ETF Edge: October 2009
Welcome to the October issuer of ETF Edge! September was an interesting month in the ETF industry, as speculation over upcoming regulations continues to swirl and ETF issuers continue their push into exotic, previously uncharted areas of the investable universe. Here’s a look at what’s inside this month’s edition:
- Heard On The Street: From efforts to curb speculation in commodity markets to potential issuer acquisitions and a potential change in the way new ETFs are developed and launched, there is a great deal of uncertainty in the ETF industry. Hear what the industry insiders are predicting for the coming months.
- Actionable ETF Investment Ideas: As investors try to determine whether the recovery is just beginning or if the markets have run too far too fast, our ETF expert has identified five ETF strategies poised to deliver excess returns.
- Inside The ETFdb 60 Index: We take a look at the biggest gainers and losers in our all-ETF index for the month of September, and draw some interesting conclusions from the monthly numbers.
- Now Is The Season To: Rebalance your portfolio’s equity/bond allocation.
Commodity Regulations Could Be A “Gamechanger”
The fund’s popularity caught the eye of commodity futures regulators, who are apparently convinced that UNG’s massive size threatens to disrupt the market for this “commodity of finite supply.” The fact that UNG has elected to cease issuing new shares has done little to dissuade investors from purchasing this ETF. In a clear example of demand outpacing supply, UNG saw its premium to NAV rise above 20% this month, before falling down into the mid single digits on news that more shares would be issued.
Exchange-Traded Commodities: In Danger Of Extinction?
September saw the ominous closure of the PowerShares DB Crude Oil ETN (DXO) due to “limitations imposed by the exchange on which Deutsche Bank manages the exposure of the Notes.” ETCs have been in focus in recent months, as regulators continue to crack down on products that provide investors an opportunity to bet on the prices of “commodities of finite supply.” Regulators seeking to reduce the contributions of these products to market volatility and speculative behavior have apparently found a new weapon in the form of accountability limits.
While options for these funds are numerous (such as spreading exposures across multiple months and investing in swap contracts), we believe the constant scrutiny will prove too troublesome for many institutions still trying to restore reputations that were stained during the recent financial crises. Deutsche Bank, the primary sponsor of commodity products offering exposure through futures contracts, has kept its plans for its line of ETCs to itself, but we expect numerous fund closures before the end of the year, a major setback to retail investors who had seized the opportunity to gain exposure to commodity prices through ETFs.
ETF Product Development: The New Paradigm
The launches of two new silver and gold ETFs from London-based ETF Securities (SIVR and SGOL) marks a distinct change in the strategy of ETF issuers. In previous years, as the ETF industry was growing by leaps and bounds, issuers seemingly brought every product they could think up to market, hoping that at least some of them would stick and ultimately become profitable. It isn’t exactly cheap to launch an ETF, but the potential reward was so great that issuers were willing to.
Now we’re seeing significantly more research and discipline surrounding product launches. ETF Securities clearly did their homework to determine what investors want that isn’t currently available. Instead of developing complex strategies or probing obscure corners of the globe, ETFS has made relatively minor changes to already popular products. SGOL is comparable in most ways to State Street’s GLD (both hold gold bullion), but SGOL keeps its holdings in Swiss vaults. The detail is minor to most investors, but extremely important to gold bugs with large holdings in the yellow metal.
Over their first 10 trading days, SIVR and SGOL had average daily trading volumes of 192,000 and 123,000, respectively. By comparison, iShares EMIF and EPU, which began trading earlier this year, drew less than 10,000 in their first 10 days. Going forward, expect fewer product launches, but also funds that languish under $20 million in assets and 5,000 daily shares for extended periods of time.
Patent-Weighted ETFs Validated
Another story that slipped through the cracks this month relates to the valuation of intellectual property. A group of Microsoft rivals is reportedly near an agreement to purchase a group of patents that would reportedly ward off legal actions regarding the use of the Linux operating system. Microsoft believes that Linux, popular among many programmers, violates nearly 200 patents. If Open Invention Network were to acquire the patents, potential lawsuits may lose their luster.
So what’s the connection to ETFs? Claymore offers two ETFs whose holdings are based on the relative value of the patents owned by the company. The Microsoft-Linux developments don’t necessarily make OTP a buy. But is an interesting validation of the investment thesis behind these products. Valuation of intellectual property is an extremely difficult and subjective exercise, but the value of patents is real.
Intellectual property accounts for an increasingly large portion of firm value, making the ability to accurately assess its worth a very valuable skill. For investors looking for exposure to large cap equities that may outperform traditional cap-weighted benchmarks, OTP is an interesting option.
iShares’ Next Big Push
As the market for “core ETFs” has become increasingly saturated, market leader iShares has turned to more targeted niche ETFs to continue growth in its product line. Already this year, iShares has launched an emerging markets infrastructure fund (EMIF) and an ETF focused exclusively on Peruvian equities. Look for iShares to introduce some innovative products in the coming quarter, including more emerging markets products, corporate bond funds, and risk factor-based ETFs.
Precious Metals ETF Boom Continues
ETF Securities, already a giant in the European ETF industry, has stormed onto the scene in the U.S., as its first two products, physically-backed products holding precious metals, each surpassed the $100 million in assets mark in their first month of trading. With safe haven investments in high demand, look for ETFS to look to build in its initial success and continue new product launches in the fourth quarter. We expect to see both physically-backed platinum and palladium ETFs in the upcoming quarter, and anticipate that ETF Securities will top $1 billion in assets before the year is up.
PowerShares S&P 500 BuyWrite Portfolio (PBP): Over the last two years, volatility has reigned supreme on Wall Street. Triple digit swings are no longer unusual or unexpected. The Dow has plummeted from 14,000 down to 6,000 before surging back up above 9,500. But things may be beginning to settle down. The CBOE Volatility Index, a measure of implied future volatility, closed near $24 last week, near its 52 week low and well below its 52 week high of almost $90. Economic news is mixed. Consumer confidence and spending have been revived, but unemployment still hasn’t bottomed out and business spending is yet to pick up. So it seems possible that the markets may (gasp) just move sideways for a while, finally settling into a period of relatively low volatility.
The relationship between volatility and PBP is a strong negative one. PBP follows a buy-write strategy on the S&P 500, going long the index but selling call options with exercise prices above the current level. This strategy maintains some upside exposure, limits the downside, and offers potential for a free lunch if the markets stay steady.
iPath Dow Jones-UBS Sugar Total Return ETN (SGG): Sugar prices have surged in the first nine months of the year, but price movements have been driven at times more by emotions than fundamentals. The fuel to the fire came in the form of an August letter from American food companies declaring that they would run out of sugar if import bans weren’t lifted. While short term supply concerns are very real, we think the 60% rise in sugar prices this year is a bit of an overreaction. Over the longer term, supplies will rebound (as we’re seeing already in India and Thailand), and prices will be forced to retreat.
All indications are that the speculators have jumped into the sugar arena, meaning that prices may continue to be volatile and unpredictable in the near term. But for investors able to stomach these short term fluctuations, going short in SGG could make for some sweet returns over the next year.
Claymore/AlphaShares China Small Cap Index ETF (HAO): HAO has been one of the top-performing equity ETFs so far in 2009, gaining more than 80% through the first nine months of the year. Even after this dramatic run-up, the fact patterns are still favorable for HAO. China has spent three times the amount of money (relative to GDP) to revive its economy, and has continued to grow at a rate of nearly 8%. As Bill Gross recently noted “it’s premature to award the 21st century to the Chinese as opposed to the United States…but China is sort of lookin’ like Muhammad Ali standing over Sonny Liston in 1964.”
We took note of a recent development in China this month largely unnoticed. The government is contemplating a plan to restrict the export of all rare earth metals, a valuable component of many tech gadgets and defense systems, a move that would send companies around the globe scrambling to replace supplies. While some think this is part of an effort to exert control over other countries, it is more than likely a reflection on an increase in anticipated consumption in China. An increasingly resource hungry China is a good sign for HAO.
PowerShares Dynamic Software Portfolio (PSJ): The technology markets in the U.S. are a tale of two sectors at present. Consumer confidence (and more importantly consumer spending) are beginning to recover, which is good news for consumer-heavy companies like Apple. On the other side of the coin are companies that depend heavily on business spending. Unemployment continues to rise (albeit at a slower and slower pace), and companies have put off updates of technology infrastructure to reduce costs.
As a result, software companies have seen major declines in profitability. But while system maintenance can be delayed, it can’t be eliminated altogether. If the economy does indeed stabilize, many businesses will find themselves in need of a freshening, and while they may not go all out, some software and infrastructure spending will be necessary.
PSJ tracks the Dynamic Software Intellidex Index, an “intelligent” benchmark that employs various screening criteria in an effort to select stocks poised to experience above average appreciation. Over the last year, this index lost about 4%, compared to a 17% drop for the S&P SuperComposite Software & Services Index and 26% for the broader S&P. With 30 holdings of companies engaged in the production of various software products, PSJ could see a big gain if a tech refresh cycle is indeed around the corner.
ETFs Under $7
ELEMENTS Dogs of the Dow ETN (DOD): Near the bear market lows is March of this year, fixed income investments offering attractive current yields were abundant. As the markets became more rational, however, these bargains began to disappear. Now that all of the “cheap” fixed income options have been scooped up, expect investors to begin hunting out equities with attractive dividend yields. DOD is an ETN linked to the return of an index comprised of the 10 DJIA components with the highest dividend yield.
Last Month’s Actionable ETF Plays
|Ticker||ETF||Monthly Return||Our Take|
|GDX||Market Vectors Gold Miners ETF||19.0%||GDX surged in September as investors rushed to safe haven investments and sent gold bullion prices above the psychologically important $1,000 per ounce mark. GDX doesn’t invest in bullion, but rather companies that engage in mining activities around the world and therefore benefit from higher prices.|
|JNK||SPDR Barclays Capital High Yield Bond ETF||5.0%||Junk bonds benefited from narrowing credit spreads in September, as investors continued to discount the likelihood of another wave of bankruptcies hitting the U.S. With a 30 Day SEC Yield of 10.05%, we continue to be bullish on JNK as a fixed income play.|
|IYW||iShares Dow Jones U.S. Technology Index Fund||4.7%||Technology ETFs received good news on both fronts in September, with increases in consumer confidence translating into additional discretionary purchases and upbeat outlooks for many businesses raising hopes for a “tech refresh” cycle at the end of this year of the beginning of next.|
|UUP||PowerShares DB USD Index Bullish||-2.0%||We thought that the greenback had bottomed out against its major rivals, but our call may have been a bit premature. Downward pressures in the form of near-zero interest rates and an improving economic outlook have pushed the dollar don even further.|
|SPY||SPDR S&P 500||3.1%||The broad-based S&P 500 ETF was up 4.5% in September, driven not by good economic news, but rather the lack of any meaningful regressions and hopes for a sustained recovery going forward.
The ETFdb 60 Index is an equal-weighted benchmark comprised of the largest ETF in each ETFdb Category, excluding inverse and leveraged ETFs. The Index gives an indication of the overall direction of the investable asset classes represented by this group of ETFs. At present, the ETFdb 60 Index includes 32 equity ETFs, 14 fixed income ETFs, 5 commodity ETFs, 2 real estate ETFs, and 6 miscellaneous ETFs (including currencies and multi-asset funds). For more information about the ETFdb 60 Index, or to see a complete list of holdings, click here.
Monthly Winners and Losers
Most equity and fixed income benchmarks saw made modest gains in September with 53 components of the ETFdb 60 Index in the red for the month and only 6 in the black. September was particularly good for the Latin American Equities ETFdb Category, driven by continued strength in Brazil’s economy. On the other side of the coin, ETFs in the Volatility ETFdb Category plummeted as the VIX traded near its 52 week lows.
The three components of the ETFdb 60 Index that saw the largest monthly gains in September:
|ETF||ETFdb Category||Monthly %|
|iShares MSCI Brazil Index Fund (EWZ)||Latin America Equities||19.0%|
|Market Vectors Gold Miners ETF (GDX)||Industrials||16.8%|
|United States Natural Gas Fund (UNG)||Oil & Gas||14.3%|
iShares MSCI Brazil Index Fund (EWZ): Brazil’s economy has staged a strong recovery following its first recession since 2003, spurred by interest rate cuts to record lows, new-found oil wealth, and perhaps anticipation of an opportunity to host the 2016 Olympics. While Brazil’s economy is expected to contract in 2009, the country is expected to lead Latin America’s 2010 recovery, with GDP growth of 3.5% anticipated. The Brazilian real finished September at its highest level against the U.S. dollar in over a year, another sign of strength from one of the world’s fastest growing economies.
Market Vectors Gold Miners ETF (GDX): The rise of gold bullion prices above the psychologically important $1,000 per ounce mark in September was widely covered in the financial media, but the impact on companies engaged in the mining of precious metals was generally overlooked. Surges in gold prices during September contributed to improved profits for companies engaged in gold mining around the world. Since many of these companies maintain significant fixed costs in their expense structure, surges in the price of underlying commodities can fall straight to the bottom line. At 16.8%, the monthly increase for GDX more than doubled GLD’s monthly gains.
United States Natural Gas Fund (UNG): The U.S. Natural Gas Fund has been impacted by factors beyond the fundamentals of natural gas prices. As UNG’s ability to create new shares to meet surging demand has been hampered, this ETF has occasionally traded at a significant premium to its net asset value in recent months. After bottoming out in early September, natural gas prices staged a rally after reaching near historic lows relative to crude oil prices. With huge discoveries of natural gas in recent years, natural gas prices have tumbled this year, and are expected to remain at depressed levels for the foreseeable future.
The three components of the ETFdb 60 that saw the biggest declines in September:
|ETF||ETFdb Category||Monthly %|
|iPath S&P 500 VIX Short-Term Futures ETN (VXX)||Volatility||-19.8%|
|iShares MSCI Japan Index Fund (EWJ)||Japan Equities||-1.3%|
|Rydex CurrencyShares British Pound Sterling Trust (FXB)||Currency||-1.1%|
iPath S&P 500 VIX Short-Term Futures ETN (VXX): As equity markets have become gradually more stable following the financial crisis and global recessions of the last two years, indicators of volatility have declined to their lowest levels since September 2008. Stocks inched up slowly but consistently during the month of September, sending volatility plummeting. VXX tracks the performance of a basket of futures on VIX contracts, which measure the impleid volatility of the S&P 500 over the coming month. Despite its significant decline in September, the VIX still remains above its historical average over the last 19 years, indicating that perhaps there is room for further declines if stability continues to return to the markets.
iShares MSCI Japan Index Fund (EWJ): While most developed equity markets around the world posted stellar gains in September, the world’s second biggest economy struggled to implement a successful stimulus plan. After major tax breaks and economic incentives for consumers in the U.S., China, and Japan temporarily boosted production, it appears that these programs have now run their course, and the effects of the stimulus plans are beginning to fade. A strong yen has also eroded demand for Japanese-made products, striking a blow to the company’s manufacturing sector in September.
Rydex CurrencyShares British Pound Sterling Trust (FXB): Sterling continued its precipitous decline in September, falling against most major rivals, including the dollar. With official interest rates at record lows, the pound has found itself on the short end of many currency carry plays. The Bank of England is reportedly considering a cut in its deposit rate to enhance its quantitative easing program and a rapidly increasing budget deficit, making it unlikely that the pound will strengthen significantly at any time in the near future.
Rebalance Your Equity/Bond Allocation
As hopes that the recession has come to an end abound, equity markets have surged in recent months. While bond markets have performed relatively well in recent periods as well, they have lagged far behind equities, putting many buy-and-holders in need of a rebalancing.
VTI, which offers exposure to the broad U.S. stock markets, has gained about 34% over the last six months, while AGG has added only 4%. Investors with a 60% stock / 40% bond asset allocation when the second quarter began may have seen their equity allocation rise above 65%.
For disciplined investors with a long-term investing focus, the discrepancy between stock and bond returns over the last six months may mean it’s time to sell some stocks and reload on fixed income products.
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