World Series of ETFs

I am writing this piece on my return flight to Chicago from The World Series of Exchange Traded Funds (7th Annual) in Miami, FL on March 26, 2007. Various sources indicated that this is the most popular ETF conference. This was my first time at this conference so I am pleased to report that the popularity of the event is not solely due to the location and creative name (although major league baseball was my first career choice over finance and professional money management). Virtually all of the leading ETF families (Barclays Global Investors and State Street Global) and emerging ETF providers (XShares Advisors) were in attendance as well as several leading industry analysts and commentators. More importantly, the conference provided valuable information about current ETF industry trends and product developments.

We know from academic studies performed by Gary Brinson and his colleagues that asset allocation, rather than security selection, accounts for 90% of the variation in a portfolio's investment returns. We also know from studies by Ibbotson and others on the returns of major asset classes that stocks are the best performing asset over long periods. Most institutions, like the large endowments of Yale and Harvard University, have long adopted these and other academic findings in their investment processes. Unfortunately, a large share of the retail marketplace (individuals, families, etc.) has not. The retail world has adjusted its focus from individual securities to the portfolio level, but these investors have not fully embraced the advantages of strategic asset allocation, passive investment management (indexing) or the consideration of after-tax returns. The ETF industry is an emerging leader in applying academic theory to real world investing and making these institutional best practices available to the retail investors through their products. This article provides information on some of the product and other developments from the conference from the perspective of a potential retail investor.

One of the most significant take aways from this conference was that the ETF industry continues to be at the forefront of innovation in investment management. The industry as a whole is providing investors with valuable tools to manage risk at the asset class and portfolio level. There has been and will continue to be a proliferation of ETF products that capture various risk and return elements of the various asset classes. Optimally, these tools when effectively utilized will allow an investor to increase investment returns while lowering portfolio risk (variability in price). A critical element in chosing between various competing ETFs to achieve investment objectives is an understanding of the ETF structure - index construction and objectives, tax characteristics and liquidity. The following discussion will focus on index construction.

A review of the progression of the various ETF index structures is helpful in understanding these concepts. The initial criteria used to differentiate ETF products was primarily based upon existing index providers (S & P and Russell) and style classifications (Value, Growth and Core), similar to Morningstar's mutual fund classifications. An example of product risk segmentation at this level is large capitalization value ETFs (S & P 500 Value and Russell 1000 Value; indices favor lower price to earnings and price to book value stocks) as compared to various large cap growth ETFs (S & P 500 Growth and Russell 1000 Growth; indices favor faster growing companies with higher price to earnings and price to book value multiples). In addition to the porfolio composition differences at the index provider level (500 stocks versus 1000), each of these style based ETFs tries to capture a different risk-return element of the large capitalization domestic equity asset class based upon valuation metrics (PE and book value multiple).

More recently, the evaluation of risk and return elements of ETF products has progressed to strategic elements (active risk) with the creation of proprietary index weighting methodologies. These propreitary indexing methodologies generally did not exist prior to the introduction of the related ETFs and encompass strategies intended to generate excess returns relative to the market. Most of the more popular indices (S & P 500) used for ETFs are market weighted (index tends to hold more of the higher market cap and higher valued stocks). Proponents of alternative weighting regimes argue that there are better risk-adjusted indexing methodologies than market weighting and cite the 2000 and later bear market in which the higher valued S & P 500 market cap stocks suffered more than the S & P 500 as a whole. Alternatively weighted indices have emerged such as equal weighted ETFs (own 0.2% each of S & P 500 stocks) from Rydex Investments and fundamentally (strategically) weighted ETFs (weighted on fundamental factors like dividends, sales, etc.) from Wisdom Tree Investments, Inc. Since new ETF products are generally aggressively marketed at launch, it is very important to understand index composition to properly assess the level of active risk involved with these products.

An example of this product assessment would be the comparison of a marketed weighted S & P 500 ETF with about 20% of its portfolio in the top 10 names versus 2% for an equal weighted S & P 500 ETF. Although the level of active risk is far from the theoretically highest (single stock risk) by holding only the smallest, most volatile stock among the S & P 500, the equal weighted S & P 500 ETF certainly contemplates security "bets" very different from the market. Clearly, these ETFs should not be considered purely "passive" investments. Fundamentally weighted ETFs take a more pragmatic approach to the introduction of active risk than an arbitrary equal weighting and may have more practical use in an investor's portfolio construction process. This is particularly true if the investor has conviction that the strategic factor(s) (driver of security selection process) underlying the fundamental weighting and portfolio construction are likely to result in excess returns (expectation that active risk will generate higher returns). Wisdom Tree's fundamentally weighted ETFs may be the most appealing product currently available given that their predominant weighting factor is dividends. Dividends have been a significant component of total market returns (dividends plus price appreciation) over long periods of time. Regular quarterly dividends also tend to give managements and boards an additional element of focus and discipline. Wisdom Tree's backtesting of their weighting regime indicates significant outperformance at lower risk (volatility), but, of course, past performance is not necessarily indicative of future results.

A second highlight from the conference was that ETFs are a superior structure for alternative asset classes. This is most visible in commodity ETF products. For example, prior to the introduction of commodity based ETFs an investor seeking exposure to this low correlated asset class (reduces portfolio risk/enhances returns because commodity price movements have historically been mostly independent of stock and bond price movements) would have to pay 1.5% to 2.0% in management fees for access to an "actively" managed commodity pool, futures account or other product. Diversified, "passively" managed exposure to commodities (gold, silver, oil, natural gas, industrial metals, grains) can now be achieved cheaply through ETFs at approximately one-half the fees. As with equity ETFs, an understanding of a commodity ETF's index construction and objectives, tax characteristics and liquidity are critical to the investment decision. The ETF structure is also currently being used for investment in other low correlation asset classes and investment strategies generally not available to retail investors on a cost effective basis, such as currencies and leveraged and short (or inverse) exposures to equities.

A third benefit of the attending the conference was the opportunity to meet with two thoughtful, independent ETF research analysts. I recently subscribed to ETF research coverage provided by AltaVista Independent Research (http://www.etfresearchcenter.com/). I met with the company's president Michael Krause and was pleased to find we share a value orientation and an interest in country demographic trends as an indicator of future economic activity. AltaVista's extensive valuation and performance research on ETFs can be leveraged to manage risk. I also introduced myself to Richard Kang of The Beta Brief (http://www.thebetabrief.com/). Richard is a forward thinking, quantitative analyst on the ETF industry. His bloggings are generally thought provoking and informative and his contrarian views help keep readers alert to potential market risks and opportunities.

In summary, the World Series of ETF conference generally demonstrated that the ETF provider and analyst communtity are providing retail investors with useful, innovative and efficient products along with insightful research and analysis to properly assess these investment products. The ETF fund families together with an emerging independent analyst community are providing retail investors with practical tools and information necessary to adopt investment best practices commonly used by institutional investors - strategic asset allocation, passive investment management (indexing) and consideration of after-tax returns.

Comments

[Richard Kang]

Thanks for the kind words, John. Thanks as well for the plug for my blog. I hope you continue to find value in its content, and if so, please let others know of my work. I also look forward to learning more on how you handle the various challenges in the portfolio construction/maintenance process for your clients. Best, Richard