Two Concerns With the New ETFs Hitting the Market

by: Richard Kang

There's been alot of recent news about new offerings being introduced by WisdomTree and Powershares and some not so recently by the bigger shops. I have two comments:

1. Market cap weighted indices.
Rob Arnott is often credited with the introduction of an alternative to market cap weighted indices – specifically, the idea of an equal weighted cap index. The data looked conclusive and made a lot of common sense. In many ways, the basic idea overlapped well with the Fama-French 3-factor model which considers size (small versus large stocks) and value (high book-to-market ratios versus low BTM ratios) in addition to just market risk [CAPM]. So when the Rydex S&P Equal Weighted ETF (NYSEARCA:RSP) came out in 2003, which in highsight was a perfect long-term entry point after the bear market of 2000-2002, it looked like a good core holding for US equity exposure.

Thereafter, Arnott’s writing moved into the area of fundamental weighted indexing and with it, a combination of various fundamental measures which could determine the composition of an index in a slightly more complex manner. More recently, Arnott’s firm Research Affiliates has worked with various manufacturers to introduce the next stage of non-market cap weighted ETFs, specifically PowerShares FTSE™ RAFI US 1000 Portfolio (NYSEARCA:PRF) as well as ClaymorETFs FTSE™ RAFI Canadian Index Fund (CRQ on the TSX), both based on his concepts of fundamental indexing. However, just like any other method of building an “index”, fundamental indexing will perform better than other manners of indexing in certain, but not all, markets.

WisdomTree’s new ETFs tread fairly closely to these also using the term “fundamental weighted indexing” in their marketing material (.pdf). I give true credit for a practical alternative to market cap weighted indices to Dimensional Fund Advisors. I find it interesting that DFA, the real pioneers of “thinking outside the box” in the world of index investing and whose funds revolve around the Fama-French 3-factor model, have not entered the ETF space. Their US-domiciled funds have a much longer-term track record compared to most ETFs, and have a loyal, almost “cult-like” following which is now growing internationally into the UK, Australia, Canada and other jurisdictions.

However, the way in which they market their funds through selective advisors does not lend well to a transition into ETFs. Furthermore, with the recent entry of WisdomTree, there may not be enough space in such a specific ETF market, but there still are some differences between the philosophies and methodologies at the two firms.

To me, the simplicity of RSP (equal weighted indexing) is magnified compared to the newer offerings of recent weeks or even the 3-factor model+. Costs seem comparable, but what we are seeing here is the move towards something that looks less like a traditional index instrument and more like a quasi-active fund. Powershares seems to be pushing the envelope the most as WisdomTree’s offerings lean more towards a simple dividend oriented bias.

Will someone try to build a fund that tracks an index whose underlying constituents are actively managed, such as a hedge fund index? Whether the logistics works out or not, I’d rather not see that happen. I can only imagine the spread between the market price versus the underlying fund’s NAV in addition to the numerous other potential complexities. Overall, it certainly is interesting what’s happening and I’m always eager to see what new innovation in coming down the pipe.

2. Although I am happy to see innovation in the ETF space as explained above with alternatives to market cap weighted indices, I am not so happy with what is broadly coined as “alternative investments”. Obviously, we’ve seen new products brought forth in conjunction with the commodities boom of the past few years, and especially very recently (NYSEARCA:GLD), (NYSEARCA:SLV), (NYSEARCA:USO), (NYSEARCA:DBC).

My concern with these is similar to the countless Nasdaq linked index products which came out just prior to the top in 2000. The idea of investing in materials and energy makes sense as components in a broadly diversified global portfolio. I just can’t see them being major (> 10% in each) holdings in this kind of portfolio.

Speaking of this type of portfolio, what would be a good model to follow? I like to see what certain large institutions are doing. Up here in Canada, we have a few pension behemoths that are quite innovative. In the US, there are far more interesting ones to choose from, but I’ll focus on endowments such as those at Yale and Harvard.

Without going to deep into details, I propose a read of Yale’s latest annual report (.pdf). A key excerpt that shows how different they think in terms of asset allocation:

Today, target allocations call for less than 20 percent in domestic marketable securities, while the diversifying assets of foreign equity, private equity, absolute return strategies, and real estate dominate the Endowment, representing more than 80 percent of the target portfolio.

Furthermore, they state that

The Endowment’s long time horizon is well suited to exploiting illiquid, less efficient markets such as venture capital, leveraged buyouts, oil and gas, timber, and real estate.

Clearly, there are challenges to building an ETF, or other highly liquid instrument, for certain of these asset classes. So far, for investors interested in building a portfolio more aligned to institutions such as Yale, the energy complex and real estate are areas where they have been able to participate.

For real estate, REIT ETFs (NYSEARCA:RWR), (NYSEARCA:IYR), (BATS:ICF) are a start and Robert Shiller has been making the rounds promoting housing futures that began trading on the CME in late April. So, for the next stage of the growing ETF universe, what about an offering related to timber? Investment returns related (among other things) to the physiology of trees sounds like something that should be uncorrelated to the broad markets and may also provide decent yield. Another interesting area is infrastructure. So far, closed end funds (NYSE:MIC), (NYSE:MFD), (NYSE:MGU) are the only viable choice for non-institutional investors.

Despite the interest from institutions in both these areas, I doubt there’s any significant interest from the ordinary investor that could lead to an ETF. But how many large cap value funds (whether domestic, international, or whatever) can you have out there?