“Hello?”
“Hi, is this Joshua M. Brown?”
“Yes, this is Josh. Who’s this?”
“Josh, my name is Keith,* and I work in the sales and marketing department for ProShares. I’m calling because of a few articles you’ve written about some of our products.”
“I don’t write articles, Keith. I’m a blogger, and I write blog posts. But do go on.”
“Fine, blog posts. Look, we don’t think you’re being fair when you say that our inverse ETFs are ‘poisonous’ and that the ProShares UltraShort Financials ETF is ‘for crack-heads only.’ You can’t call our SKF fund a crackhead, Josh.”
“I hear ya, but SKF is a crackhead fund. It was built for crackheads and is traded primarily by crackheads. Dude, you built a leveraged fund that gives people two times the exposure of the bank stocks’ downside, and you released it during the worst banking crisis in modern history. Keep it real, partner. Just own it.”
“Well, I also think there’s a lot of misinformation being spread on the Internet about how our leveraged ETFs work or don’t work. On an intraday basis there is very little tracking error. The negative compounding that all you bloggers are complaining about really only happens over longer periods of time,”
“OK, Keith, so what you’re saying is that your leveraged funds are really only suitable for people who want a volatile trade with double the intraday move of the index itself, right?”
“Well, yes, Josh, they do work more efficiently for intraday trades and shorter holding periods, that’s correct.”
“Great, so we agree. Your leveraged ETFs are for crackheads. The record-breaking volatility we’re already coping with right now just isn’t enough for them, they need SKF and QID and such for an even higher high … like crackheads. So I’m gonna write whatever I want, Keith. Anything else I can do for you?”
(Click)
Sometimes it seems as though there are more ETFs on the market than there are stars in the sky. There are an estimated 1,335 exchange-traded products available in the global marketplace from 50 different issuers. We are still very much in the gold rush phase of the ETF revolution, with 156 brand-new funds having made their debut in just the first six months of 2011.
Every single conceivable index, sector, asset class, investment style, and classification that can have an ETF probably does at this point, and in many cases there is multiple choice. If you’re looking for a way to play Chinese small-cap footwear retailers whose CEOs were born in April, there’s probably an ETF for that.
In addition to the near-unlimited choices of equity ETFs, there are also a myriad of fixed-income offerings. These bond ETFs finished 2010 with over $130 billion in assets and offer investors as many segmented flavors as there are in the open-end bond fund world, including corporates, municipals by state, high yields, emerging markets, government bonds, and even a fund that lets you short government bonds. As investors went on the hunt for yield in the 2009–2011 period of ultralow rates, they poured money into these newer fixed-income products at a torrid pace. In an August 2010 research report from State Street Global Advisors, we are told that:
The growth of fixed-income ETF assets, which increased 78 percent in 2009, remained a key trend during the first half of the year. Fixed-income ETF assets increased by $21.2 billion or 21 percent in the six months to June 30, 2010, as the number of bond ETFs available to investors reached 105. This growth illustrates the rapid evolution in the ETF industry in order to meet the needs of investors. In 2006, just six fixed-income ETFs existed, representing approximately $20 billion in assets. In the first half of 2010, six of the 10 ETFs with the highest net cash flows were bond ETFs.
There is perhaps no better example of the “build it and they will come” concept than what we are seeing in the bond ETF bonanza. Products and even whole new index categories are being conceived of, innovated, created, marketed, and adopted by investors at an astonishing pace.
Many fixed-income professionals have vocally denounced the bond ETF oeuvre as being a square peg jammed into a round hole. One of the big hurdles to creating and maintaining a bond index ETF is the fact that many of the smaller, more obscure bond issues that make up the index are in finite supply; hence the underlying bonds cannot actually be purchased by the fund. The Vanguards of the world have found a clever way around that by building their “index” ETF creation units using only 10 percent of the index’s actual bond holdings. While they have been able to mirror just enough of the index to make their products a viable proxy, concerns continue to linger.
There has also been some consternation about mirroring the actual indexes themselves in terms of credit risk. Most mainstream bond indexes are cap-weighted, meaning the more debt a corporation issues, the larger its bonds loom in the index itself. This is a scary thought when you consider that an ETF based on this scheme could end up holding a large proportion of bonds from a heavily indebted coven of companies. Fundamentally weighted bond index ETFs have sprung up to address this concern that will stack their holdings based on creditworthiness and various debt service coverage metrics.
I’ll also mention that there was a recent episode concerning a widely followed national muni bond ETF. Its price dropped precipitously on the ravings of bearish strategist Meredith Whitney when she groundlessly claimed that 50 major U.S. cities would default on their debt in the coming year. So far none have. Because muni bond professionals understood how nuanced and striated the municipal market is, very few of them even flinched as the media went into full-on sensationalism mode. But that didn’t prevent a panic in the retail market as investors were dumping and even shorting the muni bond ETFs in droves. Because many municipal bonds are highly illiquid (unlike the average common stock), the market was simply unprepared for the underlying selling engendered by the sudden ETF outflows. The fund recovered once the panic subsided, but the episode illustrated that we’re still in the early stages of the evolution process for bond ETFs, with a long way to go yet.
In addition to stock and bond products, several other investment categories are being addressed by the ETF revolution. We’ve recently seen the rise of actively managed ETFs that mirror various hedge fund styles such as long-short, convertible or merger arbitrage, distressed, global macro, and event driven. These are too new and untested to gauge their efficacy, but should they achieve their stated objectives to mirror those hedge fund index returns, you can expect a super-sexy marketing campaign aimed point blank at Mom and Pop.
Another variation gaining traction is the so-called smart index ETF, exemplified by the Wisdom Tree suite of products, which track indexes that are dividend- or equal-weighted as opposed to the traditional market cap-weighted orthodoxy.
Investors can also now access commodity-tracking exchange-traded notes (ETNs), allowing them to be short copper but long hog bellies and soybeans using these products instead of trading in the more intimidating futures market. The thing to keep in mind about an ETN is that you don’t really own an equity instrument when you purchase one; you own a debt instrument (hence the word note). This means that your investment is only partially dependent on the particular commodity futures the fund is buying for you; it is also dependent on the solvency of the product’s issuer. For example, many of these commodity ETNs have been issued by the likes of a Deutsche Bank or a UBS, depending on their ability to invest in the underlying commodity futures and to distribute those returns to holders. In addition to commodity futures–based products, a gaggle of currency ETFs beckon those who either are fed up with their incredible-shrinking-dollar risk or are looking to speculate on various outcomes in the tumultuous globalized economy.
Are we overloaded with ETFs? A reader of my blog recently sent me the fact sheet for a new fund called the Global X Fishing Industry ETF. The product describes itself thusly:
The Global X Fishing Industry ETF seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the Solactive Global Fishing Index … The Solactive Global Fishing Index is designed to reflect the performance of the fishing industry. It is comprised of selected companies globally that are engaged in commercial fishing, fish farming, fish processing or the marketing and sale of fish and fish products.
My e-mailed response to him was “Are you f*cking kidding me?”
“A pill for every ill,” he replied, and I think that about sums it up. We are, without question, completely over-ETF’d. I last counted that there were around 50 different issuers in the marketplace. That’s an awful lot of people sitting around in conference rooms trying to figure out the next hot thing they can sell to us. A lot of these “innovations” are blatantly story-based at this point. Nobody ever says, “You know what my portfolio is missing? I don’t have enough exposure to the aquaculture industry.” No one ever woke up in the middle of the night worrying about whether or not they had enough exposure to beryllium prices or Brazilian hospital real estate or (fill in the needless opportunity).
But as long as we keep buying these products (by putting our dollars into them), you can rest assured that people will keep making them. Why? The fund companies get paid on the level of assets under management. If the product can make it through the first 36 months, it finally gets the all-important three-year track record, which could ultimately lead to real inflows. This ain’t rocket surgery.