of swaps to meet the market level of demand (because the supply of QFII approvals is limited, those with the status are able to charge a premium for exposure, and the arbitrage mechanism built into the ETF structure breaks down). So while there are some risks to PEK, the potential to access a previously inaccessible asset class presents investors with a unique opportunity as well.
Disclosure: No positions
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