Emerging market bonds are a unique asset class with extraordinary characteristics, which many ETF investors have chosen to make a part of their portfolios.  Emerging market bonds have high absolute returns with low correlation to other markets, and are also high yielding vehicles.

Of the products on the market, The WisdomTree fund is the only local currency and actively managed fund.  The passive US Dollar ETFs have been on the market for some time and Van Eck Global launched its Market Vectors Emerging Markets Local Currency Bond ETF (NYSEArca: EMLC) recently as the first local currency emerging market bond ETF, which is also a passive product.

Because of these two newer entrants into the emerging market bond space, investors have a lot of choices when including emerging market debt into portfolios.

The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) is unlike other emerging market bonds in the ETF marketplace to date. Given in its name, the WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) invests in emerging market bonds dominated in their local currency.  This is in contrast to the other bond ETFs in the category on the market.  For example, the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca: EMB) is the largest in the category with assets of $1,962,167,846.  EMB is a passively managed index fund.  The index that this fund tracks invests in bonds issued by emerging market governments in US Dollars.  The reason for US Dollar dominated bonds is to add a layer of currency security.  Emerging market currencies tend to be extremely volatile with wide swings down and up.  With US Dollar bonds, the issuing governments bear the risks from the currency volatility.  Long-term currency valuations are, however, reflected in the value of the bonds despite the issuing currency, since currency can express many relative things to an economy-such as a country’s relative strength to the US or Europe.

The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) affords investors an opportunity to gain access to emerging market bonds issued in local currency and an active edge on the asset class.

“ELD will offer full exposure to local currencies, a feature we consider important for many investors because of the potential lower correlations and currency appreciation against the U.S. Dollar,” said Bruce Lavine, President and CEO of WisdomTree, in a press release.

Currency does have a significant impact on total returns of international investments.  Over the last year, currency has contributed to a 3.80% difference between local currency and US Dollar returns in Emerging Market stocks; the MCSI Emerging Market Index Local Currency returned 13.98% and the MSCI Emerging Market Index USD returned 17.78 over the same time period.  During other time periods, however, this effect has hurt the US investor and can cause a significant difference in returns.

Long-Term Focus in Emerging Markets

In an ETF category with four investment vehicles all offering a small twist on the asset class, it will be a great study on which style of investment works best for emerging market bonds over different market conditions. The WisdomTree Emerging Markets Local Debt Fund (NYSEArca: ELD) is active and will seek to take advantage of inefficiency in the emerging bond markets.  This will be very interesting.  In inefficient markets, bonds can offer many places where a manager can take advantage of including duration, currency, default risks and valuation.

A major concern brought up by many ETF commentators is how passive bond indexes will award issuers who have more debt issues with higher allocations.  In effect, this means that the funds reward debt, allocating more heavily towards more indebted countries and companies.  Active managers should be able to bypass this problem very easily and will therefore lower some of the inherent risks in the bond portfolio.

So What Happens

Bad investments happen when investors buy investments high and then sell investments low.  This seems like a simple, common sense and easy to follow rule, but each time extraordinary events happen in the stock market and the rule is broken, people will ultimately say, “This time it’s different.”  John Templeton, a mutual fund pioneer and asset manager, had this to say, “The most dangerous words in investing are ‘This time is different.’”

As the chart shows, when stocks are historically at their cheapest, investors sell stocks and buy bonds.  When stocks are at high prices historically, investors buy stocks and sell bonds.

Going Forward

Going forward into the unknown, investors will make money by having a wise investment strategy and sticking to it.  Good investment strategies may still have time periods where performance lags in times of crisis.  For example, during the rise of the tech bubble at the end of the 90s, a good investment strategy lagged the performance of tech stocks people were using to get rich.  However, the good investment strategy didn’t crash like many of the tech stocks.

Gravitating towards shorter duration bond holdings in the TIPS marketplace will mean choosing a higher correlation with inflation, lower volatility and only small yield differences.  PIMCO is currently the only ETF issuer with a full family of TIPS exchange-traded products.

Duration is a measure of the average life of a bond.  The duration of a bond is the percentage change that a 1% change in interest rates will move the bond’s price in the opposite direction.  For example, a bond with a 5-year duration will decrease 5% when interest rates increase 1%, all things being equal.

Currently, PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) is the only TIPS ETF giving investors access to the short end of the yield curve in the TIPS marketplace.  The ETF in this space with the 2^nd lowest duration is the iShares Barclays TIPS Bond (NYSEArca: TIP).  The iShares Barclays TIPS Bond (NYSEArca: TIP) has an effective duration of 4.15, while PIMCO 1-5 Yr US TIPS Index Fund (NYSEArca: STPZ) has an effective duration of 2.55.

TIPS ETF funds are great to compare since the US government equally backs up the income and principle from the bonds held by these funds.  Of the two lowest duration funds, SPTZ and TIP, the yield difference is important when looked at in relation to duration and risk.

Here’s a breakdown of the ETFs on the market today that compares average coupons and duration.  The chart below is similar to a risk/reward scatter-plot, replacing risk with duration and return with the average coupon payment.   Data is from Morningstar, Inc.

There is a very clear pattern formed in that duration is rewarded with risk, but not in an efficient way.  This is not a yield curve, since maturity and yield are not being measured, but rather a measure of maturity and a measure of yield (average coupon).

Inflation Correlation

TIPS, or Treasury Inflation Protected Securities, have a built in feature that adjusts the principle of the bond based on changes in inflation. When investing in TIP Securities, the lower term the bond is, the higher correlation to inflation the bond will have.  This is because shorter-term bonds are effected less by interest rate movements and investors’ interest or inflation sediments.  Therefore, a change in inflation is more clearly reflected the shorter-term TIPS bond.

According to PIMCO’s research, The BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index (the index PIMCO’s STPZ tracks) has a .27% correlation to inflation, while the Barclays Capital U.S. Treasury Inflation Protected Securities (TIPS) Index (the index for iShares’ TIP) has a .07 correlation to inflation. In the current low inflation and interest rate environment, now is a good time to buy inflation insurance and dial down on duration exposure.

TIPS have another unique usage for investors that relates to inflation.  Investors often purchase commodities as a way to protect against inflation and use TIPS as collateral for their commodity futures positions.  For instance, PIMCO uses TIPS as collateral in its Commodity Real Return mutual fund.  Since the yield from TIPS is a real return, meaning inflation is included, investors do not need to worry about losing in a high inflation environment.

Scenarios With TIPS

The main case for TIPS would be during an inflation spike.  The Federal Reserve appears to be committed to low inflation and low rates for the time being, aiding the US Government with a low borrowing rate.  The question is whether or not this is an artificial environment.  Will inflation begin to happen despite the Fed’s best effort because of the country’s growing debt-to-GDP level, currently at 54%?

There are some particular market scenarios where TIP Securities do great and some others where TIPS can be a scary investment and lose a substantial amount of value.

In a scenario mentioned by Anne Lester, a senior portfolio manager at JPMorgan Funds in a May 2009 WSJ article, interest rates rose from 10% to 15% while inflation (CPI) fell from 14% to 10% from July 1980 to July 1981.  She refers to this time (TIP Securities did not exist at the time) as the “perfect storm’’ that could cause TIPS to lose 20% in value.

It is important to note that with TIPS indexes, bonds are being rolled in and out as they fit into or become excluded from the indexes target ranges, and many indexes do not just hold bonds until maturity.  Also, it should be noted that the par value of bonds is changed based on the change in inflation.  Like the situation above, in a high inflation environment where inflation moves down, par values of these Treasury Bonds would decrease.

PIMCO’s TIPS Family ETFs

Although PIMCO is firm about active bond strategies being more efficient than indexing, they seem to be dedicated to running an effective indexing strategy with the ETF vehicle offering a full family of indexed TIPS ETFs, ranging from long, broad, and short term.

The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) is the most popular of the three with over $500 Million in assets.  The underlying index, the BofA Merrill Lynch 1-5 Year US Inflation-Linked Treasury Index, is capitalization weighted and is rebalanced monthly.  The PIMCO 1-5 Year US TIPS Index Fund (NYSEArca: STPZ) pays dividends monthly and has a low 20 basis point expense ratio.  Holding only 11 bonds, this ETF is set up to efficiently have low turnover.  The effective duration of this fund is 2.55 years.

Conclusion

With a specialized bond like TIP Securities, keeping maturities low is where the benefit of the inflation hedge is at its best.  The other factors that affect bond price can be minimized in lower maturities.  The primary reason an investor allocates into TIPS is to hedge against inflation.  Low duration TIPS will benefit from increasing inflation (CPI) and the expectation of inflation increasing.  Both of these factors will be directly affect these bonds’ prices and lower maturities will allow the highest correlation to these factors that the investor is looking to access.

The bill ventures into some areas that legislation has previously left alone. In many ways, the financial system needs some changes. However, for the most part, the Independence Day bill is more confusing than freedom-promoting.

Business Models

You may have guessed it, but banks will be receiving many new regulations. Economists believe that the increased costs to employ these new regulations will increase the cost of credit to the individual and small business, will drive out smaller banks from the market and exclude many of those who are less creditworthy from receiving credit. Those costs could be acceptable if the bill is effective, but it is largely unclear as to whether it will be. The Senate is somewhat split over the bill as a solution to these issues.

The financial industry landscape is a diverse one, ranging from financial advisors serving individual clients, hedge funds serving unique wealthy investors, and interest groups, venture capitalists and broker-dealers creating the transactions on the stock exchanges. Also to consider are the myriad of other functions and business models like investment banks, market makers and mutual fund-type companies functioning in a wide range of capacities to help the financial sector run.

It seems that some of these business models will have to endure higher taxes and higher audit and regulation fees where there was previously only some oversight.

The Individual

One area where this bill truly gets it right is looking at the standard of care given to the individual investor. After all, isn’t that what it should be all about? The entire bill came into existence so that America and Americans would avoid another major financial collapse and to plug the holes up in the system.

Currently, depending on whom the individual investor goes to for portfolio management, they could have an advisor who is compensated from the products them sell, and is regulated by how the advisor sells them. For example, a broker must only sell a product (like a mutual fund or annuity) to someone who is suitable for the product. There are many philosophies on what this means, but basically it comes down to the question of if a reasonable person would invest with this product.  If the answer is yes, then the investor is considered suitable.

In contrast to the above situation, an individual investor may go to an advisor regulated not by what they sell, but by the advice they give. As such, these advisors are unable to receive any kickbacks from the service they provide. They must give the client their best advice, and act in the best interest of that person. This role is similar to a defense attorney and it is called fiduciary. Registered Investment Advisors have a fiduciary standard of care to clients. Brokers have a suitability standard of care to clients.

Currently, brokers are not required by law to give their best advice. Registered Investment Advisors are.

Why is this an issue?

In 1855, William Travers, a New York businessman, was in Rhode Island and saw a long line of yachts and was informed stockbrokers owned them all.  This led him to ask his famous question, “Where are all their clients’ yachts?”

We have created an industry and a culture inside the stockbroker industry of double-mindedness when serving clients in how the advisor is compensated.

New words like fee-only have come up to express the way Registered Investment Advisors are paid, by a plain, transparent fee, only. They cannot accept payment from mutual funds for selling the product and receive no benefit from not giving the best advice possible.

Last year, in the early talks of the Financial Reform Bill, the problem was raised that people just cannot tell the difference between fiduciary advisors or Registered Investment Advisors and Brokers. Both had a similar “Advisor” type title and from research,  it was determined that these people are all perceived the same by investors.

In The Bill

The bill appears to give the SEC the ability to begin to regulate brokerages in a much stricter way and would allow them to be brought under the fiduciary standard.  Small advisories under $100 million in assets would be regulated by each state. This would greatly increase the level of protection individual clients would receive, as the SEC, who currently regulates those size firms, does not properly look at firms that small in size.

Reform seems to be coming this 4^th of July and though not giving investors more freedom, some protection seems to be on its way, slowly.  Investors do have options available to get fee-only advice, where kickbacks and product sales do not exist, but they will have to know what they are looking for:  an independent, fee-only, Registered Investment Advisor.

PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) is designed to track the S&P International Corporate Bond Index. The index includes investment grade bonds, rated by S&P or Moody’s issued in the following currencies, Australia dollar (AUD), British pound (GBP), Canadian dollar (CAD), Euro (EUR), Japanese yen (JPY), Swiss franc (CHF), Danish Krone (DKK), New Zealand dollar (NZD), Norwegian Krone (NOK) and Swedish Krona (SEK).

Like many other bond indexes, the S&P International Corporate Bond Portfolio uses a modified market valuation methodology. This is similar to a market capitalization methodology, except the allocation of bonds in each currency is limited to no more than 50%. Currently, bonds issued in the Euro have the maximum 50% weighting.

The fund rebalances monthly and contains a feature designed to boost yield. During each monthly rebalance, any currency with more than 10% allocation will exclude the lowest 25% of bonds with the lowest yield. This is an interesting feature and could be viewed as something similar to fundamentally weighting an equity index with a twist. The twist is that the rebalance makes sure the bonds with the lowest yield, which could also mean the bonds with the most recent run up in price, are excluded. Yield reflects risk, so by using this method, the PowerShares International Corporate Bond Portfolio (NYSEAcra: PICB) will keep only average yielding bonds within a currency. Dropping the lowest yielding bonds could possibly mean dropping the strongest bonds in the currency; this could be an unwanted risk, but will make the yield higher than it would be otherwise. In the same way that fundamentally weighting stock indexes use a factor other than price to determine weight, this methodology will be dropping high priced bonds.

Capping Debt

Turnover will also be high, due to this fund’s monthly rebalancing schedule. Typically in investment indexes, a passive investor likes to see very low turnover with not a lot of activity. In this case, however, investors might welcome keeping a tight rein on allocations in this fund, as bond markets can quickly shift. Some ETF investors have argued that bond ETFs do not work because of their overly passive approach to allocating to higher levels of debt.

For example, most bond indexes use a market capitalization style methodology, a system that works great for equity indexes since as a company issues more stock, stock prices will reflect the new ownership dilution. Whereas with bonds, companies and countries can issue debt and artificially get market capitalization as long as the market believes it can repay and will not default.  This is why Japan typically dominates international government issued fixed-income indexes. Japan has a national debt to GDP ratio of 192%. The risk is obvious there, but extremely passive fixed-income indexes will reward that debt level with allocation and not cap it.

The State Street Global Advisor’s two-week-old ETF, The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND), tracks the more passive The Barclays Capital Global Aggregate ex-USD >$1B, which includes bonds over $1 billion in market value. Doing this keeps the fund and index extremely liquid. The ETF is more Euro heavy than its competitor and holds its highest Euro allocation in the relatively strong Eurozone nation of Germany at 18%, immediately followed by US companies issuing in non-US Dollar fixed income at 17%.

The Barclays Capital International Corporate Bond ETF (NYSEArca: IBND) has an expense ratio of 0.55%, while the PowerShares International Corporate Bond Portfolio (NYSEArca: PICB) has a slightly lower cost at 0.50%. With these two funds being issued in such close timeframes, it will be a test to see which ETF emerges as investors’ preferred choice. Both funds have similar targets, prices and coverage zones. The question is whether investors will choose an ETF more concerned with liquidity like IBND, or an ETF capped to improve yield and limited exposure like PICB.

Risk Factors

The international corporate bond market is something that has been missing in the ETF space. There has been exposure to different international fixed income in the arena of emerging market bonds and developed market government debt, but the corporate space has long been empty. International corporate bonds are affected by both the risk factors of the currencies they are issued in and the credit risks of the individual issuer.

The unfolding of credit problems in Europe will be a large determinant of how these funds will perform. Currency will be a major contributing factor if the Euro continues to fall, hurting returns. The funds do contain high quality issues and will be an extremely low cost way to gain exposure to this important part of the global fixed income market. Since these funds are fixed income with total return coming both from price and income, currency will affect income, as it is translated into US Dollar. This could be a huge benefit for income seekers, since currency works in the US investors’ favor.

Bond ETFs are tricky, and definitely not as simple as equity indexes. The differences need to be understood, as well as the historic instances and implications of credit freezes. Bond ETFs can be liquid when the underlying bonds are not, even with large international bond issues such as those in these ETFs. These instances might look like significant tracking error, when the bond market was actually just not trading and no updated prices were being given. An ETF, being liquid, will reflect current prices, even when markets are closed where the underlying bonds trade, like these international issues. Overall, bond ETFs have been seen as efficient even when efficiency measures like tracking error and premiums and discounts look differently.

Among issuers, there are no major changes year-over-year. In April 2009, the National Stock Exchange reported that the number of ETFs and ETNs on the market was 844, 89% of those being ETFs. In April 2010, the ETF/ETN marketplace has grown to 998 securities, 90% being ETFs.

To gain some perspective on how that breaks down and to what extent the market actually utilizes those 998 ETFs and ETNs, the chart below displays the number of ETFs and ETNs above $100 million in assets. This serves no purpose other than to show to what extent ETFs are adopted by the marketplace. As you can see, only a relatively small number of ETFs get the majority of investment. This could be for a number of reasons, including index popularity, for example. It seems that the ETF marketplace is increasingly becoming more educated, and the most efficient ETFs are rewarded with usage. That being said, I do believe that there are many inefficient and useless ETFs out there, and in the past, investors have used the more expensive and less efficient of two ETFs that track the same index. Despite those situations, the chart below lends credence to the idea that investors haven’t taken hold of a majority of ETFs.

Where the Money is Going

Compared to this time last year, when investors were pulling billions from large cap ETFs, there are now normal inflows into that category. Cash flows to note are in the fixed income and global ETF categories. Despite potential worries in both categories, assets have been flowing into the ETFs

To put fixed income ETFs in perspective, there are no fixed income ETFs currently listed in the top ten ETFs, which continues to be largely made up of stock funds and the Goliath gold fund, GLD.

As shown above, over the same time period year-to-date, fixed income has not led to cash flows. Although not hugely significant, we can see this by looking at investors’ usage of both fixed income and global ETFs. Global ETFs are also a statement of currency fluctuations and it is something to note that YTD, currency ETFs have negative cash flows, while global ETFs report inflows.

So why is an increasing employment rate good in this case?

The amount of jobs added went up in April even well above what is expected, adding 290,000 jobs to the market.  This is up from 200,000 added in March.

The fact that the employment rate is down is showing that there are more people actively looking for jobs.

The workforce, defined as those looking for employment and have employment, rose to over 800,000 according to the government, and despite increasing job numbers, percentages are down.

This means that optimism about job growth among the unemployed is rising, which is a positive.

Currency is a huge contributor to the total return of any international investment; so, naturally, falling foreign currency against the investor’s currency hurts its performance in the same way falling US Dollar benefits its return. For this reason, many investors have included foreign investments in their portfolio, recognizing its importance to the global economy.

Shown above is the iPath Euro/USD Exchange Rate ETN. This is an ETN that tracks the spot rates of the Euro/US Dollar exchanges, showing a short history of the two currencies. The Euro makes up 44% of the currency hedged by the WisdomTree International Hedged Equity (HEDJ). ETNs have no tracking error because of their structure.

As shown in the graph, the Euro has recently plunged against the Dollar similar to the way it did in the 4th quarter of 2008 when the Dollar was globally relied on as a safety currency during the September credit crisis. In the years before, the Euro steadily rose against the Dollar. This recent Euro downturn has been caused by Greece’s and other struggling Euro countries’ economies under the euro currency, unlike in 2008.

The new ETF, issued by WisdomTree, is the first of its kind to hedge international currency risk in the ETF space.  The fund, WisdomTree International Hedged Equity (HEDJ), is intended to invest in the WisdomTree DEFA index, which is tracked by the WisdomTree DEFA ETF (DWM); only HEDJ hedges the currency exposure of DWM. This means that investing in HEDJ is designed to be similar to investing in local markets with local currency. If an investor were to switch between the two funds, the expense ratio would not be prohibitive- a ten basis point difference. The newer WisdomTree International Hedged Equity ETF (HEDJ) is charging 0.58%, while the WisdomTree DEFA ETF (DWM) charges investors 0.48% annually. These expense ratios aren’t cheap by ETF standards, but both ETFs offer unique qualities not found elsewhere on the market, which may justify the cost.

How WisdomTree Delivers the Hedge

WisdomTree, as an ETF issuer, is a true innovator in the area of fundamental indexing and providing currency exposure inside of an ETF package, thus allowing the investor to avoid the ETN structure. To date, WisdomTree has a full line of currency income ETFs, including the WisdomTree Dreyfus Emerging Currency Fund (CEW), which tracks a basket of emerging market currencies.

The company has been able to provide this kind of exposure through its expertise in managing currency forward contracts. The WisdomTree International hedged Equity ETF (HEDJ) will hedge currencies by using the same kind of rolling forward contracts. The fund will replicate owning the index as if the investor were investing in the local markets.

Erasing Currency in Your International Investment

This ETF is interesting because the short-term movement of currencies is extremely volatile, making up a good deal of the volatility in the MCSI EAFE Index (an index benchmark for Europe, Australasia, and Far East)-a market cap weighted index in a similar space as the WisdomTree DEFA Index.

In the last 3 years, currency has added about 21% more variability than a local investment would have incurred over the same time period. Currencies also tend to trend against one another in a long-run generalized way. Until 2008, the Euro and many other developed currencies have gained against the US Dollar.  With the problems in the Euro’s economies, the Euro has been floundering against the US Dollar. Investors with this viewpoint can use WisdomTree International Hedged Equity ETF (HEDJ) to stay invested in the international developed markets while dropping their currency exposure.

This strategy is sensible when investors like the long run growth potential of developed nations covered in the ETF, but would prefer not to see direct losses if the US Dollar strengthens.

Furthermore, the WisdomTree DEFA Fund, DWM, and WisdomTree International Hedged Equity (HEDJ) can be ‘twin’ ETFs, allowing investors to switch fluidly between them, exchanging currency risk (benefiting when the dollar falls) for a currency hedged fund (safeguarding against falling foreign currency).

Currency is often associated with national economic growth and regularly reflects the relative growth of national growth. This trend is what makes emerging market currencies attractive when the economies of those nations eventually develop.

A Fundamental Index

WisdomTree employs a fundamental indexing strategy in its equity ETFs. For the two ETFs discussed, this means a value-tilt to the funds. According to WisdomTree, this allows for better long run performance. Whether this is true or not, these two funds allow for access to unique investment qualities- the ability to hedge or not hedge the same equity stocks.

By breaking down the global sector ETF products on the market, the investor can get a grasp of the best way to capture sector returns throughout the globe, in domestic, developed and emerging markets.

Businesses throughout the globe seem to correlate most with other companies within sector groups even before country, region, size and style.  Therefore, when using a strategy involving sectors, reaching outside the US, even into emerging markets, makes sense as a way to add better risk and reward possibilities while controlling sector exposure, which tends to be correlated even across regions and borders.

Global returns can be explained by sector returns. Correlations among countries can even be explained in a great deal by sectors and the differences in asset allocations between their respective market indexes.

The Global Benchmark

The 10 global sector iShares ETFs represent the sector makeup of the S&P Global 1200, which represents 70% of the world’s market cap. The sectors are broken down from this index based on the 10 GICS (Global Industry Classification Standard) sectors, which are jointly managed by S&P and MSCI Barra. Below is a chart of the iShares global sector ETFs. Each ETF represents a GICS sector from the S&P Global 1200 Index. Also included are each ETF’s total net assets.

The GICS sectors are designed to place companies throughout the globe into sector categories.  Currently, the S&P Global 1200 Index, which is made up of the 10 GICS sectors, is broken down below as of 9/30/2009.

Data: Morningstar Office 9/30/2009

Why Global

Since sectors have a higher correlation globally compared to different sectors domestically, investing on a global sector basis could provide significant risk reward profiles, as making sector decisions for the US is benefited by global correlations and the higher growth possibilities abroad and the lower correlations to the overall US market. Instead of concentration on sectors domestically and adding international exposure, moving to a global sector strategy is a way to capture both domestic and international exposure. Since sectors seem to correlate throughout the globe, from US companies to companies within emerging markets, using global sector ETFs is a way to efficiently execute an investment strategy involving sectors.

Data: Morningstar Office 10/1/2004-9/30/2009 (US sectors are the S&P 500 GICS Sectors and Global Sectors are the GICS Sectors from the S&P Global 1200 Index.)

The above scatter plot displays the similar risk and total return characteristics of the US sectors, shown as circles, and the global sectors, shown as squares of similar colors. Note that the global sectors do include a significant allocation of US holdings and the chart merely shows the movements of a sector as international developed and emerging markets are added. In general, the movement from US to global has a positive risk reward effect.

Comparing global sectors to the S&P 500 GICS Sectors shows the benefit that could be added to US sectors by adding international holdings. The differences vary throughout the different sectors; however, typically, the global sectors (squares) are above and often to the left, showing higher total return and less risk throughout the last five years. This is what using global sectors would have added even if the investment decision was based on the more familiar US sector analysis. Based on the above chart, over the past five years, adding international sector holdings to US sectors had a positive effect.

Reaching Out Internationally

The Global Sector ETFs, being market cap weighted, have heavy US allocations. This provides a way for the investor to make global sector allocation decisions while leaving domestic and international, developed and emerging market and market cap decisions to the index or marketplace since correlations among sectors run high across borders.

This means that the risk of adding international sectors to sector strategy decisions has a low marginal affect on risk relative to the overall sector decision. This is because correlations have been proven to be high within sectors, explaining returns. Therefore, the largest risk factor is in the sector and the risks associated with it.  Emerging and developed international markets will bring unique risks; however, the risks of the sector are among the most dominant.

The graph below breaks down the exposures of US, international developed and emerging market  holdings within the iShares ETF series. It is interesting to note that the breakdown of developed versus emerging markets shows the areas where emerging markets have the greatest effect on the global economy. For example, the iShares S&P Global Materials Sector Index Fund (NYSE Arca: MXI) has an 8.5% exposure to emerging markets, which shows the growth of the world’s demand of developing countries’ mining products, metals and other materials.

Data: Morningstar Office 10/6/2009

Sectors Have A Place

Keep in mind that this is not necessarily a call to abandon broad diversification, but a need to focus on the importance of sectors as they relate to global return. Also, when investing with sectors, using and adding international exposure has returned benefits to almost every sector. In this way, an investor can analyze and invest among US sectors, while gaining correlated international exposure, which has higher long term risk and reward potential.

“Neither the Trust nor the Investing Pool is an investment company registered under the Investment Company Act. Shares of the trust are not subject to the same regulatory requirements as mutual funds,” said iShares in a new warning on its Web site about GSG. (Quote Source: IndexUniverse.com)

“The different set of regulatory approvals needed by commodity pools includes government approval to issue more shares at certain predetermined periods,” said Murray Coleman, Editor of IU.com, in a report on the subject.

Why?

Since I’ve been studying ETFs, there have been rumors of potential problems with commodity ETFs that the regulatory agencies have been overlooking. Recently, the problem came up with the United Natural Gas Fund (NYSEArca: UNG) after quickly gaining assets this spring. The fund stopped issuing shares in mid-August due to regulatory investigation into the commodity marketplace and the role of these kinds of ETFs. Basically, UNG was controlling the vast majority of all trading in the natural gas market. UNG’s management is looking for ways to reopen the ETF and minimize the use of futures-this may be through the use of SWAP agreements. This fund since closing has traded at a significant premium-16% last week.

The Main Issue

The main issue being looked at is position limits for these funds. For example, the SPDR, GLD, holds more gold than many of the world’s central banks, including Canada. Possible outcomes are unknown as the CFTC (Chicago Futures Trading Commission) looks further into the matter. According to analysts, the CFTC will not overlook the use of SWAP agreements by ETFs. If size limits are enforced, funds may be forced to sell shares.

Closing Announcements

• The U.S. Natural Gas Fund (NYSEArca: UNG): Halted
• iShares S&P GSCI Commodity Index Trust (NYSEArca: GSG): to close when shares reach 55.9 million (currently 52 mil)
• The iPath Dow Jones-AIG Natural Gas (NYSEArca: GAZ): Halted
• The PowerShares DB Crude Oil Double Long ETN (NYSEArca: DXO): Halted

The Massachusetts Secretary of State, William Galvin, is looking into the marketing of leveraged ETFs and has reportedly written letters to the three biggest players in this market, ProShares, Direxion and Rydex.

In addition, FINRA, a regulatory agency for brokers and advisors, has issued a warning that leveraged ETFs are usually unsuitable for investors who plan to hold them for longer than one day.

At this time, all leveraged ETFs have the objective  to provide a daily short or leveraged position in an index. The key word is daily and often the returns can vary greatly from that expectation.

The firms issuing these ETFs are very clear to that point and advise that the funds are only intended to give daily exposure.

The concern is losses for the Massachusetts Secretary of State, as he wants to determine whether the issuing ETF providers are at fault, leading the unknowing brokers to these kind of products.

What I think is mostly overlooked is that FINRA is setting up a situation for brokers to be at fault.

The Distinction

There is a major distinction between brokers and advisors, which I believe may be part of the problem here. Brokers should, but aren’t required to, act in client’s best interest, as long as investments are suitable. An investment is deemed suitable if it makes sense to be in a client’s portfolio-not whether it is the highest quality product or whether it is prudent.

Advisors, on the other hand, are required to act in the client’s best interest. Investments must be suitable, appropriate and represent the client’s best interest.

Advisors Not Off the Hook

I have looked, with a lot of detail, at leveraged ETFs. The issuing companies and prospectuses are clear that the ETFs will not meet their objective longer than a day.

With FINRA and other Government agencies catching on to this and looking for someone the blame for major losses investors take in these funds, advisors and brokers who have misused these funds will be soon coming under a lot of heat.

Know Your Investments

Here at Wiser Wealth, we have always understood the risks of leveraged ETFs and have been very surprised to see that many of our peers do not. In 2008, if you shorted the S&P 500, you would have actually lost money. How is this possible? The S&P 500’s up days were (in percentages) higher than the down days. Since leveraged ETFs compound daily and the up days had bigger losses than the down day gains, the perfect losing recipe was in place.

There have been a few infamous ETFs to bite the dust because of poor design and complex strategies that did not work. Adopting a policy of ”if you cannot explain how the investment works to a client, then it doesn’t make the list” might be a good idea for professionals who take everything at face value.

Clearly the regulatory authorities understand the leverage risk. Do you?

Recently, I’ve seen it reported that Harvard’s endowment portfolio performed well during 2008 because of alternative investments.  As it turns out, the reporter meant their fiscal year 2008, which ends in June. It was a perfect time to end the year, right before all asset classes lost significant value…great reporting.

So, as a follow-up to that original article, let’s look at fiscal year 2009.

The Wall Street Journal reported today that one of Harvard Endowment’s top bond managers made $6,300,000 last year, managing the fixed income portion of the now $37 billion fund. It has been announced that this manager is leaving the endowment. Why?

The endowment is forecasting one of its worst years, down almost 30% at the end of June and is positioning itself to become more liquid.

This move to become more liquid is the result of being very illiquid in the past.  So much so that during the credit crisis, the school had to make cuts, lay-off employees, and borrow money due to the endowment being tied up in illiquid investments like hedge funds and private equity.

The school and endowment like other schools’ endowments have more problems than I have quickly mentioned.  It seems that the endowment, created to provide for the schools needs (the school gets 34% of its revenue from the endowment), is now in a way holding the school hostage.

Before the credit crisis, the endowment’s illiquid investments helped the portfolio to average 14% annually. This over allocation (greed) ended up hurting the school.

This shows that there is a deeper problem in the financial services industry and should bring up the question; who’s serving whom?

A blog posted on CNNMoney.com’s Money and Main Street, Click Here, discusses a vague disclosure report from the White House concerning President Obama’s household assets and investments.

Page two of the original report, which the blogger links to, lists the President’s assets, where and what they are held in and an estimated value.

What is most interesting is that the President has somewhere between $1-5 million in US Treasury Bonds and the second largest holding of somewhere between $115-250 thousand in the Vanguard FTSE Social Index.

The Obama Portfolio

When President Obama was first elected, there were many people who advertised “Obama Portfolios.”  As it turns out, the original Obama Portfolio favors US Treasury issued debt and socially responsible companies in a simple index fund package.

The interesting part is that the President of the United States, who would have the best investment advisors at his disposal, chose a low cost, diversified portfolio of US stocks.

In light of recent market turmoil, many ETF industry commentators are saying the ETF market place is too crowded and grew faster than it was able to attract assets.

Bruce Bond, president and CEO of Invesco PowerShares, said this about the closings in the press release, “After carefully evaluating numerous factors including shareholder considerations, length of time on the market, asset levels, and the potential for future growth, we proposed closing certain portfolios that have not gained sufficient acceptance with investors.”

PowerShares closes some of the category of funds it is best known for, the FTSE RAFI Index tracking ETFs and 4 ETFs tracking Dynamic Intellidex Indexes.

12 of the closing ETFs are ETFs following the RAFI Indexes created by Robert Arnott, RAFI standing for Research Affiliates Fundamental Index, which weight index components by five fundamental factors.  Fundamental indexing proponents propose that market capitalization weighted indexes tend to overload themselves with overvalued stocks, the opposite of what an investor would want to do. These weigh an index based on fundamental factors and not by market cap which is a function of price. The 12 ETFs are all sector funds and the PowerShares FTSE RAFI Asia Pacific ex-Japan Small-Mid Portfolio.

The other seven ETFs closing represent either small slices of the market or niche concepts like the PowerShares High Growth Rate Dividend Achievers Portfolio, PHJ, which seeks to track an index that includes 100 companies with the highest dividend growths rates who have increased their annual dividends for the last ten consecutive years.

The closing Process

ETFs have closed in the past and since ETF assets are held outside of the company’s balance sheet, in trust, ETF assets are returned to an ETF investor upon the issuing company closing for bankruptcy or the ETF closing.

As PowerShares has announced, it will begin the process of closing the funds in the first part of May.  During this time, the funds will no longer be required to meet their investor objective of tracking the index but will be seeking to get best price and execution of the underlying securities.  This will cause tracking error to increase.

As of May 19, 2009, the 19 closing ETFs will no longer allow new investors in the funds.  Investors who hold the ETFs at the close of trading on May 18, 2009 will receive the NAV of the ETFs as of May 22, 2009 as a cash deposit in their brokerage accounts.

Up to the closing of the funds to new investors, on May 19, creation and redemption of the funds can still take place to ensure that the ETFs represent the basket of underlying securities, which will keep this period of ETF closing orderly.  Investors will be able to trade the ETFs up to the closing of new investments and should seek receive prices close to NAV, which may include the using limit orders.

IndexIQ, on March 25, 2009, launched its first hedge fund ETF. This is following in the wake of 2008 where many hedge funds were affected by mass withdrawals and highly leveraged bets went bad, causing many to shut down.IndexIQ, through its new ETF, provides a way for investors to access a low cost, no commitment and highly liquid hedge fund replication vehicle. The introduction of this hedge fund ETF allows access to the category at any net worth size, opening doors for clients’ portfolios, where before they were limited.

Unlike what it may seem, the IQ Hedge Multi-Strategy Tracker ETF, QAI, does not invest directly in hedge funds, nor does it follow an index of hedge funds. Instead, IndexIQ replicates the return, risk and low correlation characteristics of hedge funds using ETFs as the underlying investment. In this way, using ETFs within an ETF allows investments to stay as liquid and transparent as possible as IndexIQ implements its proprietary methodology in creating hedge fund replication.

The Benefit of Hedge Fund Replication

IndexIQ, using research and technology based on studying hedge fund returns, can provide hedge fund returns to investors through copying hedge fund methods. They do this while removing the risks of being highly leveraged and the problems associated with investing in highly illiquid markets. This methodology, matched with the transparency of ETFs, allows investors to reach for very liquid and cheap alternative strategies. IndexIQ has coined themselves as “the alternative to the alternatives.”  The IndexIQ ETF will charge a .75% expense ratio. This is inexpensive compared to similar hedge fund strategies charging 2% of all assets, 20% of all profits and sometimes more.

Graphed is the multi-strategy hedge fund category average as defined by Morningstar, Inc. There is great value in an investment product replicating this kind of risk/return profile relative to the S&P 500 benchmark, which is not the most appropriate standard for hedge fund managers to be compared against, but is important to show the return and risk reduction against a common index available to most advisors and investors.

How it works

The IQ Hedge Multi-Strategy Tracker ETF, QAI, according to their recent press release, replicates various hedge fund strategies including long/short equity, global macro, market neutral, event driven, fixed income arbitrage and emerging market strategies. All of these hedge fund replicating strategies, packaged as an ETF, trade intraday.

The idea of hedge fund replication is that many active managers in the hedge fund space are really giving the investor what has been coined as “Alternative Beta.” Alternative Beta, according to IndexIQ, has been mislabeled as alpha, when in fact, managers are just accessing beta that is outside the realm of typical asset classes. In this case, alpha is defined as excess return over a benchmark. Beta is the broad category.

Looking at hedge fund performance, and using heavy quantitative analysis, replication of a hedge fund investment strategy can be picked out from the data. IndexIQ promotes that it can use tradeable securities like ETFs and derivatives to replicate the strategies. This replication is really the beta of the hedge fund strategy and managers outperforming this strategy are creating true alpha. These hedge fund strategies are said to deliver the low correlation, risk reduction and return characteristics hedge fund investors are looking for, which is this “alternative beta.”

When it is really the alternative beta that investors want, they can stop paying for high priced alpha when the alternative beta is really the main component driving the low correlated returns.

This is really what IndexIQ is creating with their new ETF, and a whole line of ETFs to come, a way for any investor to add alternative beta to their portfolios. IndexIQ uses quantitative models and academic research supported by their all-star line up of finance academic leaders and ETF research specialists like Paul Mazzilli, a leader in ETF research, analytics and development, to create the first ever US listed hedge fund ETF.

The index that the IndexIQ ETF tracks has only been published since September of 2008, but back tested data shows the five year hypothetical risk reward profile against HFRX Global Hedge Fund Index and the S&P 500 as of December 31, 2008, according to QAI’s Factsheet.

When investors and clients see the value in having alternative beta in their portfolios, the IndexIQ ETF gives this exposure at a very low price. This ETF will force others to rethink what they are actually getting from managers, alpha or beta. Also, QAI, being an ETF fund of funds, shows that ETFs are a diverse investment vehicle which can cater to many unique investment strategies.

In Barron’s March 9, 2009 issue, Andrew Bary reported in the issue’s cover story that over a six month time span, gold had risen $140 to its current price at the time of $942 an ounce.

The point of the article was to show stocks relative value. The relationship between gold and stocks indicated that stocks may be undervalued, as seen in the following quote.

“The S&P 500 index is worth about 75% of an ounce of gold, verses a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold.”

Gold and other precious metals are an interesting investment and have gained a lot of press recently through radio and TV advertising. During this current credit crisis, gold has been seen as a “safe” investment that never loses its value like stocks and bonds because it is gold, the asset that was once used to peg many currencies, including that of the US during the time of the gold standard.

Even as a perceived safe investment, the increase in its price shows that investors view that gold is perceived as a quality and safe investment relative to other asset classes. The question is whether gold deserves a long term place in an investor’s portfolio and in what proportion. In the same way, the question is not whether gold is rare or was useful to pegging currencies, but how an investor should view gold as an investment in the short and long term.

There are some that view physically holding gold as insurance for “end of the world” type situations. Other than those investors, gold inventories held by small, individual investors are very impractical. The cost or risks of this kind of investing through physically holding gold must be fully realized. The cost of insurance, security, storage, transporting and inspecting true quality may make this kind of investment completely impractical. A better, more efficient way to purchase gold is through ETFs and ETNs, which track the price movement of gold by following a gold index. These ETFs track indexes, a range of investment options from physical gold to rolling gold futures. Precious metal ETFs like GLD actually hold physical gold in trust in secure bank vaults. There are unique tax implications when investing in these ETFs that should be understood before investing.

The Difference Among Asset Pricing

Theoretically, the price and value of publicly traded companies is the present value of all future cash flows. This may not seem always true and often prices can vary greatly from “fair value” or the present value of all future cash flows. In the long run, investors have been rewarded for purchasing stock in companies below this “fair market price” and selling it above the “fair market price.”

Even if all stock prices reflected the fair market values, investors would still realize gains and receive dividends from the stocks they hold. Why? Because, if stock prices should be the present value of all future cash flows, the more recent cash flows will have the greatest affect on stock prices.

Gold has no expected return. Unlike a stock, gold and other precious metals do not have any future cash flows and therefore their values and prices are only based on supply and demand. Supply and demand forces are more complicated when describing commodities. We could say the value of gas is the price we pay at the pump or the future price that market participants have contracted with each other to deliver gas or oil in the future. This is interesting because the supply and demand of a commodity like oranges is not only the supply or demand of today’s price, but the price in the future. This is why orange producers are so concerned with predicting weather, as weather in Florida will greatly affect the future supply in the marketplace. This helps guide their decisions on the future price of oranges.

When recently asked about investing in gold and where it will be in five years, Warren Buffett said that, “I have no idea where [gold] will be, but the one thing I can tell you is it won’t do anything between now and then except look at you.” He went on to say, “It’s a lot better to have a goose that keeps laying eggs than a goose that just sits there and eats insurance and storage and a few things like that.”

Warren Buffet’s advice is not the bottom line, but an interesting perspective from someone who has had great success investing based on strict principles.

Gold’s Supply and Demand

Many people believe that rare commodities will only get scarcer and that prices of those items must increase in value. This is most popular regarding oil, but relates to all commodities. Before discussing why this may not be true, this same line of thinking happened in many places in the world over the price of land and home values.

The thinking that led to the bursting of the housing bubble in the US and Japan in the 90s, which they have yet to recover from, is that there is only so much land. Reason tells us that as the earth becomes more populated, property values will increase due to a fixed supply and increasing demand.

This is not true. In the short term, the supply curve can be shifted (to the left) signifying less quantity available to consumers and a new equilibrium price will be set above the previous price. But the long term is a different story, (economists define the long term as the period where all costs are variable, meaning that big fixed costs like owning a house is fixed in the short term, but in the long term you can move). In the long term, this new price based on a decreased demand is not sustainable for reasons that will let consumers and suppliers shift the demand and supply curve back to lower or previous equilibrium prices.

Gold’s Difference

The appeal of gold is as a place of safety as investors flee towards quality. There are reasons behind why investors see gold as safe and reasons for the play. As financial systems continue to fail, the system of paper money may fail and the usefulness of gold as a monetary unit will return. In addition, as the government measures continue to not restore investor confidence, the fear that inflation will follow and that gold, as a commodity, will be a hedge against the inflation. Also, there is a popular notion that even in the face of inflation, gold will benefit as an inflation hedge. So in either case, gold works

In a recent analyst report by Keith Lerner, Chief Market Strategist for SunTrust Robinson Humphrey, published in Indexuniverse.com, reported that gold is a difficult asset to place a fair value on

“Since gold neither pays a dividend nor generates cash flow, we have never felt a great comfort in assigning a fair value for the precious commodity. Often, in our opinion, its direction is driven primarily by investor psychology and it trades on momentum…”

According to the same report, the analyst views gold as “technical/chart perspective.” He sees the near term risks for the commodity to be outflows in gold as the economy returns back to normal and the need for safety decreases.

Gold in Perspective

What we are seeing above is that gold, as an investment, is more volatile than the S&P 500 and annually over a 36 year period gold has annually returned less.

This is not to say gold is a horrible investment in all cases, but to say that the stock market historically has performed better with less risk than gold.

Commodities in general and especially gold have a low correlation to the stock market. Since it has a low correlation and higher volatility, adding commodities and gold in appropriate amounts can provide long term benefits. The hard part is figuring out the appropriate amount to allocate to gold or commodities as a wider asset class.

The Gold Run Up

As we have already discussed previously, gold has recently seen a large price increase. Investors have been flowing funds into gold due to many factors including gold’s historic uses as currency.

Graphed below is the S&P 500 and the price of gold as seen through the London Fix Gold PM Index from 12/29/1972 through 2/28/2009. This long term price performance difference is important to notice. The better long term investment is the stock market as seen through the S&P 500. This long term perspective matched with a strong theoretical understanding behind asset pricing and value differences goes a long way.

gold-chart5

All this being said, is there a place for gold and other precious metals in portfolios of all risk levels? In short, yes. The trick is in what percent and through what investment vehicle.

Here at Wiser Wealth Management, we have between 3%-5% commodities in our portfolios. We currently use the ETN, ticker symbol DJP, an ETN that tracks that Dow Jones AIG Commodity Index. The breakdown of commodities is diversified and the index follows rolling futures contracts.

Precious metals make up 13% of the entire commodity portfolio and gold is 9.41% of the entire commodity portfolio. Please note that the percentages of commodities and gold we currently have in our portfolios is a function of the suitability of our client base and may not be appropriate or suitable for you. Also, please be aware that an ETN is different from an ETF and assumes full credit risk of the issuing investment bank.

An investor can track commodities and gold using ETFs and ETNs. The most popular of these products are the SPDR Gold Trust, GLD, United States Oil, USO, iShares COMEX Gold Trust, IAU, iPath DJ-AIG Commodity, and iShares GSCI Commodity, GSG. All have different exposure to commodities and gain exposure to the commodities they cover in different ways. Careful research is needed to determine proper exposure and suitability and to understand the difference between exchange-traded products and the methods they use to track the underlying indexes.

The information contained in this report is for informational purposes only and is not investment advice. A note about the data: All gold prices are quoted as the London Fix Gold PM Price Return USD index. Data obtained from Morningstar Advisor Workstation Office Editor.

Forbes has picked up on this and has made a slideshow of the worst  and best index-tracking ETFs.  The article, “ETFs Behaving Badly” , links to the slideshow.

Most notably, there were many emerging market ETFs in the list from all the major ETF providers; SSgA, iShares, and PowerShares.  Preferred Stock and individual real estate sectors seem to be broadly included in the worst list.  Also, the TDAX Independence Lifecycle Funds were included in the list with large tracking errors. However, these ETFs cover some different indexes designed by Zacks.

held discussions with a number of potentially interested parties as part of its practice of regularly reviewing the group’s portfolio of business.

The potential sale of its ETF subsidiary is in light of Barclays announcement to participate in the British government’s asset protection program. Potential buyers of iShares could be from any number of financial companies wanting to get at 46% of all of the ETF assets.

For iShares ETF Investors

For investors holding iShares ETFs, there is zero threat of assets being lost from any corporate action. ETF assets are held in trust, separate from the issuing company’s balance sheet.  In the case of the company closing the funds, the assets of the ETF will be liquidated and delivered back to the investor.

Here for the full report

Please visit www.indexuniverse.com our go directly to the article here http://www.indexuniverse.com/sections/features/5305-what-to-do-with-currency-etfs.html

We’d love to hear any feedback from our viewers.  You can use the “Contact Us” tab on this site to give us advice on how we can better inform you about ETFs and investing in this economic climate.

iPath is set to issue two new ETNs covering iPath S&P 500 VIX Short-Term Futures and the iPath S&P 500 VIX Mid-Term Futures ETNs .  Read Murray Coleman’s article on the topic here.

Among the conference speakers were many presidents from ETF and index companies and many of the leading thinkers within the industry.  In this post I wanted to highlight some of the things talked about at the conference.

The conference was very interesting because during 2008, ETFs accounted for up to 40% of trading volume.  This means that large institutions have completely accepted and are using ETFs.

Leveraged and inverse ETFs were among the main topics to everyone.  During 2008 short and leveraged funds became very popular.  However, the math behind short and leveraged ETFs is not simple when held longer than one day.  Companies who issue these products are extremely forthcoming about this and do not intend their product for the average person and repeatedly state that their objective is to give 2x long or short the DAILY value of the underlying index.  Over the long run, the funds can get very far away from 2x long or short.  Explaining the math may come in a latter post.

Option strategies using ETFs were covered heavily.  Using options with ETFs is a little different since a stock may very well go to zero when a company goes bankrupt but it is extremely unlikely that a broad index represented by an ETF would go to zero and so would complicated options strategies can be used to hedge risk.  The strategy discussed at the conference was the vertical spread with a fully collateralized at the money put.  This strategy has been named, insulated beta and is used to hedge against moderate downside and capping extreme upside.  I would like to do more research on this strategy and write a post about it in the future.

Also, addressed at the conference were the hedge fund like portfolios one can build with ETFs, especially using currency and commodity ETNs.

By looking at MSCI EAFE USD Index and the EAFE Local Currency Index currency risk can be shown through the differences. During the first half of 2008, the EAFE USD index gave returns over EAFE Local Currency. This was due to the falling dollar relative to many of the currencies included within EAFE. As the credit crisis peaked in September, the dollar began to reverse and strengthened against foreign currencies, creating a lag for US investors holding EAFE.

The currency risk also increases standard deviation. As seen below, the volatility of currency exchange rates to the dollar caused a currency difference. During 2008, The USD invested in EAFE lost 5.36% more due to unfavorable currency exchange rates. There is also a risk premium that the currency exchange rate causes. During 2008 this risk premium was 3.79%.

ETNs are promissory notes issued to represent and give the return of ownership of a currency exchange, commodity, and any asset that poses a barrier for others to invest directly into for a fee they receive through an expense ratio. The key difference is that ETNs do not have hold the underlying assets but instead are like a bond, promising return but representing no ownership The appeal of these investments is the ability to gain easy access to unique assets or investment strategies.

ETFs have a different structure that mandates an issuer hold the underlying assets. Commodity ETFs track an index of continuously renewing futures contracts for the underlying commodities.

Unlike many other stock indexes which have a lot of similar characteristics and holdings, commodity indexes are very different. Each broad commodity index has a unique way of weighting among different commodities and has different methods for the commodities the index selects for inclusion. Commodities are a broad category and the benefits commodities provide vary by the individual commodity as each commodity has vastly different risks and diversification benefits. When adding commodities to a portfolio two things should be considered, the kind of commodities and weather an exchange trade note or fund is most suitable.

Choosing ETF or ETN

Commodity ETFs are structured differently from stock and bond ETFs. When investing in every other kind of ETF outside of commodities, the ETF structure is relatively tax efficient. Commodity ETFs do not have this tax efficient structure and investors are considered shareholders in a trust whose sole purpose is to invest in the underlying index. Because of this, owners of a commodity ETF will receive a K-1 tax form for their share of gains and losses of the fund from the trading of the underlying futures contracts. Unlike other ETFs no selling is required for there to be tax consequences at the end of each year.

ETNs remain tax efficient but lack a certain level of security since the products are unsecured debt. The assurance of repayment lies in the issuing investment bank’s ability to meet its obligations. Lehman Brothers unfortunately defaulted on its ETNs in the wake of their bankruptcy. The risk of investing in ETNs is two fold. The first risk is the credit risk of the issuer especially with the uncertainty of banks and financial institutions continuing to remain viable. Of course the second risk is the risk from investing in the asset represented by the ETN.

What holds many back from having a very successful indexing strategy using ETFs is getting distracted by the interesting and exotic ETF offerings, giving the investor exposure to foreign and domestic niche markets and asset classes.  I think many of these newer ETFs provide value to a portfolio but too often become over-weighted because of the promise of historical performance and historical correlations to the overall market

Something that I think is flying under the radar is the introduction of iShares S&P Target Risk ETFs.  This is an area that has no previous ETF exposure.  The target risk ETFs, listed below, each track an S&P Target Risk Series Index.

Made for Success?

These risk based funds like the very similar iShares target date funds, are created by surveying other actively managed risk based mutual funds and using the aggregate of their asset allocation decisions, then using ETFs to match those asset allocation decisions.  If indexing is indeed the better strategy in each of the asset class categories, all these risk based funds need to do is continue to have the lowest total cost.  Simply, they will beat the average of their mutual fund peers.

The Passive, Passive Strategy

The target risk based ETFs can solve the problem and tendency for investors to chase after trends and fads in the investing universe, especially in so called passive indexed portfolios.  The expense ratios include the cost of the underlying ETFs and represent the category average mutual fund’s asset allocation decisions while avoiding stock selection and market timing risks.

This leaves investors with only one decision, their risk level.  There are many resources for figuring this out and the ETFs themselves, being very transparent with their allocations and holdings can send investors very clear signals on the suitability of each fund.

A New Dawn for ETFs?

These new ETFs no doubt will allow for an easier transition into 401k plans and dollar cost averaging strategies used by investors saving for retirement.  Now the trading cost of buying many ETFs can be reduced to one.  These ETFs give the advantage of professional allocation strategies and the intelligence of indexing while reducing trading cost and the risk of over allocating trends in the ETF industry.

Diversification

Diversification when investing is spreading your investments out to eliminate business risk.  Business risk is the risk one company, industry, or sector has.  This does not include the risk of the economy but the risk of a particular business model and the risk from management making poor decisions.  Proper diversification takes this risk away.  The other risk that can not be taken away is market risk.  Market risk is the risk of the overall economy on the stock market.  ‘Cashing out’ of the stock market is a common method of trying to eliminate this risk but the difficulties of forecasting downturns often makes this method hard to act on.  September 2008 showed how hard it is to avoid market risk.  When the giant, Lehman Brothers filed bankruptcy many money market funds’ value dropped below $1.  This means that what people thought of as cash lost value.  A dollar invested in cash became at that time $.98.  If you are following this, you know that a money market fund breaking a dollar is business risk gone badly.  This is a small example, and those holding any insurance or banking stock will know, business risk has been abundant in 2008.

In the past, it was thought that proper diversification could be found in 15 stocks, than it was 30 stocks.  Now, finance books report 50 stocks are needed to supply diversification.  So what does that mean, 50 stocks are needed to gain diversification?  It means that the there is no more additional benefit in adding one more stock.  However, William Bernstein has written about the research done by Burton Malkiel, author of “A Random Walk Down Wall Street.”  In Burton Malkiel’s research he shows that proper diversification requires a lot more than 15 stocks.  Berstein goes further to add that 200 stocks are not enough and that the only way is to hold all the stocks in the stock market.  This may be new to you but in affect, this is called indexing.  He does not provide a recipe for the weightings of all the stocks in the stock market but he is clear that there is no point where adding another stock is not beneficial.  It is clear by looking at all the research that there is the most addition benefit in adding stocks to a portfolio with less than 50 securities, however what this research says is that risk reduction can still be had by having highly diversified portfolio representing all the stocks available.  In affect, this is free and easy risk reduction.

Diversifying Through ETFs

To obtain and build a highly diversified portfolio is very costly for most investors, since they must incur trading costs.  Exchange Traded Funds (ETFs) can solve this problem.  ETFs are like mutual funds, except they make no management decisions, are designed to track an index like the S&P 500 or Russell 1000.  Investors can trade ETFs intraday like stocks.  ETFs can be considered investable indexes.  Investors wanting to use indexing or add an indexing component to their portfolios can utilize the benefits of constructing portfolios or different asset classes.  Building efficient portfolios can be done easily with knowledge of modern portfolio theory and its techniques.

IShares has just issued a dozen new unique ETFs which track the S&P Target Date Index Series and the Target Risk Index Series.  Below is a breakdown of the two categories with the tickers and expense ratios.

Methodology

The S&P Target Date Index Series and Target Risk Index Series are composed entirely of iShares ETFs, similar to a fund of funds.  Each underlying ETF is chosen as a broad representation of an asset class. According to Standard and Poor’s Target Date Index Series methodology guide,

“The index series reflects the market consensus for asset allocations for different target date horizons.  In particular, each index is representative of the investment opportunity available to investors for the corresponding target date horizon, with asset class exposure driven by a survey of available target date funds for that horizon.”

This means that it is the two index series’ intention to provide a benchmark based on asset allocation opportunities available in the marketplace.  This is different from most indexes that systematically hold the entire or a representation of an investable universe, defined by an asset class, style, sector, industry, etc.  These indexes instead, represent aggregate asset allocations by each index’s mutual fund peer group.

To determine the asset-class weights for each target date and target risk index, S&P surveys mutual funds categorized as Target Date funds or Target Risk funds by the Lipper and Morningstar databases.  After surveying a category peer group, a trend line is fitted to the data points, only utilizing asset classes with more than 1%.  Measures are taken to solve an outlier effect without removing the number of funds used in the survey.  The indexes are rebalanced annually using the same surveying method.

The goal of these indexes is to represent allocation decisions among asset classes and not sector, style, or individual security selections. To represent an asset class allocation, iShares ETFs are used.  It is very clear that S&P intended and designed the indexes to become ETFs.  It is interesting that S&P choose ETFs as the underlying assets instead of the indexes that those ETFs track.  This makes the creation and redemption of the ETF simpler since hundreds of individual securities are represented by the underlying ETFs.

The expense ratios of the target date and target risk index funds listed above include the expense ratios charged by the underlying ETFs of each Fund.  The expense ratio fees of the underlying ETFs, which are all iShares products, are discounted when held by the fund.  Listed below are the ETFs S&P can employ for asset allocations that are determined for their Target Date Index and Target Risk Index Series.  Each index may or may not contain all these funds depending on their asset class inclusion in each index.

Target Date Indexing

Unlike other ETFs, target-date ETFs have an ending signified by their given target date.  The S&P Target Date Retirement Income Index Fund (TGR) is designed to be the endpoint for all target date funds. According to S&P, three years after an index’s target date, the target date index will than match the Retirement Income Index.  Once an ETF reaches its designated target date it will be rolled into the S&P Target Date Retirement Income Fund.  The ETFs tracking the indexes should follow this same method.

Opening Doors for ETFs

By creating ETFs made entirely of ETFs, highly diversified global portfolios diversified among asset classes and all sectors give investors a one stop shop for risk managed portfolios or risk appropriate portfolios.  For individual investors, the trading cost of trading several ETFs can be eliminated to one ETF, since the ETF is a representation of nine other highly diversified funds.  Also, these funds can act as an investable benchmark against their advisor’s performance or be used by individual investors who want exposure to asset classes like emerging markets and international but are not sure what their exposure should be given their risk tolerance.

These ETFs are designed by sponging off of mutual funds the aggregate of their asset allocation decisions while removing their market timing and stock picking decisions.  Interestingly, these ETFs depend on mutual funds for their allocation results and therefore are perfect substitutes, suited to outperform the average comparable mutual fund taking into account fees and expenses.

The question is not whether these ETFs will compete with mutual funds and advisors but where they will compete.  Target funds are very popular in retirement 401k plans, thought of as an autopilot approach.  With software being developed to trade ETFs on an omnibus trading platform, ETFs can now be offered in a complete way to plan participates.  The need for this kind of ETF has been clear and many companies and advisors have been offering target date and risk profiled model portfolios made from ETFs.  WisdomTree, a major frontrunner in offering ETFs in 401k plans with an omnibus trading platform, has been providing model portfolios for 401k plans constructed entirely of ETFs.  The similar iShares ETF products bring more transparency by providing a direct way to invest in the model.  The drawback to the ETF structure relative to an advisor’s model portfolio is that the iShares ETFs will change weightings as market prices change and weightings can be shifted away from the original allocation when you invest since the fund is rebalanced annually.  With WisdomTree’s models one can invest in the model allocations when they decide to invest.  The problem will be solved to an investor once the fund is rebalanced annually.

Without a doubt these 12 funds open doors to new ETF investors, provide direct competition to mutual fund assets in 401k plans, and prove that having an all ETF portfolio is accessible, cheap, and potentially optimal.  I am happy to say that these new advances in ETFs fit with traditional indexing strategies providing a framework for indexing to work with all platforms, for all investors, and at very cost effective prices.

To Be Fair

IShares is actually not the first to have target date funds, TDX Independence was.  Last year TDX Independence issued 4 target date funds and 1 retirement fund, TDX Independence In-Target ETF (TDX).  On average the TDX Independence funds are twice the price of the similar iShares products and are based on Zacks Investment Research Lifecycle Index series.  The index structure tries to select equity and fixed income securities that they believe will outperform the benchmarks.  This is very different from the S&P series which is more systematic and utilizes indexing principles.

Bogle says now is the time to bet on a long term market recovery and now individual stocks.  He thinks it will take 1 to 2 and 1/2 years before the economy recovers.

He’s a quote of some advice Bogle gives that needs to be quoted,

I think investments you continue to hold through this decline will give you a return better than you can find in other places. And that is a crucial part of this analysis. We know what bond returns will be in the next 10 years – roughly 5 percent for long-term government bonds or about 4 percent for short- to intermediate-term bonds. So if stocks produce 6 percent, while you endured the volatility, you increased your total return.

Money-market funds are now yielding less than 2 percent – call it about 1.5 percent. That doesn’t look anything like 6 to 9 percent for stocks, especially when you compound them over a decade. I would not flee the market now.

Bogle is still very positive about the stock market, at the age of 79, bogle says he is 80% allocated into bonds and advices to allocate to bonds the age you are currently at.

Read the full article Here.

These increases are because mutual funds have actually dollar costs, many being fixed cost.  They then set fees according to their assets under management.  So as their total portfolio values drop due to their investing and investors it mass pull money out of these funds, the fees no longer are adequate.

This is why we will see increases among to most damaged mutual funds.  International funds may be among the largest category to increase its fees.

• S&P Pharmaceuticals ETF (NYSE Arca: XPH)
• Lehman Aggregate Bond ETF (NYSE Arca: LAG)
• Lehman 1-3 Month T-Bill ETF (NYSE Arca: BIL)

What this means

ETFs are known for their tax advantages over mutual funds who often give investors unwanted taxable capital gains at the end of the year.  What drives many out of these funds if getting hit with capital gains and big loses.  This capital gains issue represents a big mismanagement by SSgA and they should be scolded since they are a leader in the industry.

Read a full article about it here

To punish bad market timing decisions, Direxion has put out several ETFs that give 300% daily return (or 3x inverse return) relative to each respective benchmark.

How the punishment works.

Leveraged ETFs, by design aren’t made to be held for the long term, hence, they only provide 2x or 3x the daily return.  Powershares has a PDF on their website that explains this principle involving geometric return.  Basically, during volitily markets the upside of this ETFs do not make up for the downside.

So, the investor holding these ETFs only does so for very short periods of time, maybe a day or two.  Today Nov 20th, some decided to bet that the S&P would have an up day and were wrong.  The Leveraged ETF investors were 3x as wrong as regular market times and paid 3x as much.  Losing 17% in one day when the S&P 500 is down 6.71%.

This pain is worsened by how the market works.  Panic often seems to drive prices lower than they should be fairly priced.  However, panic is never sensible, wildly driving prices to fair value.

Mutual fund through their portfolio managers deliver return each year whether positive or negative.  The vast majority of Investors, investing in those mutual funds have very clearly received less return on their invested money than the funds performed.

Why?

Because investors on the whole tend to invest during market rallies (the peak of a cycle) and after the rally falls from its high price, investors sell.  This by definition is buying high and selling low.  This is worse investing strategy there there is.  The difference between what investors make and what their mutual funds make is coined the Behavior Gap.  At BehaviorGap.com they preach that your investment returns are determined by your behavior.

Enjoy BehaviorGap.com

Here’s the List with Tickers and Expense Ratios

Also iShares has issued 4 new risk-based ETFs

How They Work

The underlying indexes of these funds were disigned by S&P to ultize ETFs.  Just like other indexes are composed of stocks or bonds, these indexes are composed of nine iShares ETFs.  The weights among the different funds are determined by surveying the broad target date mutual fund market, and using each funds peer group to set weights among asset classes.

What Happens at the ‘Target Date’

Once a fund hits its target date it will have the exact allocation as the Retirement Income Fund and shares of the respective fund will be transfered into the retirement income fund and the target date fund will be discontinued two years after after the target date is reached.

Read a full analysis about these ETFs here, written by Wiser Wealth Management.

What’s not explained in the article is the explanation of correlation and the positive effect low correlation can have on an efficient portfolio.

Correlation is the interrelation among the variations of returns between two assets.

Simply put in an example,  Let’s say you wanted to avoid living in the winter or in the rain.  So you buy two houses, one in America and one in South America.  Let’s say travel had no expense and took no time.  The correlation of summers would be -1, in that when it is summer in America it is winter in South America.  Now we know that the seasons have some overlapping and the rain patterns via rainy seasons are not completely opposite.  This means that the correlation between seasons and rain between your two houses is less than perfectly opposite but not random.  Since they tend to be more opposite than similar your best chance of having a life free from winters and free from rain is in having the two houses, however there may be days you need a jacket or a rain coat.

In the same way, uncorrelated assets provide the same thing.  Perfectly uncorrelated means that when one goes up, the other down.  Mostly we can find ETFs that are not perfectly uncorrelated but soften the blow from down markets.  This happens because short term volatility is lessened (Summers within winters)- enhancing returns.

This is best seen in the long term.  During the current market crisis all assets have tended to be very correlated however any correlation less than perfect gives value, as we see everday here at Wiser in our clients portfolios.

“President Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages, and by extension reducing employment and demand for goods and services,” said Cole, also a UCLA professor of economics. “So he came up with a recovery package that would be unimaginable today, allowing businesses in every industry to collude without the threat of antitrust prosecution and workers to demand salaries about 25 percent above where they ought to have been, given market forces. The economy was poised for a beautiful recovery, but that recovery was stalled by these misguided policies.”

A few well know TV financial analyst have been heard saying to move everything to cash, run for the hills this is the next Big Depression. This week James Stewart wrote an article for the Wall Street Journal’s Personal Journal titled “Even the Great Depression Couldn’t Keep Stocks Down.”

In this article Stewart explains that during the Great Depression the S&P 500 fell 86% from September 16, 1929 to June 1, 1932. In September 26, 1930 the market was down 40% one year into its bear market.  Currently we are one year into our current bear market and the S&P is also down 40% from its October 2007 peak. If you bought stocks at this time in 1930 you lost another 40%.

If you had invested $100 in 1928 by the end of 1930, it was worth $98.75. At the end of 1935 it was worth $110.18, a 12% gain. In 1940 during World War II it was worth 107.37, still a 9% gain. If you held on to your investment for 20 years, it was worth $355.60, a 260% gain. During this same time, cash appreciated little and short term treasury’s rose 81% (far cry from 260%).

If you are in the accumulation phase of your life, this is a once in a lifetime opportunity to invest in oversold and undervalued stocks. How do you take advantage of this opportunity? Increase your 401K contributions, open up and or max out your IRA contribution. If you can pick your investments choose ETF’s or index funds and diversify your portfolio in large, mid, small and international stocks. If you want professional advice stay away from the large brokerage houses and banks, these are not financial experts, their sales associates that sell financial products rather than golf equipment at your local golf store. Instead seek out a fee only investment advisory firm in your area and from that list look for the ones that use index or DFA funds.

As to what the TV financial analysts are saying; I am on my fourth week of a no talking head diet! Long term investing to these guys is probably about 1 hour; the length of their show and now my additional time with my wife and two children.

Maintain a diversified portfolio, keep investing cost low and always invest for the long term.

www.wiserinvestor.com

With only looking at some brief performance details we can see that IJR (iShares S&P Smallcap Index) provides better return in every time period.  This is because of the index structure which is the only determinate of underlying equity holdings and not over factors like expense ratio or tracking error which a very small.  Market Cap also does not seem that a clear factor for the performance differences.

In our research there are differences in the index methodology that make the S&P index best suited for small cap exposure.  Simply, without going into all the detail which can be found on the index providers’ websites, the S&P indexes are govern by a committee that decides how to best capture within a given index the best representation of the defined objective.  This is far from managing and to be included in an the S&P Smallcap 600 Index a company must be trading on the market for more than 12 months, be tested for liquidity, and have four straight profitable quarters.  The Russell and MCSI indexes are a more passive index methodology approach.  The Russell 2000 is the smallest 2000 stocks of the largest 3000 stocks traded on the stock market.  The MSCI Index is similarly the smallest 1750 stocks of the largest 2500 stocks traded in the US.

By using these simple techniques, the S&P Smallcap Index and its investable ETF, IJR have been able to shield investors from risks that are outside of the asset class risk like IPOs and companies that are unable to make profit, giving investors the best passive approach to capturing the small cap asset class.

“I think if you have some principles and know what you’re doing, the market responds. They see that you have some structure to your actions, that it isn’t just ad hoc — you’ll do this today but you’ll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what’s going on. So I think if you’re tough about firms that have invested unwisely, the market won’t blame you. They’ll say, ‘Well, yeah, it’s your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you’re stuck with assets you can’t sell and liabilities you can’t pay off?’” But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn’t know how to react. Instead of looking principled, the authorities looked erratic and inconstant.”

Read full article wsj-interview1

Video: What’s Behind the Relentless Selling

While short-term stock-market movements can’t be foretold, the likelihood is that the market will recover before the economy or general investor sentiment do so, and ‘if you wait for the robins, spring will be over.’

He talks more about the Great Depression and how much stocks increased from 1932 to 1933 (30%).  Read full article here.

It has long been known that Warren Buffett took after Benjamin Graham, author of “Security Analysis” and the father of value investing.  What’s interesting about Graham is that at the end of his career, he quits stocks altogether because of the uncertainy involved.  Here’s a quote from a WSJ article WSJ Article about Graham and his book “Security Analysis”

Just as the roughly 90% fall between 1929 and 1932 had seemed to be fading, the stock market dropped sharply again in the late 1930s. As market historian James Grant puts it, by the time Graham was ready to finish the 1940 edition, “He had had it.”

That helps explain one of the great ironies of market commentary. Graham himself stuck largely with stocks in his investment fund. But at the conclusion of his book, he advised the institutional investors among his readers to shun the stock market entirely and invest in bonds. Graham doubted they could stomach “the heavy responsibilities and the recurring uncertainties” stirred up by stocks.

Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of financial history to those who have one.

Keeping that in mind please look at these charts done by Morningstar about market recoveries and the effects of diversification among asset classes.  Charts and all information by Morningstar, Inc

vix

This represents fears mounting as the selling continues.  The VIX index is thought the give a good representation of short term market expectations.  This post adds to the information we gave in our last post, “Is this Panic Sensible.”  It does answer whether or not it is sensible but only confirms that it is a panic.  In 2006 investors could place bets on the index that measures fear.

To learn more about volatility indexes visit the CBOE site.

Even during the Great Depression, the best investment results were earned not by the people who fled stocks for the safety of bonds and cash, but by those who stepped up and bought stocks and kept buying on the way down. A man named Floyd Odlum made millions of dollars putting his cash into battered stocks. His motto throughout the market nightmare of 1929 to 1932 never changed: ‘There’s a better chance to make money now than ever before.’

During these hard financial times, our investment strategies are pressed since this market crisis looks different than last time (they always have), we are forced to make decisions.  Just like Floyd Odlum in the 30s, our behaviors matter.  It’s okay to be fearful but not act out of fear, acting sensibly and not in panic is what has prevailed throughout every market cycle.

Hedge funds are known for their daring bets, secretive (proprietary) strategies, and the 2 and 20 fee (2% of assets and 20% of profits).  It has come to many people’s attention that hedge funds have not been hedging market risk for their clients since several have shut down this year during the bear market.  Hedge funds are not required to report earnings, investments they hold, or strategy.  During booming markets many hedge funds publish their unbelievable returns and attract many high net worth clients looking for above ordinary returns. 

It was reported today in the WSJ that some of these hedge funds are being forced out of business because in some cases 50% of their entire portfolios consisted of one company.  The idea is to take big bets proving their excelent forecasting skills, but one unforeseen mistake have cost many managers their funds and businesses.  Also other hedge funds have been unable to find ways around the temporary ban on short selling stocks. Here’s a quote from this morning’s WSJ article, “Big Bets Come Back to Bite Fund Managers”

To wit, a basket of stocks most popular among hedge funds tumbled 19% in September, more than the 9% drop for the Standard and Poor’s 500, according to Goldman Sachs.

Who would have thought that an S&P 500 ETF would have beaten hedge funds who have always attracted the best analyst and have the ability to side step companies who are plummeting?  Warren Buffet does.    Investment strategies must be able to weather all economic conditions because all economic conditions happen.  Again, diversification wins and the lower the cost, the more money you keep.

Video:  Bogle: Keep Investing – Morningstar Video

Taking a snapshot approach at the last 52 weeks,

39% of large-cap mutual funds beat the S&P 500 Index over the last 12 months.  47% of these funds beat the S&P 500 over a time period a lttile less than the last 10 years.

10% of mid-cap mutual funds beat the S&P 400 Index over the last year.  The Index returned -16.7% compared to -23.2% of the average mutual fund.

Less than 20% of small cap managers beat the Russell 2000 Index.  The small cap area is usually a place where managers are more likely to beat the index.  However, the Russell 2000 tracks some very small stocks that typical managers and investors stay away from because they are very lightly traded and there tends not to be as much information about them.  Money flowing into ETFs that track the Russell 2000 are forced to buy these extremely small stocks and in doing so drive up the price.

These are facts to consider especially when taking fees into account.

data source:  Wall Street Journal

The rule began with futures traders who must maintain a margin account with their broker and adjust their margin accounts according to the current value of their futures portfolios.  However, special options that don’t trade on the open market like credit swaps or interest rate swaps do not have price information readily available and therefore have a hard time accounting for value.  Companies like Enron used this loophole to commit fraud and in 2007 all companies were required to account for financial assets and liabilities as if they were to be sold and recognize the gains/losses in that year.

The problem is that many companies in the news right now had huge portions of level 3 assets on their books.  Here’s a good definition I found,

Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort, according to FASB. There is no verification requirement if the assumptions are in line with those of market participants.

Since the housing crisis, companies have had to “Mark-to-Market” those assets and liabilities which are very hard to value.  What makes the problem so bad as to make companies like Lehman Brothers go bankrupt is that they are using those level 3 assets as leverage to raise capital.

For more about this read this article published November 7, 2007.  It has some great priditions about Lehman, Merrill, and Citigroup.

Let’s be clear that this bill was not a free bail out for the rich; it is a plan to provide liquidity to the US financial markets. The US Government is investing in the US Economy by loaning money to banks at relatively high interest rates. The other part of the package is to create an entity that buys up the securities that are causing the problems in this market. This buy up will basically replace the bad assets with cash. After the financial markets stabilize the government could issue the purchased securities back into the market place for a profit. If the Government does not get repaid from the loans, then they will get ownership of the company in question. In my opinion, either the US Government issues the loans or we will have more foreign investment into US Corporations.

Once the Government passes an investment package, we will recover a lot of what was lost today. These last few weeks have been very difficult to long term investors, but we must stay the course. For those of you living on your portfolio, you must remember that you are still receiving your dividend payments. Your annual income has not changed, however the portfolio value at the end of this quarter will be difficult to swallow.

Our strategy is to invest assets into the world markets for long term growth while keeping company risk and investment cost low. With over 4800 stocks in our portfolios, no one company affects our performance to a significant degree. What is required in times like these is to keep a cooler head than the market.

If you are in the accumulation phase of saving for retirement, this is a great time to add additional money to an S&P 500 index fund. Any investment now will have great results in 3 – 5 years. Hopefully sooner!

Maintain a diversified portfolio, keep your cost low and always invest for the long term.

This is why I believe we are not facing a long term bear market.  Goldman Sachs is getting a $5 billion investment with potentially $5 billion more investment from Warren Buffet.  The financial sector has been dealing with this one huge problem, which i discuss in a previous blog.  Microsoft and Nike announced a multi-billion dollar stock buyback program.  Microsoft was given a AAA credit rating by Moody’s.  To us, this signals that business models who receive cash for providing products or services are weathering this market with steady earnings.

Video: Investment Strategies

Even if Barclays did not buy Lehman’s index department the assets held in trust by the ETF are safe and there is no risk of default or loss.  Since the index an ETF tracks is just a set of rules and guidelines in which an ETF most follow for investment.  This is why ETFs are called passive investing.  Worse case the ETF would have to adjust to a similiar but different index.  This may cause some assets and allocations to change but it would not have any tax consequnces.

ETNs:

Barclays will not however being buying Lehman Brothers strutured debt including their ETNs  (again read my blog on ETNs to get up to date with their unique risks).  This promisory notes that Lehman has will most likely default.  These ETNs include EOH (Opta Lehman Commodity Pure Beta Agrowculture) and RAW (Opta Lehman Commodity Pure Beta).  Read more Here

Also, AIG acts as an insurance provider for some large european ETC issuers (ETCs are Exchange Traded Commodities pretty much just like an ETN).  This large issuers have credit agreements with AIG which insures their ETCs in case of default, these are a form of credit swaps.  Read More Here

So everyone has seen the news and knows what is happening with many Wall Street financial companies, but why banks, why financials?  First of all, banks make money by borrowing money from other banks (Central Banks) and then lending that money out, charging a higher interest rate than they received on that money.  The rate that banks borrow money at is determined by their credit rating.  This is why it was so bad last Monday when AIG’s credit rating was downgraded, taking away their ability to borrow cheap money and lend it out at a higher interest rate.  Also, banks use assets on their books to leverage against the money they borrow.  When it turns out that most of their mortgage assets turn out to be worthless and the assets that they use to borrow money against are no longer their on paper, banks are forced to take huge losses and this prevents them from operating business as usual.  So, what started a year ago with sub-prime mortgages is still affecting many banks because of the “bad” debt on their books.  Some banks have been able to locate which debt was ‘bad’ and write these losses off while other banks have not been able to effectively locate and write off this debt creating huge problems.

The problem with the economy has largely been driven by this bank business model suffering.  This is called business risk and we have seen this business risk affect the entire financial sector recently.

Despite the changes seen on wall street, stocks as a whole remain intact.  The government made some very big decisions that have calmed fears on Wall Street and for the most part stopped the panic selling.

If we can take away any lessons from this last week it is that panic driven selling does not work and is not a strategy for your portfolio.  Remaining diversified again worked this week.  Below is a graph of numbers for the week.  Notice that the week looks like any other week on Wall Street.

Source: “Market Update” Yahoo Finance

Note: Casey T. Smith, President of Wiser Wealth Management, Inc provided many insights for this blog post

This November as a new president is decided for America, the Dow Jones Industrial Average drops over 500 points in one day (September 15), the S&P 500 is 28% below its high posted 11 months ago signaling that we are in a Bear Market, Lehman Brothers files bankruptcy putting $600 Billion of its assets up for sale, and AIG, Fannie Mae, and Freddie Mac should have gone under if not for bail outs to continue operations from the Federal Reserve and Treasury.  In the amidst all of this unemployment is above average, inflation is high, the dollar is weak, and gas is outrageous.  Terrorist still threaten what America stands for and American Soldiers give their lives to protect America everyday, very far from home.  This is a very brief list of examples of why November matters.

Capital-gains tax was lowered by Bill Clinton to 20% from 28%.  George W. Bush, once in office, lowered this tax rate on long-term capital gains tax to 15% where it currently is now.

• John McCain has made it clear that if elected he will maintain the 15% tax rate on the ‘unearned income’ called capital gains.
• Barack Obama has been unclear on a number but has said that “… we can have a capital-gains tax higher than 15%.”  However he has made it clear that he would not extend the highest rate that Clinton had in office of 28%.  Obama says that this decision to raise capital gains tax comes from advice from “people like Warren Buffet” who say that an increase in the range of 20-25% will not change investment decision making

Commentary:

The most common form and most efficient way Americans save for retirement and the needs of their families when they are unable to earn income is through the Capital Markets (stock market and bond market).  As they invest through the years holding assets or debt of public companies, the value of the assets increases by price increases and dividend payouts.  Once in retirement, these assets are sold over time to provide current income from past savings.  Capital-gains is the difference between the selling price and the buying price.  This ‘profit’ is taxable when held outside of a tax-sheltered account, and even some of these tax sheltered accounts force one to move money out at a certain age.

Until recently large companies would pay excess profits to shareholders in the form of dividends and these dividend checks would provide current income in retirement and more savings before retirement.  Today, These large companies are using the profits that they usually would have used for dividends to buy back company stock and retire the shares.  There are three reasons management of a company would do this: 1.  buying back company stock and retiring the shares increases the price and value of the remaining shares on the market, increasing capital gains.  2.  Management of companies are more and more compensated by stock options which increase in value as the stock price of the company increases in value.  3.  the income from dividends has long been taxed at an investors income tax rate which is usually much higher than the capital gains rate.

Stock buy back is an effective way to compensate shareholders but since there has been a shift in how baby boomers will ‘cash out’ there their retirement portfolio to live off of, there is a new focus on the tax rate that they will pay on their savings.

Also, with a stock Market that is so efficient with thousands of professionals following every stock in the US and everything that happens on Wall Street, the individual investor will be very disadvantaged when the stock market enviably has a massive sell off of stocks to capture the current low capital gains rate when a president is elected who will raise capital-gains taxes.

In Closing:  having the right to choose between two very different presidential candidates is an important symbol of the freedoms we have in America.  This log was certainly biased against Senator Obama since he has the least favorable tax policies for professional money managers who deal with clients portfolios, but when evaluating a candidate it is important to think about the situation as ‘do the benefits outweigh the cost.’

Source: Financial Intelliegence Report

All investments have fluctuations.  Houses, property, oil, and of course stocks and bonds.  We call the amount of variability standard deviation (variance is the square root of standard deviation), remember high school statistics class.  So, we measure the fluctuations of our portfolios and the stock and bond market by standard deviation.

Since all assets have fluctuations, we define more risky assets as having higher fluctuations about the mean or higher standard deviation.  Therefore in highly diversified portfolios, we can minimize the amount of risk of a portfolio by adding assets that have different fluctuations at different times or low statistical correlation.  This is a very simple version of Modern Portfolio Theory (MPT), which Harry Markowitz won a Nobel Prize for and detailed in his book, “Portfolio Selection”.  Using MPT one can ‘optimize’ a portfolio, minimizing risk and maximizing expected return.

This can give a portfolio made of many assets lower risk than each individual asset.

I think what this teaches us, the Wall Street outsider, is that investing is a “loser’s game,” a game where a defense strategy is best and where the winner makes the least amount of mistakes.  Mr. Cramer advises investors, ‘tongue in cheek’ to go completely into T-bills since the market is clearly compromised.  I feel that for a long time the market has not been a “winners game” where hot tips can lead to long term outperforming.  The idea of the “loser’s game” was coined by Charles D. Ellis in his article “The Loser’s Game.”

So, remember that the long term success of a stock is tied to the long term success (earnings) of the company.  Since no one can predict the future, the proven best way any investor can invest especially in the voilite markets of today is by investing for the long term in utra-diversified portfolios of stocks or bonds, keeping cost as low as possible, through index funds.

Read the article by Charles D. Ellis “The Loser’s Game” about how amateur tennis can relate to how you and I should play the “Loser’s Game” a game where the one who makes the least amount of mistakes wins.

[youtube=http://www.youtube.com/watch?v=EjkZRxquYDc]

An ETN can be used by individuals, advisors, and institutions to meet allocation or strategy needs like a S&P 500 buy-write strategy that otherwise may be hard or not cost effective to execute directly.  Most Commodities, currencies and commodity indexes can be held through an ETN.

ETFs are limited by the mutual fund regulations that govern them which limit commodity ownership and the use of futures.  Some of the ETFs that track commodities are actually “grantor Trust” which are complicated and hold the commodity “in trust” for investors.

ETNs are not limited by those regulations can use futures and options to exposure investors to strategies, and assets that can be unique to ETNs giving the individual and Financial Advisor access that they ordinarily would not have.

What’s the risk?

As discussed previously, an ETF can be liquidated when an issuer goes bankrupt and investors will get the market price from the basket of underlying securities.  This is not fun and could create very unfavorable tax consequences but it sure beats total loss.

However, Since an ETN is an unsecured debt instrument, the investor must  get in line with the firm’s creditors.

With all things financial, behavior is a key factor that separates successful investors and unsuccessful investors.  Now, I don’t mean that you can pick better stocks and I am not talking about the popular topic of Behavioral Finance which is a completely different and irrelevant thing.  Behaving well for the individual investor is having a well thought through game plan which involves a professional that is seasoned and is FEE based NOT commissioned based.  If you want to learn more about the importance of fee based advisor click Here and click services=>Investing=>Wiser Advice and to learn about the importance of investor behavior visit behaviorgap.com.

Here’s some quotes to ponder as you look at your investment strategy.

“Investing has and always been, and will remain, an operation in which wealth is transferred from those without a working knowledge of financial history to those who have one.” -William Berstein

“It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem—buy a well-run index fund and own the whole market.” -William Berstein

“You don’t need to participate in [the financial system's] expensive foolishness. If you choose to play the winner’s game of owning businesses and refrain from playing the loser’s game of trying to beat the market, you can begin the task simply by using your own common sense, understanding the system, and investing in accordance with the only principles that will eliminate substantially all of its excessive costs.” -John C. Bogle, Vanguard

“The biggest investment mistake people make is focusing on last year’s mutual fund performance and not on what really drives returns.” -Barbara Raasch, Ernst and Young

“In the short term the market is a voting machine, in the long run it is a weighing machine.” Benjamin Graham (father of value investing and author of “Security Analysis”)

“To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of bonds and stocks have actually behaved under varying conditions—some of which, at least, one is likely to meet again in one’s own experience. No statement is more true and better applicable to Wall Street than the famous warning of Santayana: ‘Those who do not remember the past are condemned to to repeat it.’” -Benjamin Graham

So, to take these stock market proverbs to heart you should do three things; Keep Cost Low, Diversify, and Invest For The Long Term.

Today let’s start with ETFs

1.  An ETF (exchange traded fund) is a rule based fund that tracks a designated index.  

2.  ETFs are uniquely created and unlike a mutual fund.  See Diagram below for a visual of how a ETF is created.

Click Here to Enlarge Diagram

3. ETFs trade like stocks and can be shorted (on the down-tick)

4.  Since ETFs trade at market prices and not NAV (Net Asset Value, the combined weighted prices of the stocks in the index), Market Makers can “unmake” and ETF through the fund advisor into a creation unit (the basket of stocks).  The reverse of what is pictured above.  It is done in a way that has zero tax consequences and called “in-kind” transfer.

This ability to unmake an ETF into a basket of stocks could created an arbitrage opportunity.  Therefore Prices stay very close to NAV.

In the same way, if an ETF fund advisor goes belly up the basket of securities that make up the ETF are liquidated and paid out to the holders of the ETF.  So there is no loss of principal when an issuing firm files bankruptcy.  However, this may create very unfavorable tax consequences for some investors in taxable accounts.

5.  An ETF can be created to track any rule based index such as a sectors, style, market cap, option strategy, and special attributes such as dividends or “green companies” .

In Part 2 I will go through the world of ETNs.  Also in the future I will continue to discuss the world of ETFs and the strategies that investors use with them.

To show this difference they used the EAFE index (a proxy used to represent all of developed international markets of Europe, Australasia, and Far East ).  Over a 3 year period, a US investor who invested in EAFE made returns of 10.5% annually.  A local investor over the same time period made 2.14% annually.  That means that the US investor made 8.36% on his investment just because he invested outside the US (EAFE) while back home the purchasing power of the US dollar fell.  Pretty nice way to benefit from a lagging US economy!

Click Here to read full article

This site is intended to feature the research and observations of Wiser Wealth Management, a Registered Investment Advisory Firm in Marietta, Georgia.

To preface all future postings, I would like to share and express our bias towards the investment strategy of indexing and building wealth through indexing.  In the future we will post many findings that have proved this to us.  But for now…

1.  Currently, the average professional money manager has proven, over the long run, be unable to give investors returns above the market index (S&P 500).

2.  Diversification is the best method to overcome the problem in number 1.  However, today proper diversification requires one to hold enough stocks to effectively “capture” the entire world stock market.

3.  The most cost effective way to do this today is through an investment vehicle called an ETF or Exchange Traded Fund.