Questioning the Value of New ETFs

by: Richard Kang

Let’s do a quick review of recent ETF developments:

1. Tom Lydon at ETF Trends gives notice of some new SPDRs that were launched Friday covering various emerging market regions. Here’s the press release from State Street Global Advisors.

In a post from February 16 entitled “All In All, It’s Just Another BRIC In The Wall”, I argued that for most investors, broad emerging market exposure could be done simply and cost effectively with maybe just two positions. In a February 14th posting, entitled “Is Emerging Market ETF Slicing and Dicing Necessary”, I suggested that funds focused on specific EM regions could be used for opportunistic trading including possible shorting in times of distress. And back on October 2nd of last year I argued that “More Regional Emerging Market ETFs Are Needed”.

Bottom line: There must be a market for these, as SSGA seems to be hitting some highly selective areas in recent months like infrastructure, international real estate and now these new emerging market ETFs. Somehow I don’t think the average investor, even the more experienced ETF-based investor, would be a strong proponent for use of a Mideast/Africa ETF or some combination of these emerging market funds. It’s got to be highly active professional investors like hedge funds, prop desks, mutual funds and even the internal asset allocation desks of large pension funds. Clearly, ETFs are not for mom and pop’s basic do-it-yourself retirement portfolio.

2. Next, we get news from Matt Hougan of of a “hedge fund replicator” ETF. In fact, it is to be “… a suite of synthetic hedge funds strategies, which will use portfolios of ETFs to track the performance of the ten investable Tremont Hedge Fund sub-indexes. The group plans to offer low-cost mutual funds and separately managed accounts that will track each of the ten indexes.”

So, the plan as I read it is not for ETFs with underlying hedge fund strategies but a mutual fund or separately managed account format with an underlying portfolio of ETFs that in combination will attempt to replicate the performance characteristics of certain hedge fund indices. Get it? At first, from reading the title from Seeking Alpha (”IndexIQ To Release ‘Hedge Fund Replicator” ETFs At Fraction of Cost”), you think an ETF with an underlying hedge fund is about to be released. In fact, it’s some other form of fund with underlying ETFs to mimic hedge funds. Clearly, the intersection of ETFs and hedge funds, as I’ve been repeating so often over the past few months, is something that will happen and in so many different ways.

3. One of the more common forms of such intersection is the hedge fund with underlying ETFs being used in an opportunistic fashion. It seems like one such new fund or mandate is popping up every day. For example, news of Morgan Stanley Investment Management’s former CIO starting up a hedge fund with other sell-side departees can be found here. According to the article, “The fund implements positions through futures, exchange traded funds, and customized baskets of securities” and will take long and short positions. Although not specifically mentioned, there will likely be use of leverage through the futures positions.

4. There are various other developments including life cycle funds that rebalance underlying asset classes based on some pre-determined retirement date. This seems to take most of the fun out for the “do it yourself” investor but I can see a market for these. Just as ETFs will likely take a big chunk from the mutual fund market, these ETFs may do the same to the wrap market.

There’s also news of an upcoming natural gas ETF. Why is it that I thought of nothing but Amaranth when I read about this?

This all follows ProShares’ massive set of levered and inverse ETF launches in February. All in all, this point and the three points previous to this point to the same direction: ETFs are built for active investors who are using beta as a means to obtain alpha. That could be in the form of searching for returns all over the world. It could be hedging (shorting) opportunistically. It could be used for long-short or GTAA strategies or even for some form of replication strategy. It could mean countless ways of extracting alpha.

5. I noticed this advertisement on one of the many ETF related sites I read:


No comments really. You can come up with your own.

Time For Caution

We’ve already heard from various sources that the ETF industry, at least in terms of the number of ETFs, will likely double within the next year. Who knows about the growth in assets, but I think it’s fair to say it will increase even if there is a significant market decline. But are we close to the final destination? Are we there yet? I don’t think we’re even close. But only now am I beginning to question the value of new ETFs coming on line.

In the past, there were a few ETFs that occasionally would give me reason to question their purpose. However, most have done well in terms of asset growth and trading volumes. I have greater reservations now about certain ETFs coming out now. There aren’t many, but I just don’t have the comfort level I had in the past. I’d like to think that the decision makers at the ETF manufacturers are launching products based on sound market research and overall business planning. That’s not where I have much doubt. I don’t want to dig into too much detail right now about which ETFs I think might not survive and the various banana peels I see or sense within the ETF industry. I’ll save that for a future posting.

Oh, and I haven’t even gotten to news of Bear Stearns’ SEC filing for an actively managed ETF.

Bottom line

I think we’re right about at the tipping point where the ETF industry has fundamentally changed. My bet is that the global capital markets don’t provide anything close to returns we’ve seen over the past four years or in the 2nd half of the 1990’s. Many may believe that, if my forecast is true, the ETF industry will lose its momentum.

I believe that this sort of environment (whether flat overall or down over the next ten years) will be strong for ETFs. In a sideways or downward secular market, actively managed mandates especially hedge funds should do well. They certainly won’t all do well… in fact, the majority may not do well at all. But overall, the hedge fund industry should grow in terms of number of funds and asset size. If the hedge fund industry were to increase in that manner, as it surely would in that environment, so would use of their tools, that being primarily derivatives as well as ETFs.