This was definitely a bigger event than the one I was at in New York three weeks ago, although many have told me that the biggie is the Superbowl of Indexing held every December. I’d like to attend that one later this year and my hope is that it really goes beyond just ETFs. But here are my thoughts on this 1.5 day event that was completed on Tuesday.
1. I get the funny feeling that this industry doesn’t really know where it’s going. That’s just my first impression after having been to two ETF related events in the US and having not been to any previous to that. I had some assumptions prior to this month. They’ve changed a bit. This doesn’t mean that the ETF providers are a bunch of monkeys who are randomly throwing ideas at the wall everyday. There is an exceptional amount of innovation being demonstrated in this field. But you kind of get that funny feeling … my spidey sense says that there may be a need for some caution as I first stated in my previous posting.
2. What I don’t like about these events (I know, sounds like this Kang guy wants to diss everyone!) is that it feels like one big “pat on the back” party. Everyone is so gung ho about ETFs with relatively little in terms of questions/analysis/criticism about anything. There were a few from the audience who asked some very good questions and I made it a point to continue to talk with them. It’s not that I’m looking for trouble or wanting to criticize anyone I can just for the sport of it but like mutual funds, hedge funds, pension funds or any sort of product or service, there are flaws. Not everything works for everyone. Sometimes a particular product or service may work for a very small number of users. Bogle is at one extreme where he says that something like SPY works for everyone and all investors should hold very broad exposure, low cost instruments. Nothing is absolute but I think he’s more right than wrong. At the other extreme is the highly niche sector ETFs or new strategy ETFs with an underlying rules-based methodology that don’t seem applicable for many investors because of specifics related to their portfolio construction process, risk tolerance, level of experience/knowledge, etc. There’s certainly a market for these funds and I’ll get to that later. Like I’ve said many times before, investors have no interest in seeing the smaller ETF players disappear. Nothing against the big names like BGI, SSGA and Vanguard but a more robust group of providers is good for the industry in so many ways. The innovation they provide is more than enough, I think, to keep the big guys on their toes and that’s a good thing. I think that most investors and product developers realize this, of course. But my point here is that these new niche/strategy ETFs need to think about how they fit in the larger portfolio construction process. I’ll also dig into that a bit later.
3. During my time in Miami, I was given the opportunity to see things at a much different level. I will in no way get to specifics but, likely due to my written work online, various index providers (or quasi-index providers) as well as ETF manufacturers approached me with questions about their investment methodology, or proposed ideas, as well as wanting my thoughts on their business model. There were many more of these impromptu meetings than I ever would have guessed. Again, I can’t talk about anything specific. But there’s a pipeline and it’s going to be flowing with new products for a while. To those who have written that things are getting out of hand with the number of new products, beware. You are both very right (there’s a lot) and very wrong (your call about too many ETFs may be premature).
4. Kudos to the many retail advisors I met and heard from at the event. They demonstrated a level of product knowledge that I wish existed here in Canada. There are those in Canada with the same level of acumen in this area, just not as many. I mentioned publicly during one of the Q&A sessions that I don’t consider myself to be an expert in the retail space. But I know enough that the fee based advisor is the ideal target market for the ETF wholesaler. Their holistic approach to portfolio construction based on the fundamentals of asset allocation lead well to the use of ETFs. Their processes are usually quite simple, although in my opinion perhaps a bit too dependent on optimizer software programs. However, I don’t know if the retail high-net-worth advisor is the main conduit for ETF sales anymore. Perhaps in the past they were, but I’m guessing not as much now. My arguments of the past have made me speculate that it’s the hedge funds and other professional/institutional traders who are the real users of ETFs and that’s why we see the large volume of trading in ETFs. The retail advisor sector may be significant, but I don’t know if they’re the biggest piece in the sales pie. But let’s just assume they’re very significant. They build their client portfolios and diversify between equities, fixed income and cash. The equities may be further broken down by any combination of regional, sector, market capitalization, style and other classifications all of which are nicely covered by the ETF universe. The fixed income component will likely have a combination of a laddered bond portfolio along with some additional bond mutual funds and/or ETFs. Perhaps some alternatives like a gold ETF, REIT ETF, or some other exposures are thrown in to provide added diversification which many may assume, rightly or wrongly so, to provide a certain degree of further volatility dampening. OK, that’s not too bad. Not perfect, but not bad. So the question now is where do the newer ETFs come into play within this mix. The strategy based funds (WisdomTree, PowerShares FTSE-RAFI, perhaps some of the more black-box based funds) can be used as either a compliment or substitute for the traditional SPY-type holdings. Everything else I see as even more of an active bet. Let me say this again this way: The moment you decide to invest in a Russian ETF, an agricultural commodity ETF, a cancer related ETF or other relatively narrow focused fund, you are attempting to behave more like a hedge fund than a traditional asset allocator. I wouldn’t be surprised to hear some arguments against this and I can guess some. First, even an asset allocator is making active bets. The decision to be 60% equity/40% fixed income versus 60%E/40%FI is an active bet. But you’ll agree that the degree of “activeness” isn’t the same. Second, there could be some arguments within a well thought out portfolio construction process for the addition of a niche ETF and I have written about some in the past. One example is adding alternative energy as a possible hedge for investors with high traditional energy (oil) exposure. A short ETF in this space like the one from MacroShares would serve a similar, although much more direct, purpose. But it comes down to the advisor/investor and their view of the asset allocation decision. Strategic asset allocation will generally not require use of these narrower ETFs but they could be used sparingly. Move to tactical asset allocation and then the argument for their use is strong. I’m not saying that narrowly focused ETFs including the ones mentioned above are not good. I’m just saying that for the vast majority of advisors who are building relatively simple portfolios with minimal active calls, these kind of ETFs will provide little value and thus will have limited use for them.
5. Therefore, the newer niche funds and strategy funds will likely have a smaller market in terms of interested investors. Furthermore and let’s face it, with more and more product, it’s getting harder to differentiate yours versus the competition. In the case of the newer ETFs, the low cost isn’t the selling point. It’s the idea. So, further to point #4 above, the newer and more narrow ETFs will have to search far and wide for their target market who agree with the idea(s). It’s not going to be based on the typical retail advisor/investor. It may not even be the large hedge funds as they will likely only use the ETF when the derivative contract for the same exposure does not exist. So who’s left? The smaller “emerging” hedge funds like the ones recently publicized in the press that are to be included in the large CalPERS portfolio. Many of these funds have investor capital of less than $50 million. Derivatives may not work all the time for such smaller funds and ETFs can fill this gap. The internal trading desks for some institutions, like pension funds, may also have use for these. After measuring the exposures among their external asset managers in aggregate, they may notice that they are over or underexposed to a certain sector or region beyond acceptable parameters. If their policy guidelines do not allow for the trading of derivatives, their only choice may be ETFs. I can knock off about a half dozen other potential targets but I’m sure the ETF wholesalers are already on the golf course with them. Bottom line: The relatively easy (it’s never easy) ETF sales and marketing effort is going to get much tougher. Even for something as elementary as fixed income ETFs - it won’t be an easy sell. I commented during the fixed income ETF session on Tuesday about my doubts for the suggested acceleration in growth in this area. After clarifying our statements after the session, the moderator and I agreed that delivering the message and leading this to sales would not be an easy task. And we’re basically talking about the treasury/bond market that is no small entity!
So where does that leave us? ETFs as an asset allocation tool has been done. It’s a saturated space with more than enough S&P 500 ETFs and index mutual funds to go around. Investors of all kinds are looking into different ways to use beta instruments. I received the usual morning email report from JP Morgan today. Here are too short excerpts:
“ETF volume is accounting for 26.92% of the $ volume traded on the NYSE and AMEX, suggesting selling of individual positions is not accelerating.”
“Accounts appear to be using index proxies like the SPY’s to hedge positions rather then selling into strength.”
So it seems like there’s a lot of defensive posturing going out there. Bogle says everyone should be using something like SPY. It seems like they are but in this case we see a lot of people using them for shorts to hedge their stock based portfolio. This is great. They are sticking to their knitting by remaining long-term in focus … that’s why they’re holding onto their positions (It says above “rather than selling into strength”). This is like what I’ve said in the past about investing in emerging markets with a methodology based on securities selection but with the occasional use of shorting EEM or VWO to hedge risks when the market tanks. So in a way investors are listening to Bogle about using broadly exposed, low cost ETFs. The problem is that they’re being creative in their use. Hey, it’s all about taking one form of risk in place of another. Isn’t that what we’re in the business of: valuing risk?
If so, then plain vanilla asset allocation strategies and portfolio construction based on that, is not enough. It’s not a bad start but for many reasons, including the increasing correlations among asset classes, investors need to consider potential extra steps. We can see this in the institutional space. This is an interesting article from the Global Association of Risk Professionals website.
The article describes strategies that institutions are adopting to allow their current processes (asset allocation, risk budgeting, manager selection, etc.) to be more appropriately in sync with their liabilities. This brings new frameworks to constrain the portfolio process:
“According to the results of Greenwich Associates’ 2006 U.S. Investment Management Research Study, the departure from traditional pension management practices is most evident in the increasing popularity of innovative products and techniques such as liability-driven investment strategies, absolute return strategies, portable alpha and net-long approaches such as 120/20 and 130/30 strategies. “Although actual usage of these products remains relatively low, there are signs that the current period might well represent the calm before the storm,” says Greenwich Associates consultant Rodger Smith.”
Absolute return strategies, portable alpha and 130/30 strategies right away brings us closer, if not right to, the hedge fund space. If not full blown “hedge fund” (whatever that means), at least we’re seeing a greater acceptance for purer active management. This is exactly what the ETF industry is trying to do. With all of the new products coming out, it is an attempt for the ETF industry to become more and more active … or less and less passive. It was never purely passive. But now even less so.
But I don’t see this as the only future of the industry. Based on what we see here from the institutional space, what the ETF industry needs to do is package ETFs in a more meaningful manner. It was repeated so many times at the conference: “ETFs are just a tool.” That’s right. So build some kind of process where ETFs are managed in a thoughtful way. We’re beginning to see this with lifecycle funds and managed programs from groups like XTF Advisors. My front page article on the latest issue of the Exchange Traded Fund Report [ETFR] talks about building your own 130/30 fund using levered ETFs. It can also be considered a play on portable alpha or a form of index plus. What about building some online platform where investors could choose their beta source for a particular asset class (something like SPY or a levered version of it) and overlay this in some manner with an alpha oriented program (hedge fund replication ETF, long/short ETF overlay, etc.)?
It sounds easy and of course it very much is not. Building an effective alpha oriented program in this manner is like trying to build a stealth bomber using paper airplane technology. But it’s the concept of packaging different kinds of ETFs in creative ways that I would hope to see as the next logical step in the evolution of this industry. Active management of beta to create alpha seems logical. Perhaps more logical than the need to have actively managed ETFs.
I’d like to put in a few short thoughts on the two panels I was involved with at the event. I moderated a discussion on alternatively weighted indices. Clearly, Srikant Dash of S&P, Steve Sachs of Rydex and Ken Marschner of UBS have that unique view from the inside that others need to discover to fully understand the scope of the situation. Although we’re seeing a massive bombardment of new indexing methodologies, it’s still too early to say that traditional market cap weighted indexing is on its knees. Whether in the retail or institutional space, the numbers are clear … in terms of assets under management, the traditional form of indexing is still strong and it will take a long time, if ever, for alternatively weighted indexes to even come close in terms of acceptance. Further proof that the spidey sense may be working with regard to newer ETFs.
The international/BRIC exposure discussion led by Tom Lydon of ETF Trends was fun. John Prestbo’s one-liners are great … hey, it’s a conference on ETFs … talk to 99.99% of the population on the subject and they’re already snoring, so thanks to John for adding some fun to the mix. Like John at Dow Jones Indexes, Corin Frost of BGI and Harmut Graf of the Deutsche Boerse clearly have the international insights based on their respective perches and was demonstrated through their comments. My views were relatively limited as I see international exposure from a Canadian perspective. It’s good to hear from an index provider, ETF manager and another foreign observer on how they see international exposure. I was happy to see that some attendees had reservations on the viability of the BRIC story … it’s healthy to challenge new ideas and products related to them. But the panel (including myself) seemed to be in agreement that the long term story is very strong although volatility will definitely test the strength of investors’ stomachs. If you don’t have a risk budget governing your investment process and you’re investing in emerging markets, buy the Maalox now. If you had significant EM exposure last summer then you’ve likely already restocked the meds in preparation for the next sharp decline.
Lastly, many thanks to all those that I met at the event in Miami. The overwhelmingly positive response to my work is greatly appreciated and also humbling. As a blogger, you don’t really have all the information. You can gauge how many are visiting your site and you get some commentary, but you don’t really get the real response until you’re face to face. I appreciate the feedback and of course, highly value constructive criticism. Furthermore, if there’s an area of beta (not just ETFs) that you’d like me to focus on, please send a note.
Thanks again to all.