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Converts on the Rise (convertible bonds, that is)

Convertible bonds are an item that’s not usually at the top of investors’ list of hot-button items.  But in these times, it might not be a bad idea to give closer look to a player that can swing from both sides of the plate.

Convertible bonds are fixed maturity debt instruments that typically pay a coupon but also give the holder the option to convert the bond into the issuer’s common or preferred shares of stock.  Accordingly, convertible bonds carry both bond and equity valuation/performance and risk attributes … and diversification benefits that come with the ability to convert from bonds to equity.

Convertibles typically pay a coupon which is lower than a comparable non-convertible bond but higher than the dividend yield from common shares of stock of a corresponding issuer.  Because convertible bonds can be converted into equity, they tend to benefit from strengthening in equity prices.  They also get some level of downside risk support via their bond attributes – allowing them to be redeemed for par at maturity – in the event that they don’t get converted to equity along the way.

StateStreet launched the first – and still only – convertible bond ETF:  SPDR Barclays Capital Convertible Bond ETF (CWB).  The ETF tracks the Barclays Capital US Convertible Bond $500MM Index – which includes US convertible issues with outstanding issue size of more than $500 million.  With average expense ratios for actively managed convertible bond mutual funds at 1.40% (as of 2/09, according to StateStreet), CWB’s expense ratio of 0.40% clips expenses by more than two-thirds.

Since its inception on April 14, CWB has nearly kept pace with the torrid 21% return pace set by the S&P 500.

So, where do convertibles fit into an investor’s allocation?

Because of their unique return and risk attributes, convertibles can make sense as a fixed income / equity hybrid component in both buy-and-hold and trend-following strategies, or in many tactically-oriented portfolio settings.

A Few Alternatives for Dealing with Inflation Risk

As global economies start to show signs of recovery, the US dollar remains relatively weak and our government continues to spend at record levels, inflationary worries have become the new talk of the town.

Although price hikes have remained relatively low, stirring up an equally disturbing notion of deflation, eventually we will have to pay the price for spending our way out of the worst recession seen in the past 50 years.  The Federal Reserve has forecasted rising prices in the range of 2% to 3%, but most experts think it will be much higher and may even flirt with double digits.  So what do you do when inflation hits?  Some common plays include looking into precious metals and commodities.  An equally important move could be the utilization of fixed income.

Here are a few possible plays to deal with inflation:

Gold:  The most well-known and grandfather hedge against inflation, the SPDR Gold Shares (GLD). 

Fixed Income:  The iShares Barclays TIPs Bond (TIP).  This is an ETF that invests in inflation-protected securities and adjusts its coupon payments and underlying principal to compensate for inflation as measured by the consumer price index.

Commodities:  For commodities exposure its worth considering three alternatives, one providing exposure through commodities futures and two through equities of commodity-producing companies.

In the first, the Powershares DB Commodity Index Fund (DBC) provides exposure via futures to refined and unrefined oil, precious and base metals, and wheat and corn.  GSG, another futures-based commodity ETF halted creation of new shares on August 24 in response to potential CFTC changes in policy regarding position limits.

On the equities front, the iShares S&P North America Natural Resources ETF (IGE) is the established player with plenty of traction with $1.4 billion in assets.  The CRB Global Commodities Equity Index Fund (CRBQ), meanwhile, just began trading on 9/21.  The primary point of differentiation between the two is the manner of component weightings.  Matt Hougan of Index Universe reported that IGE holdings are market-cap weighted whereas CRBQ holdings are weighted according to value of commodity production, with commodity bias weighted according to total global value of each segment’s production.

3 ETFs And Sectors To Watch

The Institute for Supply Chain Management recently reported that manufacturing crossed into expansion mode and the Federal Reserve Bank of Philadelphia stated that its general economic index measuring manufacturing rose more than 230% from the previous month to a reading of 14.1. 

This is great news beacuse it indicates that businesses are opening their wallets and starting to spend.  One major reason behind this is that businesses implemented lean measures at the beginning of the year which included trimming inventories and supplies and as these inventories started to deplete, they needed to be replenished.  To further add to this, many prominent economists expect the nation’s GDP to grow in the remainder of the year (there will be still be a net contraction for the total year).  Should this trend continue, it could benefit base metals or the PowerShares DB Base Metals (DBB) ETF.

The second place to look is energy.  As emerging markets continue to grow, they will demand more energy and the key will be exploring for and producing this energy.  The iShares Dow Jones U.S. Oil & Gas Exploration & Production (IEO) ETF is an attractive place to look because it will benefit from a recovering economy and the stocks it holds are entirely focused on the exploration and production of oil and natural gas.  This gives the fund more leverage to oil and gas prices, though with less revenue diversification than oil and gas themed funds with sizeable holdings in large integrated oil companies.

A third area to look at is precious metals, particularly silver.  Silver offers many of the same characteristics as gold, in that it offers protection from inflation and a falling US Dollar.  However, what makes the metal attractive is its role and importance in industrials.  Silver is often used in electronics and batteries and therefore, is directly influenced by base metals.  Additionally, most silver is mined as a by-product of other metals such as lead, zinc and copper.  Thus, the supply and demand influences on these metals indirectly influence silver.   As production cutbacks in the output of base metals continues, the global economy continues to show signs of recovery, and investor appetite for risk grows, supply pressures will be placed on the shiny metal.  The iShares Silver Trust (SLV) is a good way to access the silver market.

Innovation in ETFs waning? Far from it!

Some analysts and reporters question the need for additional ETFs and the value that new ETFs bring to investors. For what it’s worth, we heard the same commentary when the universe of ETFs listed on US exchanges stood at 200, 400 and 600 and still had gaping asset coverage holes.

ETFs listed on US exchanges numbered 755 at the end of August, up eight from the end of July according to StateStreet.  There are currently in the neighborhood of 500 ETFs in registration at the SEC, awaiting approvals for issuance.

A closer look at what’s been rolled out since the end of July shows that, in fact, important innovation is still very much alive and well in the ETF space.

Investors are better equipped than they were 60 days ago to make choices about how to protect against inflation risks – thanks to the launch of a short-term TIPS ETF by Pimco (STPZ).  The only two ETFs that have preceded it to market each carry short, intermediate and long maturity TIPS in a single ETF having a considerably longer average duration than the new Pimco fund.

Harry Dent?  Relative strength models?  All rolled up in a tactically-oriented, “actively”-managed ETF?  There is now (DENT), as we discussed yesterday.

US equities markets have been carved up into sector and industry ETFs by no less than a half-dozen index families-turned-ETFs.  And international developed markets equities have three index family alternatives for gaining sector-based exposure.  Since May, though, Emerging Global Advisors has been rolling out emerging markets sector and industry ETFs, with their latest launch made in the past month (EFN).

Investors in physical gold now have the capability to opt for an ETF which holds gold in Swiss vaults rather than in the UK via SGOL.  This also represents a second ETF carrying physical gold carrying a considerably smaller market footprint than the massive $33 billion GLD.

Many regard today’s “frontier” markets as the emerging markets plays of five or ten years ago. Van Eck rolled out the first ETF (VNM) designed to provide exposure to equities domiciled in Vietnam.

ProShares recently rolled out an ETF designed to track – on a daily return basis – the un-leveraged inverse of the Barclays Capital 20+ Year US Treasury Index (TBF).  In the face of the arms race to 2x and now 3x leveraged products, it’s great to see relatively simple, un-leveraged inverse tools still hitting the street.  These allow investors to participate in the continuation of price trends, even when they turn negative – all within a consistent (and un-leveraged) risk management framework.

The first regional ETF to cover Nordic countries (GXF), by Global X, provides equity exposure to Sweden, Denmark, Norway and Finland.

For the vast majority of investment applications and across all major asset classes, investors are discovering the compelling advantages that ETFs bring to the table for providing access to exposure.  And it’s only getting better.

New Actively-Managed ETF

AdvisorShares recently launched its first ETF product, the actively-managed DENT Tactical ETF (NYSE:  DENT).  This “ETF of ETFs” uses Harry Dent’s relative strength models to specify entries and exits.  Dent’s analysis is rooted in the Dent Method – an approach which uses changes in demographics to forecast future economic trends. AdvisorShares states that the fund seeks to achieve its investment objective of long-term capital growth “by identifying, through proprietary economic and demographic analysis, the overall trend of the U.S. and global economies and how consumer spending patterns may change based on this analysis.  Then, the portfolio manager implements an investment strategy using ETFs across several asset classes such as domestic and foreign equities, domestic or foreign fixed income or commodities”.

Actively-managed ETFs do not attempt to track an index like most other ETFs but instead, attempt to generate excess returns based on individual manager performance.  While the passive versus active management debate rages on, there is certainly no lack of demand for actively-managed products.  And by using the ETF structure, active managers can reduce the operational costs of managing the fund, thereby providing lower costs to investors when compared to actively-managed mutual funds.  In addition, these ETFs can offer greater tax efficiency and easier accessibility than mutual funds (a number of which are only offered through certain brokers whereas ETFs can be bought and sold through just about any broker).

One potential downside to actively-managed ETFs is that the transparency they provide (holdings must be reported daily) could minimize any advantage that the fund manager believes they have.  Outside investors can track the moves of the fund, potentially front-running entries and exits.  However, many in the industry aren’t overly concerned that this will have a meaningful impact on the performance of actively-managed ETFs and could be perceived as an advantage in an environment where investors are demanding greater transparency.

AdvisorShares has also filed preliminary prospectuses to launch two additional actively-managed ETFs – the WCM/BNY Mellon Focused Growth ADR ETF and Legacy Long/Short ETF.