| Riding the wave of investor appetite for | | | | start clamping down. |
| commodities, currencies and precious metals, the | | | | This is how it works. The typical ProShares ETF |
| makers of exchange-traded funds (ETFs) continue | | | | enters into a total return swap contract. The |
| to find new ways to slice and dice the market. | | | | ProShares trust agrees to pay LIBOR (London |
| The instruments continue to proliferate and pull in | | | | Interbank Offered Rate) or a Treasury bill return |
| money. In the last decade, assets under | | | | plus some extra amount in exchange for the |
| management at ETFs have soared 59% to | | | | return of a specified index (or twice the return of |
| $627.4 billion, according to research firm | | | | a specified index). |
| Morningstar Inc. Asset growth has slowed a bit | | | | Analysts are watching for growth from a new |
| recently, to just under 40% over the last three | | | | breed of complex derivative-style products that |
| years, as the industry has gained a more | | | | allow investors to buy risk. As yet still in the |
| substantial base. | | | | regulatory pipeline, these esoteric products would |
| But the massive asset gains have begun to slow | | | | allow investors to access strategies previously |
| slightly. Meanwhile, the number of new funds has | | | | available only to institutional investors. These |
| grown. The last decade saw the number of new | | | | risk-exposure products would be similar to credit |
| ETFs rise by 39.1%; over the past three years, | | | | default swaps (CDS), a sophisticated derivative |
| that ramped up by 52.5%. Much of those gains | | | | instrument that gives the buyer a pure exposure |
| were in 2006 and 2007, with that pace finally | | | | to a company's credit risk. |
| slackening this year as the markets became more | | | | Buying a CDS differs from simply owning a |
| unpredictable. (There were 787 ETFs based in the | | | | corporate bond, which also exposes the investor |
| United States as of May 31, according to | | | | to interest-rate risk, curve risk and prepayment |
| Morningstar.) | | | | risk. Credit default swaps have been popular with |
| Issuers of the products "are less willing to do new | | | | institutional investors for the investment precision |
| issues," says Kevin Farragher, managing director | | | | they offered when constructing a portfolio. |
| of Rydex's ETF business line. He notes that fewer | | | | However, the CDS market was also hit hard in |
| offerings have launched so far in 2008 than over | | | | the painful credit crunch of last summer. |
| the same period last year partly due to market | | | | Little-known fund advisor CCM Partners has filed |
| saturation, as the most obvious market indices | | | | to manage four such ETF-like structures called |
| already have several products tracking them, and | | | | ETSpreads, which will aim to track indices that are |
| even the most mundane have at least one. | | | | essentially baskets of CDS: a high-yield bond index |
| But Farragher also blames the fact that "there's | | | | and its inverse, and an investment-grade bond |
| less seed capital to be had." Traditionally, an issuer | | | | index and its inverse. These types of risk |
| launched an ETF by getting money to start the | | | | products would be most useful to the more |
| fund from Wall Street firms known as authorized | | | | sophisticated advisors with high-net-worth clients, |
| participants. The ETF issuer would give the firms | | | | such as corporate executives with large blocs of |
| shares in the ETF. And the institutions would act | | | | stock in their employer. Such clients have |
| like a syndicate in an equity offering, selling the | | | | portfolios that are both large and complex enough |
| ETF shares from their inventories into the market. | | | | to warrant precise removal of risk from certain |
| Partly in reaction to their own financial | | | | stocks. |
| circumstances, they are less willing to do new | | | | Similarly, there are other ETFs in registration |
| issues. "They want to do things that will be | | | | aiming to zero in on very specific risks. Earlier this |
| successful," Farragher says. "There's pressure on | | | | year, MacroShares registered a pair of products |
| the issuers to be more judicious in choosing a | | | | tied to the housing market: MacroShares Major |
| benchmark around which to build." | | | | Metro Housing Up and MacroShares Major Metro |
| Nonetheless, the industry continues to crank out | | | | Housing Down. "These are large economic |
| new products. As of May 31, there have been 131 | | | | exposures that consumers and investors have |
| new ETFs this year, or 16.6% of the 787 | | | | day in and day out," Ptak says. |
| U.S.-based funds. | | | | Instead of providing an indirect exposure to a |
| He said he expects the pace to slacken over the | | | | specific risk, products like MacroShares attempt |
| summer and for new issuance to slow in the | | | | to focus on the risk with pinpoint precision. "We're |
| coming year. Regarding the new issues this year, | | | | getting much more narrowly focused niche-type |
| he says, "You're not seeing the acceleration in | | | | products, in which ETFs divvy up risks and |
| new issues you saw the two or three preceding | | | | exposures into ever-thinner slices," Ptak says. |
| years. It's holding flat. That's because people are | | | | Indeed, the same company also has a pair of |
| delivering on their 2008 plans as opposed to all of | | | | ETFs in registration that give the investor |
| these new opportunities being discovered and | | | | exposure to the risk of medical price inflation. The |
| acted upon quickly." | | | | MacroShares Medical Inflation Up Shares and |
| The development has come from issuers creating | | | | MacroShares Medical Inflation Down Shares, its |
| even more specific instruments, from broad | | | | bearish sister, will track the medical care |
| indices to specific market caps. Jeff Ptak, ETF | | | | component of the Consumer Price Index. This |
| analyst at Morningstar, cites this as the | | | | strategy allows investors a great degree of |
| continuation of a trend toward more specific | | | | precision, in case they want to take a strong |
| exposures to sectors and industries. | | | | stand on a particular industry. If you thought |
| For example, there are some products in | | | | medical inflation would go up, before these ETFs, |
| registration that give investors exposure to real | | | | the natural bet would be to buy shares in an |
| estate in general and the housing market in | | | | index holding the big pharmaceutical stocks, or an |
| particular. | | | | actively managed sector fund, or an ETF such as |
| Other ETFs track individual countries and | | | | the Vanguard Health Care ETF. But often those |
| geographic regions. Consider the recently launched | | | | indices hold extraneous companies. Plus, there are |
| ETF from Invesco PowerShares, called the MENA | | | | other influences between consumers and inflation, |
| Frontier Countries Portfolio (ticker symbol: PMNA). | | | | such as the company. With the new structure, |
| It's based on the Nasdaq OMX Middle East North | | | | the investor does not have to think about what's |
| Africa Index, which is designed to measure the | | | | going on in the company, only medical inflation. |
| performance of the largest companies in the | | | | MacroShares already has a pair of funds that do |
| Middle Eastern and North African countries of | | | | the same for oil prices, but they are being closed |
| Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, | | | | down. They were created with a kind of |
| Bahrain, Qatar and the United Arab Emirates. | | | | self-destruct mechanism that triggered a |
| The index has 67 companies with market | | | | termination clause when the price of oil hit $120 a |
| capitalizations between $243 million and $10.4 billion. | | | | barrel. The company is liquidating the funds by |
| Bulls and Bears | | | | giving a cash redemption to investors, similar to |
| The areas that have seen the largest increase in | | | | mutual fund liquidations. |
| interest are leveraged and inverse ETFs. These | | | | Hitting the Right Note |
| funds seek to give the investor bearish and bullish | | | | Meanwhile, exchange-traded notes continue to be |
| exposure to an index. | | | | much discussed because of their advantageous |
| According to Morningstar, there are 77 leveraged | | | | tax status. But the Internal Revenue Service still |
| and inverse ETFs, all based in the United States, | | | | may remove that beneficial tax treatment at |
| holding $17.5 billion as of May 31. That outpaces | | | | some point in the future. (The agency has already |
| the growth of the ETF industry overall, something | | | | removed the tax breaks from one specific type |
| Ptak describes as "no mean feat." | | | | of ETN; those tracking single currencies.) |
| He cites ProShares as one of the more successful | | | | For a non-single-currency ETN, the only taxable |
| managers when it comes to gathering new | | | | event for an investor is when the note is |
| assets. One of the company's popular | | | | redeemed. If the investor sells after a year, there |
| strategies-on the positive side-has been the Ultra | | | | are only 15% capital gains. Compare that with an |
| QQQ (which tracks the Nasdaq). But given the | | | | ETF, which sees 60% of its gains taxed at |
| poorly performing markets, there have been | | | | long-term rates and 40% taxed at short-term |
| many more bear hits lately: UltraShort S&P | | | | rates. Those taxes get passed on to the investor |
| 500, UltraShort Oil and Gas, UltraShort Financials, | | | | regardless of how long he held the ETF. |
| and UltraShort Russell2000. In these cases, the | | | | Regardless of how the IRS rules, though, ETNs |
| ETF holder is betting on getting twice the inverse | | | | are still a very efficient way to own currently hot |
| of the daily index return. So if the S&P 500 | | | | asset classes like commodities and currencies that |
| index loses 2%, the fund aims to deliver 4% on | | | | were difficult to own before. Part of the reason |
| the day. | | | | for their efficiency is their structure. |
| Gary Stroik, chief investment officer at WBI | | | | They are notes, or debt instruments, which are |
| Investments in Little Silver, N.J., chairs his firm's | | | | tied to the performance of a particular |
| investment committee and uses mostly individual | | | | benchmark, rather than a trust that holds a |
| securities and ETFs. He likes ETFs for giving | | | | basket of securities, as with an ETF. As in a |
| advisors access to tools that would otherwise be | | | | traditional bond, the issuer of an ETN promises to |
| unavailable to the typical client in his $275 million | | | | pay the investor that index return. That means all |
| practice, like commodities. "You could invest in | | | | the investor has to worry about is the credit risk |
| Exxon-but not oil," Stroik says. "You could invest | | | | of the issuing bank. And because one of the |
| in Newmont Mining-but not in gold. It's a powerful | | | | biggest issuers of these new instruments is |
| tool, but like other powerful tools, you've got to | | | | banking giant Barclays, Ptak regards the credit risk |
| be careful how you use it. It's a chainsaw," he | | | | aspect of many ETNs as fairly safe. |
| says, alluding to the leveraged ETFs that give an | | | | What investors do not have to worry about is |
| investor double the exposure to a particular index | | | | the transaction costs within the ETN, as |
| or sector. He uses the term "double exposure | | | | compared to an ETF in which managers buy and |
| funds" to describe them and says they can be | | | | sell securities. So the ETN structure eliminates two |
| dangerous. | | | | of the main problems with investing in |
| For example, say an investor wants a $10,000 | | | | commodities, currencies and precious metals: |
| exposure to the S&P 500. He could could | | | | transaction costs and tracking error. |
| buy $5,000 worth of a double-exposure ETF, and | | | | But, investors should note that ETNs are not as |
| safely stash the other half in a Treasury bill or | | | | cheap as the cheapest ETFs. The median |
| money market fund. "I get a return in the case, | | | | expense ratio on ETNs is 75 basis points. The |
| get the same portfolio exposure and | | | | cheapest tracked by Morningstar costs 30 basis |
| performance I wanted, and pocket the interest | | | | points, and the priciest runs 1.25%. But as with all |
| on the cash," Stroik says. "On the other hand, if | | | | ETFs, ETNs carry the same transaction costs for |
| you put the entire $10,000 into the double | | | | the investor as a stock. So, frequent trading can |
| exposure fund, you'd get twice the risk exposure | | | | erode gains. |
| and no cash cushion." | | | | Still, in spite of the question mark over their tax |
| Ptak says these ETFs are handy for making a | | | | treatment, ETNs are becoming popular ways to |
| bearish bet because of their ability to spread risk. | | | | get a piece of the energy and commodity action. |
| "When you look at the risk-reward profile on a | | | | Plus, they are relatively cheap for issuers to |
| particular stock, and contrast that with the risk | | | | launch and run, compared with ETFs, according to |
| profile of shorting a basket of stocks, the latter | | | | Ptak. That makes for a lot of new products. As |
| choice is better," he says. "You sacrifice some | | | | of May 31, there were 78 ETNs holding $6.5 |
| upside, but you spread uncertainty across lots of | | | | billion-with 52 having been launched so far this |
| stocks." Ptak points out that, unlike the old | | | | year, according to Morningstar. |
| method of shorting-borrowing money from your | | | | At the moment the majority of the wealth is |
| broker on a margin account, which could lead to | | | | concentrated in a handful of names, including the |
| unlimited losses-the downside with bearish ETFs is | | | | iPath series from Barclays, the biggest issuer at |
| limited to the investment in the ETF. "It's a better | | | | the moment, with 17 ETNs holding 54% of |
| mousetrap," he says. | | | | U.S.-listed assets. |
| In addition, these products are especially useful | | | | One of the biggest winners among ETNs is the |
| when credit markets tighten. "Hedge funds in | | | | iPath Dow JonesAIG Commodity Index, the |
| particular have taken a shine to these leveraged | | | | biggest commodity instrument among ETNs and |
| products because these ETFs will be there | | | | ETFs. It held $3.5 billion as of May 31. The next |
| whether banks are lending or not," Ptak says. A | | | | largest ETN is the iPath MSCI India, which holds |
| hedge fund manager can get 200% exposure to | | | | $739 million in assets. The assets in the rest of |
| a particular index quickly and easily by buying a | | | | the pack drop off rapidly, with 42 of the 78 ETNs |
| leveraged ETF, without drawing down a line of | | | | holding less than $10 million. |
| credit with their bank, or worrying about a margin | | | | "A lot of them just came online, and they haven't |
| call. It also saves the hedge fund manager from | | | | had an opportunity to gain traction on the |
| worrying about a nervous banker calling in all of | | | | market," Ptak says. |
| the fund's lines of credit when the bond markets | | | | |