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 by 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 places where 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 boast 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 has 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.  Up from 200,000 added in March.

The fact that the employment rate is down is showing there is 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, and optimism is a good thing.

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 ETFs 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 benefitted 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 runs 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 below graph 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 verses 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.” Murray Coleman, Editor of IU.com, said 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 reportedly has 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 loses 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 and 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 surface here.  Brokers should, but aren’t required, to act in client’s best interest, as long as investments are suitable. An investment is 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 and 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, you got the perfect losing recipe.

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 that 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?