Is WisdomTree Moving From ETF Evolution to ETF Pollution?

Further to recent articles by Tom Lydon we find continued interest in the exponential growth in ETF product development. The movement to more thinly defined sectors as well as alternative index weighting methods seems to be of great interest to many. Just yesterday I saw something from WisdomTree (WSDT.PK) about their upcoming earnings-weighted index ETFs.

I wonder what’s the longer-term plan at WisdomTree? They’re certainly pushing the envelope with arguments against market cap weighted indexation in favor of fundamental weighted indices. But with their first wave (actually, multiple waves) of product offerings, the focus was on ETFs whose underlying portfolio is weighted based on each position’s cash dividend payout. The question I have now is why the shift to ETFs that track an underlying index whose focus is on another fundamental factor – in this case earnings? According to the press release (.pdf) these new offerings are very similar to WisdomTree’s existing “Domestic Dividend ETF” lineup. For example, the first ETF listed in the press release is the WisdomTree Total Earnings Fund (EXT) which has a 28bps MER. It seems to be the exact counterpart to WisdomTree’s Total Dividend Fund (DTD) which has the same MER. Little surprise to me, the backtested performance of the two underlying indices do not have significant deviations as shown on this chart on a page (.pdf) from WisdomTree site.

Despite what seems like a potentially redundant new set of ETFs due to what could be future performance within very close proximity to existing ETFs (is cannibalization a concern?), WisdomTree does give some suggestions for how an investor may decide to focus on one factor over another:

How Do I Decide Which Approach Is Right for Me?

All of the WisdomTree ETFs provide investors with an alternative to market cap-weighted ETFs, and all are designed to be used as core holdings within an investor’s portfolio. If you are seeking the potential for income-generating yields and relatively lower volatility, you may want to consider the Dividend Family. If you are seeking broad market exposure or exposure to traditional sector classifications through companies with an earnings track record, you may want to consider the Earnings Family.

I’ll be very interested to see the growth of assets in this new family of earnings based ETFs. Even more interesting, I’d be interested to know what market environment would cause any sort of significant deviation between WisdomTree’s dividend based ETFs versus their earnings based ETFs. I’m guessing not very many situations. If so, my feeling is that this provides more fuel to the existing discussions of there being too many ETFs. As Richard Ferri of Portfolio Solutions LLC puts it:

“What I am seeing is a rapid shift from ETF evolution to ETF pollution.”

As Keanu Reeves so eloquently said in The Matrix, “Whoa”. The above quote is from John Spence’s recent article “ETFs wade into a dead pool”, he puts out an argument that suggests a significant market decline could not only slow down ETF product development (he suggests consolidation and I’d buy that), but also close down some as well. I’d buy that too but to a lesser degree.

Let’s be honest. Fund manufacturers including ETF providers are just as bad market timers as any other investor. TD Asset Management up here in Toronto had to close their ETFs a few years back. They had a nice lineup of ETFs with broad market exposure to Canadian equity markets even with some value and growth biased ETFs and this was at a time when ETFs weren’t considered to be so “weed like”. Perhaps Canadian investors just didn’t have the will to accept the passive approach at that time to warrant product offerings beyond what Barclays had already been providing the market. But we also saw the same with a small US provider of bond ETFs. They didn’t last long either. Clearly, many of the new niche funds are providing investors access to markets which are hot and at or near their all time highs. Furthermore, the fact is that nearly all markets are at or near their highs. Beta is hot and thus ETFs are the flavor of the day. If we were in a 1970s-like environment we would surely see less interest in ETFs and more interest in hedge funds and defensive strategies. Perhaps even more likely the popular choice would be term deposits … I’m thinking an environment like the beginning of the 1980’s when no one talked about the stock market.

But we’re in 2007. After the risk taking environment of the late 90’s to the sudden risk aversion during and immediately after the bear market of 2000-2002 and the shift to “risk management” thereafter (Basel, Sarbanes Oxley, growth of hedge fund use, etc.) we find ourselves now again at a time of relatively high risk taking. That’s what a four and a half year bull market and VIX down to 10 does to the collective psyche of the global investing public. By the way, have you seen where VIX has been in the past week?! And don’t think that the Bank of Japan’s 25bps rate hike changes the carry trade situation.

It’s also little wonder that hedge funds are having a hard time finding stocks to short. Actually, it kind of sounds like value managers in the late 90’s saying they can’t find good stocks to buy. Shorting is a tough sport in today’s environment. The stock you might want to short could be the same one Carl Icahn is looking to take private, turn around and resell to the public market. It’s tough to be a hedge fund these days. They’re dying to finally get some decent performance fees. They need a bear market badly. Whether they actually do well in a future bear market is another story. Some will and some won’t. Maybe cash really is king. But until then, ETFs are king.

Unfortunately (or fortunately, depending on your view of monarchies), Kings get dethroned. Spence has a heading within his piece called “Shades of 1999”. He doesn’t mention this but it made me think if the ETF explosion could be compared to the dot-com bubble. Well in the one case you have money chasing various asset classes or sectors. In another case you have money chasing stories with no fundamentals to back them up. A broad generalization but enough for me to think that it’s not the same. Still, we’ll definitely see some ETFs disappear as Spence has given some examples similar to mine above. I don’t think it will be like all the tech mutual funds that closed up during the bear market. The King may get hurt, but I don’t think he’ll get dethroned.

What I don’t think people realize is that ETFs are not for the buy-hold investor. They can be; but the direction or trend of the industry is focused towards the more active investor who either prefers a slightly more tactical rather than strategic asset allocation framework or the investor who wants to do some sector rotation … or in fact a multitude of other active approaches including hedge fund like strategies.

Can’t it be possible that there is a level of “micro” efficiency within asset classes such that ETFs provide an ideal, or at least preferred, means for exposure whereas in the more broad “macro” world there can be a significant of overall global inefficiency such that some active management of positions (whether ETF or not) is required?

If so, then the active management of ETFs has some merit. The level of comfort, proficiency and experience as well as other factors will determine to what degree of activity one will allow for their own portfolio. Again, it’s good to have ETFs so as to allow investors that choice. If there is to be a concern, the concern should not be about instruments such as ETFs, but for the overall risk appetite in aggregate within the investing world and what repercussions that may have in a much broader sense if things turn for the worse.

Comments

[Panskeptic]

It is interesting to note how many boosters of free-market capitalism have turned faint at the prospect of ETFs closing for lack of interest. Exactly what is wrong with throwing investment concepts out at the public and letting the weak ones die? Isn't this the "magic of the market" at work?

I think some advisors prefer passive index ETFs so they can take all the credit for alpha. If you have to say part of that tasty wholesome goodness belongs to Powershares, Wisdomtree, Claymore or First Trust, there's less to pat yourself on the back for.