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Innovation on the Sector Front: Emerging Markets

Some investors allocate capital entirely along sector lines. Others use style and capitalization to specify asset allocations. Still others use a combination of the two, employing sector ETFs to overweight holdings within one or more sectors.

Prior to May 21 the universe of sector index ETF families numbered five covering U.S. equities, two covering international developed market equities (ex-US), and one covering global equities (including US). Conspicuously absent from the lineup was an emerging markets sector family.

For those that would employ sector ETFs to cover portions of international developed markets, the ability to allocate along sector lines may be equally important at the emerging markets level.

On May 21 Emerging Global Advisors (www.egshares.com) launched trading on two of a family of twelve ETFs to soon be trading. The ETF family will consist of ten sector ETFs, based on Dow Jones Emerging Sector Titans Indexes, one emerging markets “composite” and one emerging markets industry ETF, also based on Dow Jones emerging market indexes.

The DJ Emerging Markets Energy Titans Index Fund (EEO) and DJ Emerging Markets Metals & Mining Titans Index Fund (EMT) each cover 30 companies domiciled in thirteen and nine countries, respectively. 88% of Energy’s initial country allocation resides in Russia (36%), India (19%), China (16%), Brazil (10%) and South Africa (7%). For Metals & Mining, the top 5 country holdings, representing 94% of the total, include South Africa (31%), Brazil (23%), China (16%), Russia (13%) and India (10%). Company weightings are based on float-adjusted market capitalization and are capped at 10% with adjustment quarterly.

So what might the new emerging markets sector family mean to investors?

Investors using entirely style and capitalization-based allocation disciplines allow sector concentrations to migrate as economic conditions evolve and the business cycle marches on. For those preferring to overweight certain sectors, they soon will be able to do so at the emerging markets level, rather than only at the U.S. and developed market international levels.

For sector allocation investors, the same sector strategy framework one might apply to U.S. and international developed markets will now be possible at the emerging markets level. For sector allocators in international developed and emerging markets, control of sector exposure is the primary allocation objective, with country, capitalization and style distribution remaining migratory in nature. Individual countries tend to have distinct industry concentrations. Purchase of an ETF covering the U.K., for example, would find energy/petroleum and banking to figure prominently in the holdings. Likewise, an ETF covering Switzerland would be expected to have a heavy proportion of holdings in banking and insurance industries. Prior to the roll-out of the emerging markets sector family, sector allocation practitioners had to attack allocation needs to emerging markets through regional, country-specific or thematic alternatives (e.g., BRIC, Chindia) alone.

Emerging Global Advisors indicated that institutional investors constitute the primary target audience for the family of emerging markets sector ETFs. And, apart from tactical plays involving up to only a few of the family at any given time, that’s quite understandable. A challenge for sector-based allocators is to cover the equities landscape with as many as thirty sector holdings (10 U.S., 10 international developed markets, 10 emerging markets). Perhaps the next big innovation step for sponsors of families of sector-based ETF will be to create a single ETF which holds each of the sectors in a prescribed concentration (equal weight or another, relatively agnostic, proportion). This will then allow any “overweighting” to be done with one, two or three of the individual sector pieces – thereby enabling the use of a sector-based approach with one-to-four holdings rather than 10 for each of the equity asset areas (U.S., international developed markets, emerging markets).

Look for this family of ETFs to stick around. Creation of the emerging market sector ETF family addresses specific strategy needs for a meaningful, if minority, slice of the investment community.

Pimco Joins the Party

Pacific Investment Management Company, better known as Pimco, made headlines this week with the launch of its first exchange-traded fund – the Pimco 1-3 Year U.S. Treasury Index Fund (TUZ).  TUZ tracks the Merrill Lynch short-term U.S. Treasury index and immediately becomes the cheapest fixed income ETF on the market with a paltry 0.09% expense ratio.  Pimco’s entrance into the ETF space represents a potentially game-changing moment for the ETF industry.  With investor assets continuing to flow out of mutual funds and into ETFs, Pimco joining the party further pushes ETFs into the mainstream and increases the growing pressure on other high profile mutual fund companies to develop or increase their suite of ETF products.

Pimco, the standard for fixed-income mutual funds, manages over $750 billion in assets with one of the strongest track records in the world.  With its foray into ETFs, Pimco is signaling a shift in the mindset of large mutual fund companies who have been slow to embrace the rapidly growing ETF industry.  With their low cost, transparency, tax efficiency, among other benefits, ETFs have been cutting into the highly profitable mutual fund model.  As we recently explained with Fidelity, the mutual fund giants are facing considerable pressure to move quickly into ETFs as the mutual fund model continues to look less attractive.

Pimco’s foresight to adapt to the quickly changing investment landscape might be the necessary catalyst to push the other large mutual fund companies to develop viable ETF strategies or face getting left behind.  Pimco’s 1-3 Year U.S. Treasury ETF represents just the beginning for the company, as they also announced SEC filings for six additional ETFs:   Pimco 3-7 Year U.S. Treasury Index Fund, Pimco 7-15 Year U.S. Treasury Index Fund, Pimco 15+ Year U.S. Treasury Index Fund, Pimco Broad U.S. TIPS Index Fund, Pimco Short Maturity U.S. TIPS Index Fund, and the Pimco Long Maturity U.S. TIPS Index Fund.  It appears that the party is just getting started.

A Primer on Energy ETFs

This week we’ve fielded calls requesting information and guidance regarding ETF coverage of energy commodities. And while the entire commodity arena warrants attention, for the sake of brevity, we’ll limit our discussion here primarily to the energy segment.

Most any form of commodity exposure that the individual and institutional investor would need is currently available in the form of an ETF. And there’s more in the SEC registration pipeline that will provide additional granularity through a broader menu of single commodity ETFs during the coming months.

Commodity ETFs can be grouped along three primary lines: energy, metals and agricultural.

The most developed of the three, selection-wise, is energy. Exposure can be had across all three segments via a single ETF or can be tailored by the investor via the use of single ETFs covering individual commodities or commodity subclasses.

Construction-wise, (un-leveraged, long) commodity ETFs purchase short-maturity treasuries which are then used to collateralize ownership in commodity futures positions. Among alternatives covering a given commodity, there are important differences in how expiring futures positions are rolled to forward futures positions. This is not an issue for two of the gold ETFs, which directly hold physical gold.

Deutsche Bank Commodity Index Fund (DBC), marketed through Powershares, is 55% energy (35% crude, 20% heating oil), 22.5% metals (precious at 10% via gold, base at 12.5% via aluminum) and 22.5% agricultural (11.25% for each of wheat and corn). The fund is rebalanced back to these weightings once per year in November.

The players in energy ETFs are US Commodity Funds LLC and Deutsche Bank (DB). Energy exposure can be taken in the form of a multi-commodity ETF, comprised of refined and unrefined components, or via single commodity ETFs.

DB Energy Fund (DBE) is a mix of crude oil (45%), refined oil products (45%) and natural gas (10%). The crude component is split between WTI and Brent at 11.25% each. The refined is split between heating oil and RBOB gasoline, likewise at 11.25% each. Holdings are rebalanced to the base weights once per year in November.

On the crude oil front there are three choices – differing primarily in what futures contract(s) they hold and how they roll expiring futures positions forward.

US Oil Fund (USO) owns near futures month and rolls positions over a 4-day period.

US 12 Month Oil Fund (USL) spreads ownership across 12 months, rolls expiring month to the back.

DB Oil Fund (DBO) holds positions in a single month (currently June); between the 2nd and 6th trading days in contract expiration month the fund rolls position to one of 13 forward months depending on spreads and the application of DBs roll optimization methodology. This same roll methodology is applied to futures positions in other DB commodity ETFs.

 USO might be preferred in price-strengthening environments as inter-month futures spreads tend to become increasingly backwardated (i.e., forward months trading at discounts to near months). USL or DBO might be preferred in flat-to-weakening price environments in the event that forward futures prices move to premiums over nearby months.

Others (all hold near-month futures positions)

US Gasoline Fund (UGA)

US Heating Oil Fund (UHN)

US Natural Gas Fund (UNG)

All of the abovementioned ETFs have actively-traded options available.

There are also 2x leveraged long (UCO) and 2x leveraged short oil (SCO) ETFs (issued by Proshares). These generally don’t hold futures positions directly, although their prospectuses allow this in addition to the holding of options on futures. Most positions held by leveraged and inverse ETFs are in the form of over-the-counter swaps, with third party institutional providers / market-makers, which are trued up (collateral-wise) on an ongoing basis. There are critically-important tax considerations as well as serious cumulative return dynamics that investors need to fully understand before wading into any leveraged or inverse products.

Commodity exposure can also be taken on via exchange-traded notes (ETNs) – except for options, which are not available on ETNs. Multi-commodity ETNs tend to provide exposure to broad commodity indexes having a composition mix that is variable over time. Multi-commodity ETFs typically have a base allocation schedule across commodities that is rebalanced periodically. There are a number of very important differences between ETNs and ETFs, including important aspect of ETNs being debt instruments.

We outlined the critical features both ETNs and leveraged and inverse ETFs in feature segments in our May newsletter. Please let us know if you haven’t received a copy of that letter but would like to.

For those interested in equities exposure, there is an abundance of ETF alternatives holding stocks of companies engaged in energy sector, sub-sector and industry-level activities. And many of these also are available in un-leveraged, leveraged and inverse forms.

 We’ll follow up with discussion on metals, agricultural commodities and currencies – all worthy of attention.

Another Fan of Commodities

In the May 18, 2009 edition of Barron’s, there is an article from the authors of the book Globality: Competing with Everyone from Everywhere for Everything, that presents a concise explanation of why every long-term investor should have exposure to commodities in their portfolio.

While we are mired in an economic slump unlike anything since the great depression, it is important to know that in other parts of the world economies are still growing.  China, for example, still grew its GDP over 6% in the fourth quarter of 2008 and is expected to still have an expansion of its GDP this year.

There are a few important differences between the US and other economies that are still expanding.  The most significant is that those countries aren’t in hock up to their eyeballs and can invest in their economies without borrowing.  The second is the continuation of a dramatic growth in their middle class.  Millions of people are moving out of poverty each year in those countries.  When they do, they want to live like other middle class people around the world.  In short, they want more stuff, including more protein in their diet and new cars outside their new houses.

The growth in these populations, along with the growth in their economies generally, will put dramatic strains on the world’s natural resources.  Growth in a desire for protein rich diets will strain the food supply and agricultural inputs of all types.  The need to build infrastructure to handle enormous growth in autos and trucks will drive up demand for iron ore, and there will be the obvious strain on global oil supplies (do you think wind or solar power will be powering cars around the world anytime soon?).

For a US investor, the supply and demand economics of commodities make for a compelling investment theme.  These economics will be further augmented by the likelihood of a decline in the purchasing power of the dollar.  The massive growth of the money supply and the related massive deficits are likely to trigger a drop in the dollar that will add icing on the cake to the returns of long-term investors with exposure to commodities. 

Unfortunately, the majority of individual investors don’t have investments in these ‘hard assets’.   Right now is a good opportunity to allocate part of your portfolio to commodities.  An opportunity that will quickly vanish once inflation raises its ugly head over the next few years and the growth in economies around the world begins to accelerate.

ishares Putting Money in Your Pocket

The announcement hasn’t received a lot of attention, but if you participate in a 401k plan, there was a recent news release from ishares that might help put money in your pocket.

To date, the penetration of ETF’s into corporate 401k accounts has been minimal at best.  ETFs offer 401k participants dramatically lower investment costs over most 401k options, and they also offer broad exposure to investments rarely found in those plans: commodities and other alternative assets.  However, the back office infrastructure (think recordkeeping and trading platforms) of the industry was built primarily for traditional mutual funds and it has been difficult to convince industry players to change the way they do business for investment options that were, until recent years, not in high demand.

How times have changed.

Enlightened HR and Finance executives who oversee 401ks are now pushing for ETFs and ishares is stepping up to meet the demand.

ishares will team up with some of the largest administrators, custodians, and technology providers to make it very easy for financial advisors to provide ETFs investment options inside the plans.  ETFs can be offered as exclusive options or alongside traditional mutual funds.

It is too early to tell whether the ishares initiative will be successful, but the bet here is that ETFs are getting ready to make a big move against mutual funds inside 401k plans – and put a lot of money in investors’ pockets.