ETFs, Commodities and Dubai

 |  Includes: GAF, GLD
by: Richard Kang

Just got back from yet another conference and, no surprise, it covered the current hot topic: commodities.

Speaking of hot, this event was in Dubai. I’ve experienced some hot and humid conditions in my life in places like Manila, Seoul, Singapore and Hong Kong. But this was by far the hottest climate I’ve ever experienced. It was a dry, baking heat. When outdoors, finding shade helped and certainly the buildings had great air conditioning. But, for example, I had my cousin who lives in the city take me around the gold (souk) market. Getting out of the car into the sun was incredible. It felt just like a dry sauna. And they say it’s just the beginning of the hot season! Luckily, the hotels, office buildings and shopping centres are all so luxurious that climate does not have to be a concern. With most taxis I rode in being a Lexus, you get a sense of what this city is about. Never mind the Burj Al Arab hotel, indoor skiing and other obvious signs of excess.

A quick comment on the souk. It’s all about gold there. Prices are quoted daily and there are people buying. I wish I was in Dubai six months ago and a year ago to get a handle on the number of people transacting. A good sign was at the retail section of the Dubai airport (departure section). They had a gold merchant right at the centre when you pass through the last security checkpoint (I think my carry on luggage was scanned only twice which is hopefully enough). Unlike the real souk market which was not empty but certainly not busy, this place was packed! And people were really buying. They didn’t look like momentum traders nor supermodels but everyday travelers. Maybe they know that gold is back to where it was near the beginning of the year:

Or more likely, maybe they knew better than me than to take the heat and walk the outdoor souk.

From the moment you cruise into Dubai International or drive into downtown, you can’t help but notice the construction. It beats Las Vegas, Miami and other real estate bubble regions of the US. It kind of reminds me of Seoul when I first went there as a youngster in 1979. My bet is that Dubai will want to host an Olympics … but they’re held in August and if that’s still the hot season I just don’t know who could survive the marathons, triathlons and other outdoor events. Still, you can’t help but sense the feeling of ambition in Dubai. For some reason, a lot of the new buildings going up have the number of floors in the triple digits. Excess is a relative term when you’re in Dubai. The sense on the ground is that the construction boom is in full throttle but not anywhere close to the bubbly stage. But I can’t get my mind off the fact that a lot of the construction is done at night when the temperatures are simply cooler. It’s the endurance of the migrant workers who have the day shift that I find quite astonishing. Think of the pyramids in Egypt and the Yucatan, the Taj Mahal and other larger-than-life structures and the same can be said for the city of Dubai. The super-skyscraper “Burj Dubai” was front and centre from my hotel room window. I can’t remember and certainly could not even count the number of cranes working throughout the day and night when viewing the skyline. Part of the view is filled with very unique and certainly luxurious looking buildings, but among them were cranes working on competing structures. The success story that is the UAE is of course based on the decision of its leaders to diversify beyond oil. But the structures we see being built today, like the pyramids of the past are built from the labors of a massive force that are too often left forgotten. I think that in today’s world when we think about gold and oil, the supply/demand imbalances are often cited as being driven based on what’s happening in the emerging world. That’s certainly true, but the commodity that is labor is certainly a key factor as well and you can see that when driving by any construction site in Dubai. Of course, think of the factories in coastal China and the low cost IT worker in Bangalore and you quickly get the story of the emerging markets.

An important point to make on this is the importance of the success of the emerging markets in aggregate. It simply has to happen. Jeremy Siegel at Wharton wrote a paper in the September 2007 Financial Analysts Journal titled “Impact of an Aging Population on the Global Economy”. To summarize one of its key conclusions I begin with a simple fact: The western world is aging and it can’t eat its financial assets during its retirement stage. Much has been said of an equity market depression should the boomers sell their equity investments as a whole even if it’s spread out over several decades. Siegel’s paper articulates the fact that the growing middle class of the emerging world can be a very significant group that buys these financial assets. As individuals, they may not have much residual assets left for savings and investment, but in aggregate the numbers can and likely will be in their favor. This logic makes sense and our only hope is that the typical worker from the emerging markets does not go berserk with their discretionary spending and adopt a savings rate similar to many in the west. Furthermore, we have to hope that the western world does not adopt a protectionist stand. We see the beginning of potential trouble already. How do most Americans (never mind their government) feel about some sovereign wealth funds buying significant parts of major Wall Street financial conglomerates? What about if the same happens to media firms, utility companies and certain defence/high tech firms? Much of Western Europe isn’t happy with the rising growth of mosques versus churches across the continent. Will religious as well as racial discrimination hamper the transfer of wealth, and as important, capital investment? I think that the factors driven by demographics are so strong that any reasonable person or society will figure out what measures are required in order to survive. Unfortunately, the short-term horizon of politicians often conflict with this simple assumption.

Getting back to this commodities conference, the overall turnout was a bit of a disappointment but what was especially poor was the level of institutional investors in attendance. I couldn’t find one. Luckily I had meetings set up for me prior to traveling or this would have been a rather uneventful trip. One observation that I made was the fact that despite this being a commodities event in a growing part of the emerging markets, on day one of this conference all sessions except for one made some reference to indexing, passive investing or the use of ETFs. I did not attend day two and so I can only wonder if this fact remained true. Now I know that most of the discussion revolved around the active use of ETFs and/or derivatives but this still strengthens my case that the ETF story is not only strong but expanding globally. I think that the saturation we see today in the US will grow to many other regions. However, it’s still early. Today, there are no ETFs domiciled in Dubai. Great fanfare has been made about Dubai as the financial centre bridging the time gaps between the financial centres of Europe and East Asia. It will only be a matter of time before Dubai becomes a hub for derivatives and ETFs. From my travels, I see a parallel between ETFs (or financial services products in general) and airports. The US and Europe are full of busy yet aging airports. The emerging world is now making waves about their fancy new and relative large airports, albeit in much smaller numbers. I think the ETF industry will expand to these same regions with a few but relatively large (by asset levels) offerings in the not too distant future. Who knows what the expansion will be like thereafter. I don’t see a duplication of what has happened in the US but perhaps something fairly close in a few markets. We’ll see how the BGI’s, SSGA’s and other ETF providers do in entering these markets to compete with the local providers.

By the way, I’ve mentioned that the ETF industry within the region is still sparse. However, we’re not much better here in North America. The SPDR S&P Emerging Middle East & Africa ETF (GAF) is all we have now.

Not exactly the greatest diversifier but the high correlation story is one you’ve heard from me enough times I’m sure.

An interesting tone I sensed at this conference and confirmed at my meetings was some urgency in terms of dealing with the commodity complex. The need for active management was clear. Most would agree that a “buy-hold” mentality just doesn’t make sense for this highly volatile asset class. This would be true not just for a diversified (index-like) exposure but also positions in specific sub-indices (agriculture, metals, energy) or direct single commodity exposures. Despite the fact that so many commodity tracker funds have been launched in recent months and years, it looks like the need for them is very high indeed.

If you were to ask an investor what was their main reason for commodities exposure, you’d get a variety of answers. This may be true for any stock, hedge fund or asset class but I’m very interested in those given for commodities: inflation hedge, low correlation to other major asset classes, macroeconomic rationale given growth of emerging markets and relative dormancy in 1980’s and 90’s, demise of US dollar. These are all risk based rationale but for whatever reason, it seems like there’s a vast array of investors jumping on the Jim Rogers bandwagon. This includes the many ETFs, ETCs and ETNs that have hit the market over the past few years with exponential growth both in terms of numbers and assets. Should there be cause for concern that these new assets are helping fuel the fire? I think so as it will likely lead to greater volatility both up and down. Don’t get me wrong, even without all these new commodity tracker funds, I’m still in the camp that we’re in a long secular bull market albeit with the strong possibility of down markets (drops of 20% easily) with the possibly of not regaining new highs until at least six to twelve months if not longer. The question is whether the magnitude of drops and time to recovery are magnified due to ETFs and related instruments. I can’t help but think so.

And the main reason why I think this is so is just from considering who would be using these commodity trackers. The big user has to be the hedge funds which for me includes managed futures/CTAs. Don’t have anything against them. My first job in the industry was basically in this space although the focus was squarely on equity indices. Just like quant funds that were quite synchronous (unfortunately to the down side) in the late summer of 2007, I could see CTAs herding in and out of the broad commodities complex to capture the major up and down markets … I’m not saying they’ll all move in line to day-to-day volatility.

This excess momentum due to mass herding is what angers the emerging countries when they consider the foreign “speculators” (not “investors”) getting in and out of their market. That’s one of the prices of capitalism. The key, like we see in Dubai, is to find the long-term story. Dubai and other countries in the GCC region and beyond will not only survive but evolve into a longer term success story based on their ability to reap the rewards of this high oil price period (or “era” depending on how long this lasts). My hope is, just as South Korea copied the Japanese model through a well educated workforce and strongly industrialized infrastructure, the neighboring countries in the gulf and the broader MENA region can duplicate some of the success of Dubai. We can see some of this already in Bahrain and Qatar but there needs to be more.

Final thought on Dubai. I had dinner with a gentleman in the industry and asked what model Dubai used for its success to diversify beyond its core asset. My guess was Hong Kong but he said it was Singapore. Makes sense since Singapore is a bit more diversified in terms of having had greater labor requirements in the past (not so much today) from abroad to help build its infrastructure whether it be engineering, financial or otherwise. Singapore definitely has a more culturally diverse population than Hong Kong or any other Asian city I can think of. In this regard, I can’t help but think that the commodity that is often left unconsidered or, at best, overlooked is labor. Where will the migrant worker move to next? Where can one find skilled or at least partially skilled labor? I heard of the incredible housing and food inflation in the UAE and I wonder how that effects the laborer at the very bottom of the ladder. Probably not well but it’s certainly better than their prospects at home. Still, on one of my comfortable taxi rides, I saw a bus packed full of workers … something I’ve seen in countless other cities but I could see that conditions for them were not good. Not to pick on Dubai, but I wonder how fair their labor laws are for immigrant workers. This question is easily applicable to other booming economies that have significant immigrant populations and the debate in the US on this subject is an appropriate example even though their economy, nor its outlook in my opinion, could not be described as booming. This trip was certainly an eye opener for me. The chance to see and feel the luxury was nice but I’m glad I was able to observe a bit of the other side although from far away. Cliche as it it may be, I think it’s Pierre Trudeau who first said something to the effect that you really don’t appreciate the value of Canada until you’ve traveled the world. It’s certainly not meant to be an insult to Dubai - clearly one of the great success stories of the emerging world and especially within a volatile region - but I find it interesting that after this trip I realized just how great Canada is. Maybe it’s also the fact that we get roughly ten days at most of 40 degrees Celsius heat or worse a year.

I spent some time today with my wife and daughters at the park with warm sun and a cool breeze. Perfect weather.