Evolution and Defensiveness in the ETF Industry

On Tuesday March 6th and Wednesday March 7th I attended and participated in my first ETF conference in the US. At the “ETF Evolution 2007” in New York, I learned quite a bit. The news from Amex regarding actively managed ETFs especially got me and a lot of people up and alert giving that it was near the very end of the event. Some of my thoughts after having given a week to mull things over:

First, this industry is small. Well, truthfully this event was rather small, but there are a relatively small number of participants in terms of organizations in the ETF manufacturing business. Of course there are the giants like BGI, SSGA and Vanguard. They were keeping a low profile at this event since it was about the ETF “Evolution” … and more like evolution away from what they do. I felt rather bad for the guy from BGI who was taking some shots from others in his panel where the discussion was on new ETF indexes. He seemed to take it well and I think it’s a fair metaphor for the 3 large firms. They’re comfortable now. But they have to admit that the growth of the industry is pushing against them.

What I’m talking about is the move away from the origins of classic passive investing. The broad consensus at this event seemed to be against the thought of investing in the CAPM framework. Thus, building portfolios based on market cap weighted indexes seemed to be generally out of favor to the benefit of alternative weighting schemes such as equal weighting or the various forms of fundamental weighting. Of course, market cap weighting is not dead as the push to international exposures and niche sectors usually still leads to this traditional weighting method.

I was very interested in listening to the index providers speak. They’ve had to significantly change their business model. I know first hand that the large index providers have put much less attention on the traditional business of providing benchmarking related services to pension funds – “been there, done that times infinity” … I’m pretty sure kids don’t say anything like that anymore. Instead, index providers are highly focused on building new indexes specifically tailored to ETF manufacturers. Maybe it’s not the dominant revenue generator in their business but it is an interesting shift. Just imagine going in for an interview at one of these firms. Instead of asking you about a broad US equity index, what if they instead said “So, give me a few ideas on a market exposure that you think could be engineered effectively yet sell to plug a space that needs exposure?” Sounds more like the “Give me three ideas” question you would expect from a hedge fund or prop desk. No shock then of news from most, if not all, of the big index providers about massive numbers of indexes coming on line in the near future. I’ve written in the past about Russell.

There’s been talk (not at this conference, of course) about the ETF industry looking a little “bubbly”. My only comment here is that, if true, we’re still in the very early stages. There are, at most, about a dozen small ETF providers each slowly building their niche in this space against the big firms mentioned earlier. The way I see it, we would first need to see many more new participants for me to think of this as being anywhere near bubble territory. Next, we’re starting to see merchant bank/VC type firms entering the picture to help finance startup ETF firms. But I know of only a couple of situations. There’s a lot of product out there but the numbers tossed around this one conference speak of a magnitude of new offerings that could see a doubling of ETFs within the next year. This event was quite US-centric so I will have to wait until the World Series of ETFs conference in Miami in a couple of weeks. Let’s say, that there’s a doubling in the number of ETFs globally over the next twelve months. That would certainly be interesting, but the key factor would be the corresponding values for assets under management. If we get into the same habit as mutual funds with a high proportion of ETFs versus the total assets invested in them, then I would agree that a problem exists and we could see some fund closures as a result.

However, with so many ETFs domiciled and focused on the US markets, it’s clear to everyone that the future expansion of the ETF industry will be based on international exposures. And I’m not talking just about super broad exposures like the new Vanguard® FTSE All-World ex USA Index Fund (VEU) or State Street Global Advisors’ SPDR® MSCI ACWIsm ex-US ETF (CWI). As neat as these are for those building a highly simplified core portfolio, the real demand is coming from investors who wish to be more nimble with their decision making. International exposures by region and sector still have some gaps that can be filled. We’re seeing the first shot at moving away from market cap weights in overseas exposures from firms like WisdomTree. Although shorting is a possibility as well as options (but not as robust a list as I’d like), there is still a gigantic void in terms of inverse ETFs for international exposures as another line of defense. Hey ProShares and Rydex: Before you completely super-saturate the market with a hundred more or so US-centric levered and short ETFs, what about a few for international markets?! Even an EAFE based fund and one for emerging market exposures would be nice to see. SEC hoops for these two can’t be that tough to jump through. Perhaps some locals have made their own levered/inverse ETFs for their home market. For example, BetaPro ETFs here in Canada have ETFs for both long and short exposure to the S&P/TSX 60 Index, both with 200% exposure.

I want to come back to actively managed ETFs. I’m not sure if it’s the biggest thing in the world to have this next step in the evolution of ETFs actually occur. We’re doing all right with ETFs on the passive side and closed end funds with underlying active strategies. There are flaws, as everywhere, but anyone can build a pretty darn good portfolio just with ETFs and CEFs (throw in some cash, certain futures and option contracts and then I think you really have all you need). The move to push away from market cap weight exposures is, in my opinion, the industry’s initial attempt at moving towards active management. I’ve discussed in previous posts my opinions on new rules-based ETFs and my belief that they’re not active management and thus they do not provide what I would call “alpha”, in a philosophical sense. However, if the numbers (historical backtests!) show some outperformance relative to market cap weights, then the related ETF providers will make their case for “statistical alpha”. And their case will always be strong as no one builds, and reveals, a historical backtest that sucks. People brag about their kid at U.Penn, not their kid at the state pen.

So, if what was introduced about actively managed ETFs in New York, and hopefully will be expanded further in Miami, is true and in full throttle, where will this take the industry? One participant at the conference mentioned that it wouldn’t make sense to see ETFs with an underlying hedge fund strategy as hedge fund managers wouldn’t go for the low management fees. True, hedge fund managers would see their fees cut to something probably close to a quarter (at best) of what they receive now. And I think this actually argues in favor of hedge fund strategy ETFs. If ETFs are about providing exposures to replicate the performance of a particular benchmark, region, sector or even strategy (anything from WisdomTree, Claymore’s new ETFs built with Robeco and I can name many more rules based products), then why can’t there be an ETF with an underlying hedge fund replication strategy especially considering the modern and informed investors’ loathing of fees especially if and when little value is demonstrated by the manager? Merrill Lynch, Goldman Sach and JP Morgan are three I-banks already promoting their work in this new space. A few smaller, yet still very significant European firms are equally, if not more advanced in their product development work. And their concept is the same: Build a product that replicates certain hedge fund strategies in a manner that can provide a low cost means for investing. I’m not saying that things will move this way next week or even this year. But if there’s anything we’ve seen in the ETF industry over the past few years, it’s that providers are finding ever more clever ways to introduce new and unique exposures to capital markets. Hedge fund strategy ETFs are just one example. I’m sure there are dozens if not hundreds of other ideas being considered today.

Lastly, I want to consider down markets or a potentially more serious bear market which, no surprise, was not a big topic at the event in New York last week. Let’s say we get whacked by a big one. Either something like 1987 or even worse, a longer more drawn out and painful decline. Well, if it brings us back to where we were in the early 1980’s, investors will be as unenthusiastic towards ETFs as they would be towards any other instrument as well as the markets in general.

But let’s just say that we’re in a period where we’re simply going to experience several down markets (who knows how often or the decline) very similar to what we saw last summer. Further to that, it’s almost irrelevant if the overall curve of the markets bends flat relative to the growth we’ve seen over the past few years or if the markets continue to zoom up of if it crashes. The question to ask is: Are investors well served by having a portfolio with a fairly standard asset mix consisting of a very small number of ETFs each with fairly broad exposures and focused on extremely low costs? I’m thinking about the countless “model portfolios” that hold something like ten or fewer ETFs.

I’m as big a fan as anyone of many of Vanguard’s ETFs, as well as some of BGI and SSGA’s broad ETFs which are dirt cheap. But simply adding a REIT ETF, a gold ETF and a few fixed income ETFs doesn’t make the portfolio protected. The unfortunate reality (Al Gore’s title sounds better) is that diversification won’t save your skin in today’s world. Not only are correlations among the vast majority of asset classes high, they spike at times of distress. Even asset strategies (hedge funds, private equity) don’t have the same diversification benefits they once had. I heard someone once say that diversification fails when you need it the most. This doesn’t mean that we all have to be market timers although there are various degrees of timing. When Warren Buffett says he can’t find good companies to buy and builds up his cash position, is that timing? The oracle believes in “buy and hold” but waits to buy in when the time is right. Moving into cash and potentially parking in a fixed income ETF or even a currency based ETF can be considered one form of defense.

What about sector rotation to re-allocate based on changes to the economic cycle? The new sector based ETFs could be used more for protection than for opportunistic and aggressive trading. What about fundamental based indexing? Doesn’t it just make sense that in times of market stress you would want to be more heavily exposed to companies that pay more dividends, have better earnings (assuming SarbOx is working and no one’s pulling an Enron) or are a function of a combination of various fundamentals? Of course, inverse ETFs in addition to outright shorting of ETFs is like a last line of defense.

Trade ETFs like a hedge fund and you can be aggressive with a somewhat shorter term perspective and a ton of choice. Construct a portfolio with defensiveness in mind, and there are also many ways that you can see the current ETF evolution as more of a solution than a problem.

Comments

[Panskeptic:]

Nice post. Well done.

2007 Mar 13 11:13 AM

[lony:]

I read all ETF related Alpha posts.
Most report facts as they occur.
Mr Kang's approach is very different, reporting but with arguement and extrapolation.
Keep it up.
Look forward to your report after the Miami conference.

2007 Mar 13 07:13 PM

[bigjohn_hk:]

Mr. Kang mentioned ETFs and CEFs . What are CEFs? thanks

2007 Mar 14 02:53 AM

[Richard Kang1:]

Thanks PS and DHL. BJ: Think of closed end funds (CEFs) like an ETF in that in trades on an exchange although the underlying strategy is not based on an index. Instead there is a manager who applies some form of active management for the fund. One of the key differences between ETFs and CEFs is that CEFs may have a price on the exchange that deviates significantly from the net asset value of the underlying fund. This premium or discount value is given in various online sources like Yahoo Finance or Google Finance along with the price. CEFs are key considerations for me because sometimes an ETF is unavailable or simply not preferred over a comparable CEF. For example, as much as I like infrastructure as an asset class, and you know I'm a proponent of ETFs, I'm not so keen on the new infrastructure from SSGA. It's not that it isn't good. It's just that certain CEFs from Macquarie traded on the NYSE (MGU, MIC, MFD) may be better choices. If you're willing to accept the added variability (active manager risk) beyond ETFs, then CEFs are worth considering.

2007 Mar 14 12:14 PM