Basis Pointing

On ETN Pricing

2008-05-09T16:49:03Z

Summary: In the spirit of brevity, here's the long/short of what I'm saying below--I think ETN pricing is out of whack. The following lays out my rationale.

(Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, Claymore, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.)

I've fielded a number of reporter calls recently along the following lines: We've seen a lot of ETNs launch thus far in 2008 - how come?

The (More) Obvious Reasons

There are a few reasons, some more apparent than others. Let's start with the more obvious ones first:

Typically, investability is a problem with futures-based commodities indexes like the Dow Jones/AIG or S&P Goldman Sachs commodity indexes, and variants thereof. For instance, rolling futures can be a costly endeavor, making it more difficult to track the benchmark closely. ETNs are better suited to tracking those areas. Indeed, ETNs surmount the challenge associated with transaction costs by removing transactions from the equation altogether-the ETF issuer promises to pay the index return, which is devoid of transaction costs. How the issuer comes up with the money needed to deliver that return is its problem, not the ETN investor's. Problem solved.
Investors are seeking a more tax efficient way to invest in commodities and currencies, gains on which are typically subject to more punitive tax rates. Enter ETNs, which, for commodities and multi-currency strategies at least, enjoy clear-cut advantages over mutual funds. For instance, a commodities ETN investor won't pay a nickel in taxes until she sells her investment. And any gains are taxed at the 15% long-term capital gains rate. Contrast that with other structures, including ETFs, which would have to distribute any realized gains/income at least annually. Further, any gains would be subject to the so-called 60/40 rule-60% of the gains are eligible for long-term capital gains rates, the other 40% are subject to much higher short-term rates. In other words, ETNs are exploiting a loophole in the tax code for all it's worth.
The glass-half-full part of me says, reassuringly, ‘as commodities have become a more prominent part of the investing scene, investors have grown more knowledgeable about commodities investing and sophisticated in their needs, explaining the demand for a wider variety of commodity-based investment products.' The glass-half-empty part? It snarls ‘More sophisticated, my shoe. They're performance chasing, plain and simple.' As with so many things, the truth probably lies somewhere in the middle.

The Less Obvious Reasons

But why else? My take is that the economics of these notes, and the relatively exclusive nature of the ETN market, are quite attractive to the fund companies and issuers concerned. How so? Let me count the ways:

There is no management team behind these, or at least not in any traditional sense. The issuer promises to pay the stated return. But how the issuer delivers that return is up to it. In other words, there's no portfolio being assembled. Investors are buying a promise - a synthetic.

It stands to reason that this is a very cost-effective proposition. True, the fund company has to share a portion of the expense ratio with the issuer. And, yes, the issuer presumably has some kind of personnel and resources tasked with hedging out the firm's exposure to the notes (i.e., investing the capital they've received so as to capture the return they've promised to pay...and then some). But let's get real-in some cases, most notably the iPath family of ETNs, the issuer (Barclays Bank) is an affiliate of the fund company (Barclays Global Investors), making the fee split little more than inter-company accounting legerdemain.

And when the issuer is unaffiliated-as with the Elements and Market Vectors families-the market maker concerned isn't hiring an army of personnel to manage the firm's exposure to these instruments. Instead, they just tap existing resources, the epitome of leverage. Again, the incremental cost of an ETN to the issuer is likely a rounding error. The fees ramp with assets. You do the math.

(Full disclosure: One of the Elements ETNs licenses the use of a Morningstar index.)

It's free capital. No, scratch that - it's accretive capital, as the investor is paying the issuer a fee (the portion of the expense ratio it receives) in forking over her cash. Ok, so the issuer has to put that capital to work in order to hedge out its exposure to the notes. But look at the roster of firms that are signing up to issue these instruments-global banks and market-makers, all. Risk management and arbitrage is the lifeblood of these organizations (or, as recent events well attest, a pathogen when it fails). So, one can't help but sense that no-strings-attached capital is a very sweet deal to the issuer, especially at a time when the banks seem reluctant to lend to one another amid the credit crisis.
To borrow a bit of Morningstar parlance, ETN issuance is a ‘moat'y' business. That is, it's founded on defensible competitive advantages.

Generally speaking, you need a few things to issue these instruments-a balance sheet, securities inventory, and some faculty for risk management and trading. Asset managers could, in theory at least, issue these on their own balance sheets, especially if they own a chartered bank (as T. Rowe and Franklin Resources, to name a few, do). But asset managers don't make markets in securities, and probably aren't especially keen to start doing so. Further, an asset manager's business isn't predicated on managing risk per se, let alone in managing a sprawling securities inventory. Also, as a practical matter, asset managers--firms which are already heavily levered to the capital markets--probably aren't chomping at the bit to lard their balance sheets with debt, as it would amplify the volatility of their results. So if you ‘x' out the asset managers, who does that leave? You guessed it--the big banks and broker-dealers.

One could of course argue that the relatively low upfront costs involved in launching an ETN-they're not '40 Act funds and thus aren't freighted with many of the costs that normally apply to mutual funds and ETFs-opens the ETN market to greater competition, as the barriers to entry are ostensibly lower. And, in fact, many of the banks that have issued ETNs have probably taken a shine to the space because they can enter it without expending untold sums of capital in the process.

But it's not as if the local thrift is going to be able to launch an ETN. It requires scale, know-how, and, heaven knows, financial strength. Thus, I would expect that at least part of the allure of ETNs stems from the fact that it plays to the banks' traditional strengths and doesn't demand a hefty upfront investment, yet is exacting enough to keep most potential new entrants at bay.

Fair Shake?

If ETNs are a great deal for the fund-company and issuer concerned, it's only natural to wonder whether the party on the other side of the trade-the ETN investor-is getting a fair shake. That is, to ask whether ETNs are priced fairly?

At first blush, ETNs look like a pretty good deal. They levy reasonable fees in absolute terms-typically anywhere from 0.30% to 0.95%. And they still offer all of the benefits of traditional ETFs-transparency, liquidity, they can be shorted and margined, etc. Plus, as noted, they give investors the ability to access heretofore difficult-to-reach segments of the market, and do so with remarkable tax-efficiency.

But what makes ETNs inherently different than traditional mutual funds and ETFs is the credit risk that they pose to the investor. They're ~~jun~~senior, subordinated, uncollateralized debt instruments. So, if an ETN issuer goes belly-up, ETN investors line up in bankruptcy with all of the other creditors. That's a risk that mutual fund and ETF investors most definitely do not court.

Some have argued that these banks are so strong that credit risk goes out the window. But it's not as if the capital markets give the most financially stable, fortress-like companies a free ride. Last I checked, for instance, if General Electric floated commercial paper, it had to pay interest on those borrowings. And so forth. Recent events-pocked by the near-collapse of one issuer, Bear Stearns, to whom the ‘too big to fail' catch all had formerly applied-pretty much cut that argument to ribbons.

In that sense, evaluating ETN fees on an absolute basis, or pitting them against some benchmark, like the average cost of a comparable ETF or mutual fund, is misleading. It doesn't adequately account for the incremental credit risk that ETN investors assume.

Whither Counterparty Risk

So, are ETNs being priced in a way that takes counterparty risk properly into account?

To answer that question, we must turn to the derivatives market for comparable examples. There one finds what's arguably the closest analog to ETNs-total returns swaps. For those unfamiliar, a total return swap is a credit derivative in which one party agrees to pay another party a specified return (say, the T-bill) on some notional amount of capital (say, $100 million) in exchange for a different specified return (say, the Dow Jones/AIG Commodities Index) tied to that same notional amount of capital. When the swap commences, the payor and receiver don't literally exchange $100 million in capital and then go about investing those monies in order to generate the return they've promised. Instead, they simply net out the returns at specified intervals. So, if DJ/AIG logs a 10% gain and the T-bill returns 3%, the T-bill-payor/DJ AIG-receiver would pocket that 7% difference. Assuming annual settlement, that would translate to a $7 million payday (7% difference multiplied by the $100 million notional value of the swap).

Now, you might be wondering how ETNs are similar to total return swaps. In several respects, they're not. For instance, whereas there's no exchange of notional principal in a total return swap, here ETN investors are actually handing their capital over to the issuer. In addition, the ETN investor isn't promising the ETN issuer any return, the T-bill yield or otherwise. Instead, she's giving that issuer her capital and, in essence, saying ‘do with this what you may'. Furthermore, unlike a typical total return swap, there's no periodic settlement schedule or term to the agreement. An ETN investor can redeem-that is, sell-at any time with no strings attached, but she won't receive any payment on her investment until she does so. Finally, total return swaps are a form of leveraged investing-I don't have to put up $100 million in order to get that equivalent economic exposure-while ETN investors are putting up every last penny of capital and earning a return on those monies and those monies alone.

But the economic substance is quite similar. For instance, it's not at all unreasonable to think that the issuer, in receiving ETN investors' capital, can put that money to work at T-bill-like rates. And the issuer is already promising to pay a specified index return. And the fee that ETN investors pay...what might we liken that to? What I didn't mention is that the T-bill-payor in the swap example I presented would pay a percentage spread atop the T-bill. Why? To compensate the DJ/AIG-payor for incremental counterparty risk and for its services in delivering the index return.

Going Apples to Apples

Given that, what you'd ordinarily expect is for the overnight swap spread to exceed the expense ratio that ETN investors are paying. Why? ETN investors shouldn't have to compensate ETN issuers for any incremental counterparty risk. Remember-the ETN investor has given her capital to the ETN issuer, meaning that the issuer has no exposure whatsoever to counterparty risk. Thus, the ETN investor should only have to compensate the issuer for the service it is providing in delivering the index return. (The spread on an overnight swap is the most relevant measure given the liquidity of ETNs-as mentioned, investors can buy and sell them at any time, making swaps with the shortest duration the best litmus test.)

What's the spread on a typical overnight T-bill-for-DJ/AIG total return swap? It'll vary depending on the creditworthiness of the counterparty, the settlement terms, and other factors. But according to a source at a large money manager, one could have recently entered into such a swap at a 15 basis point spread.

And what does it cost to own iPath Dow Jones/AIG Commodities Index? 0.75% per annum, or five times the spread on a T-bill-for-DJ/AIG total return swap. That's not what one would expect.

What could explain the disparity? Ordinarily, you'd expect a large, lump sum, private party transaction (i.e,. total return swap between a broker-dealer and an institutional investor) to be less costly to the issuer than a series of smaller-dollar transactions with a widely diffused investor base in the open market (i.e,. ETN). And, yes, retail investors probably ought to have to pay a tad more for access to the commodity and currency markets than an institution would-size has its advantages, after all. But it seems like an awfully big stretch to claim that these differences adequately explain the cost disparity.

Minding the Gap

What ought to happen in a situation like this? The notes should trade like a zero coupon bond, where they're initially issued at an amount less than face value and then gradually accrue to face as time elapses. Here's how I'd foresee this working:

An ETN issuer registers to issue a certain amount of notes, say $500 million par. Let's suppose that the notes have a stated term, say 30 years. On the day the ETNs begin trading, assume that each note has a $10 face value. If we were to assume that investors deserved some minimal amount of compensation for the counterparty risk they're assuming, say 1% per annum, then those notes would trade at a roughly $7.42 net asset value (NAV) out of the gate-that amount approximating the present value of an instrument that's worth $10 thirty years hence. What would those notes trade for the following day? Supposing that the index the ETNs are linked to is flat, the notes' NAV should inch up ever so slightly, the increase reflecting the value that's accrued with the passage of a day. Thus, the note's NAV on a given day would be a function of three factors:

The return of the index to which the note is linked.
Market supply/demand
The note's maturity and the issuer's risk profile

This calculus would hold for any note that's issued, regardless of when the issuer floats it. As such, if the issuer in the example above turned around and issued another $100 million worth of notes on day two, it would do so at the prevailing market price-a price that reflected the accrued interest on the note. (This assumes that the ETN's price approximates, if not equals, NAV.) In that way, the issuer doesn't lose any of the flexibility needed to issue and redeem notes, while the investor receives compensation for the credit risk she's assuming.

And what of the risk that an ETN's price could diverge from its net asset value because, say, the market is mispricing the interest that's accrued on the notes? For instance, suppose an ETN is trading for $550 when it should be trading for $551. In that scenario, an arbitrageur would purchase the shares for $550 and then sell then at NAV, pocketing a $1 risk-less profit. In so doing, the arbitrageur pushes the ETN's market price toward NAV, and so forth.

Conclusion

ETNs ought to trade more like...well...the bonds that they are. ETN issuers might frown at the complexity and higher cost that such a change would entail. But the economics of these notes--which appear to favor issuers at the expense of investors--demand it.

Filing Hints at Future Manager Change

2008-05-06T18:03:56Z

Update: Change in plans--Frontier recently amended the filing referred to below. The amended filing makes no mention of Rebellion Asset Management, contains no reference to GIPS, and uses completely different language to describe the strategy. The reason? It appears that Frontier ultimately opted for a different small-cap growth manager, Timpani Capital Management. Brandon Nelson, formerly of Wells Capital (and before that Strong Capital) will run the fund, which is to be known as Frontegra Timpany Small Cap Growth. It appears that Frontier has taken a majority stake in Timpani, which is a start-up.

So we were recently reviewing a filing for a forthcoming small-growth mutual fund--Frontegra Small Cap Growth--and stumbled upon something: The sub-advisor, which is described in rather specific terms (all the way down to the nature of the strategy they employ when running money), doesn't exist. Or at least not in any practical sense.

You see, the sub-advisor in question, Rebellion Asset Management, is--best we can tell--a shell. The subadvisor's two principal owners, William Forsyth and Thomas Holmberg, also happen to be the principal owners of Frontier Partners, a Chicago-area based 'solicitor' for asset managers. Essentially, they help asset managers, start-ups and spin-offs especially, with marketing, business development, distribution, and the like. But Rebellion doesn't run any money. Yet.

Chances are that Rebellion will serve as the future home of, or affiliate to, a manager that has spun-off from another firm. The language in the Frontegra fund's prospectus refers to "GIPS", a performance-reporting standard that the fund will use in setting forth the sub-advisor's results at a previous charge. GIPS only permits such reporting in certain, carefully prescribed circumstances. One of the criteria that Frontegra Small Growth Fund must meet in reporting the sub-advisor's prior results is manager continuity--the management team responsible for amassing the record in question must remain substantially intact at its new firm. Given that, the most plausible scenario is a spin-off or lift-out, where the manager and his team bolt their previous firm en masse for another shop (i.e., Rebellion).

And that's to say nothing of the fact that there's precedent for this--several of the funds in Frontegra's line-up are being run by managers that spun-off from their former firms, presumably with Frontier's assistance.

So, who's going to manage the Frontegra fund? We ran certain telltale phrases describing the Frontegra fund's investment process through an Edgar-parser. One strategy in particular came back as a near match: Boston Company Small Cap Growth.

Here's the prospectus language describing the Boston Small Company Growth Fund's investment process:

"Theadviser selects stocks by:

- Usingfundamental research to identify and follow companies considered to haveattractive characteristics, such as strong business and competitive positions,solid cash flows and balance sheets, high quality management and highsustainable growth.

- Investingin a company when the adviser's research indicates that the company willexperience accelerating revenues and expanding operating margins, which maylead to rising estimate trends and favorable earnings surprises.

The adviser focuses on individual stock selectioninstead of trying to predict which industries or sectors will perform best.Each fund's investment strategy may lead it to emphasize certain sectors, suchas technology, health care, business services and communications."

Now compare to the language used in the Frontegra fund's prospectus:

"Rebellionresearches the fundamental attributes of companies in order to identify andtrack companies with the following characteristics: strong competitivepositions; high quality management; sustainable growth; strong cash flows andbalance sheets; sales momentum; credit worthiness; accelerating revenues; andexpanding operating margins.

This methodology allows Rebellion toidentify small cap companies which are experiencing or which Rebellion believeswill experience rapid earnings or revenue growth. Though Rebellion’smethodology is based on individual stock selection rather than attempting topredict which industries or sectors will perform the best, Rebellion’sinvestment strategy may result in the emphasis of certain industries orsectors, such as technology, health care or communications"

It's essentially the same description, with a few words moved around here and there.

The managers of Boston Company Small Cap Growth Fund are B. Randall Watts and P. Hans Von Der Luft. As of Sept. 30, 2007, they were running slightly more than $1.5 billion across a number of retail and institutional small-cap products, according to relevant filings.

As of this writing, the Boston Company fund's advisor had not amended its prospectus to announce a manager change, meaning that Watts and Von Der Luft remain on the job. Assuming we're not grossly misreading what's happening here, we wonder for how long.

Claymore Registers ETF That Will Track Frontier Index; Kazakhstan Bulls, Rejoice!

2008-04-02T15:27:45Z

(3/2/08 update in bold underscore.)

On Tuesday, Claymore registered an ETF--Claymore/BNY Frontier DR--that will track the BNY Frontier DR Index. Should the fund launch, it will be the first U.S.-listed ETF devoted exclusively to so-called 'frontier' markets, which consists of stocks domiciled in developing countries that typically receive bit (if any) weightings in the prevailing broad emerging markets indexes.

Frontier countries typically span regions including sub-Saharan Africa, the middle east, eastern Europe, the Pacific rim, and central and South America. The following countries are eligible for inclusion in BNY's index (weighting as of Jan. 31, 2008, per BNY): Bahrain (4.7%), Jordan, Kuwait, Lebanon (4.5%), Oman, Qatar, United Arab Emirates, Egypt (26.8%), Ghana, Kenya, Malawi, Mauritius, Morocco, Nigeria, Tunisia, Zimbabwe, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Kazakhstan (21.1%), Latvia, Lithuania, Poland (19%), Romania, Slovak Republic, Slovenia, Ukraine, Bangladesh, Pakistan (9.9%), Papua New Guinea, Sri Lanka, Vietnam, Ecuador, Jamaica, Panama and Trinidad & Tobago.

If you invest in an emerging markets ETF, you probably already have exposure to some of the names that the Claymore fund will own. For instance, Poland, the Czech Republic, and Egpyt are part of the MSCI Emerging Markets Index. As such, these nations accounted for 1.6%, 0.8%, and 0.7% of Vanguard Emerging Markets ETF, respectively, as of Feb. 29, 2008.

Per the prospectus, the BNY index consisted of 26 names as of Jan. 31, 2008. Though we weren't able to find with the actual holdings list, we screened BoNY's depositary receipt database using some of the criterion laid out in the prospectus. Here's what we came up with, sorted by country of domicile:

Bahrain

Gulf Finance House | GFH | General Finance
Investcorp Bank | IVC | Equity Invest Instru

Croatia

Hrvatski Telekom | THTC | Fixed Line Telecom.
INA Industrija Nafte | HINA | Electricity

Czech Republic

Zentiva | ZEND | Pharma. & Biotech.

Egypt

EFG Hermes | EFGD | General Finance
Orascom Telecom | OTLD | Mobile Telecom.
Lecico Egypt | LECI | Industrial Engineer.

Georgia

Bank of Georgia | BGEO | Banks

Kazakhstan

Chagala | CHGG | Leisure Goods
Halyk Savings Bank of Kazakhstan | HSBK | Banks
JSC Alliance Bank | ALLB | Banks
KazakhGold | KZG | Mining
Kazakhstan Kagazy | KAG | Forestry & Paper
Kazkommertsbank | JSCD | Banks
Kazkommertsbank | KKB | Banks
KazMunaiGas EP | KMG | Oil & Gas Producers
ShalkiyaZinc | SKZ | Mining

Lebanon

BLOM Bank | BLBD | Banks

Lithuania

Teo | TEOL | Fixed Line Telecom.

Nigeria

Diamond Bank | DBG | Banks
Guaranty Trust Bank | GRTB.LI | Banks

Oman

BankMuscat | BKM | Banks

Pakistan

MCB Bank | MCBS | Banks
Oil & Gas Development | OGDC | Oil & Gas Producers
United Bank | UBLS LI | Banks

Poland

Bank Polska Kasa Opieki | BPKD | Banks
Polski Koncern Naftowy Orlen | POKD | Oil & Gas Producers
Telekomunikacja Polska | TPSD | Fixed Line Telecom.

Romania

A & D Pharma | ADPH | HealthCareEquip.&Ser

Tunisia

Banque Internationale Arabe de Tunisie | BIND | Banks

United Arab Emirates

Kingdom Hotel Investments | KHI | Leisure Goods

If you tallied-up the names above, you probably realize that there's more than 26. How do you say 'Doh!' in Romanian? In truth, the difference arises because the index will apply various liquidity and market-cap screens that we weren't able to apply using BoNY's tool. So, not every name listed above will make the cut. Dobrze? ('Ok?' in Polish, my mother tongue.)

It's worth noting that a firm's shares must trade as depositary receipts on the London Stock Exchange, Luxembourg Stock Exchange, NYSE, Nasdaq, or Amex in order to qualify for the index. While the fund would technically invest in shares that are denominated in dollars, since depositary receipts are tied to the ordinary shares denominated in the home currency, any monies invested would be subject to currency gyrations.

No word on how much the fund will cost. 'Not less than 0.64%' seems like as good a guess as any (that's the expense ratio that sibling Claymore/BNY BRIC levies).

WisdomTree Registers Growth, Middle East ETFs, Among Others; SSGA Registers Int'l Sector ETFs

2008-05-01T14:32:37Z

Continuing a parade of recent ETF registrations, WisdomTree registered on Wednesday to launch six new funds--WisdomTree LargeCap Growth, WisdomTree International Large Cap Growth, WisdomTree Middle East Dividend, WisdomTree Global Dividend, WisdomTree Global Small Cap Dividend, and WisdomTree Global Equity Income.

In addition, SSGA registered a raft of foreign sector ETFs on Tuesday. Those forthcoming ETFs, which would be the companions to their domestic siblings (i.e., Financial Select Sector SPDR, etc.), include SPDR S&P International Consumer Discretionary, SPDR S&P International Consumer Staples, SPDR S&P International Energy, SPDR S&P International Financial, SPDR S&P International Health Care, SPDR S&P International Industrial, SPDR S&P International Materials, SPDR S&P International Technology, SPDR S&P International Telecommunications, and SPDR S&P International Utilities.

WisdomTree

The forthcoming growth funds and the Middle East fund strike me as most interesting. The two growth ETFs would be the first of their kind in WisdomTree's line-up, which primarily emphasizes funds that track dividend-weighted or earnings-weighted indexes. In fact, only one of WisdomTree's ETFs--WisdomTree India Earnings--can be found in the growth column of the Morningstar style-box.

The domestic growth fund seems to take a page from WisdomTree Low P/E's strategy, as it'll only consider firms that have posted cumulative positive earnings in the past four quarters. However, it'll also require that each name have notched positive year-over-year EPS, book value per share, sales per share, and stock price growth. Of those names, it'll sweep in the top-1,000 by market-cap, rank those 1,000 based on annual earnings per share growth, annual sales per share growth, annual book value per share growth, and annual stock price growth, and then select the top 30% of names that score highest on that basis. It'll then weight those names based on their earnings over the most recent four fiscal quarters.

The international growth fund is similar, with a few notable differences. First, whereas the domestic growth fund will only consider firms that have posted positive earnings in the past four quarters, this fund will only include those that have paid at least $5 million in regular cash dividends in the past year. The other requirements appear to be identical (i.e., year-over-year growth, market-cap). But the index will weight the top 30% based on cash dividends, not earnings. (Interestingly, the prospectus makes reference to a WisdomTree World ex-U.S. Index, from which it will draw firms that have paid the requisite $5 million in cash dividends. That's the first time such an index has been mentioned in a filing, possibly suggesting that WisdomTree will eventually launch a WisdomTree World ex-U.S. ETF.)

As for the Middle East Dividend ETF, here's how the prospectus describes the security selection process...

Companies eligible for inclusion in the Index must be incorporated in and have their shares listed on a major stock exchange in Bahrain, Dubai, Egypt, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar and the United Arab Emirates. Companies must have paid at least $5 million in cash dividends on their common stock in the 12 months prior to the most recent index measurement date. Companies are weighted in the Index based on regular cash dividends paid. The Index is composed of primarily mid capitalization stocks. As of March 31, 2008, approximately 54% of the index consisted of companies with a market capitalization between $2 billion and $10 billion.

We recently blogged about the forthcoming PowerShares MENA Frontier Countries Portfolio. That ETF will track an index spanning the same countries with two exceptions--it includes Nigeria, which the WisdomTree index omits, and excludes Bahrain, which the WisdomTree index includes. And, of course, the PowerShares fund's index will weight stocks by market-cap, whereas the WisdomTree index will dividend-weight its constituents.

Of the other WisdomTree ETFs included in the filing, perhaps the most remarkable attribute is their global mandate, as there aren't any other U.S.-listed global dividend ETFs in existence at the moment, to our knowledge at least.

SPDR International Sector ETFs

I'll keep things uncharacteristically short/snappy here: It looks like the various international sector ETFs will draw from the same parent index--the S&P/Citigroup BMI World Index--and then make a few tweaks to cap holding weightings (in order to comply with the Internal Revenue Code). Though I don't have ready access to the particular indexes these ETFs will track, we can at least approximate what the portfolios might hold judging from the holdings of SPDR S&P World ex-U.S, which tracks the S&P/Citigroup parent index mentioned. For instance, if we strip out all of that fund's energy holdings and then rescale the weightings, we end up with the following holdings list.

Name	Weighting %
BP	13.5%
TOTAL	11.6%
Royal Dutch Shell A	8.8%
Royal Dutch Shell B	6.2%
BG Grp	5.6%
Eni	5.3%
Encana	4.3%
Suncor Energy	3.5%
Canadian Natural Res	2.9%
Repsol YPF	2.7%
StatoilHydro	2.6%
Woodside Petroleum Ltd	2.5%
Petro Canada	2.0%
Enagas	1.8%
Imperial Oil	1.8%
TransCanada	1.8%
Crescent Point Energy Trust Trust Unit	1.7%
Fortum	1.7%
Talisman Energy	1.7%
Canadian Oil Sands Trust Trust Unit	1.6%
Tullow Oil	1.6%
Espanola de Petroleos-CESPA	1.5%
OMV Aktiengesellschaft	1.5%
Husky Energy, Inc.	1.4%
Nexen, Inc.	1.2%
Cameco	1.1%
Neste Oil	1.1%
NIPPON OIL CORPORATION	1.1%
Technip	1.1%
BOURBON	0.9%
CGG Veritas	0.9%
Norsk Hydro	0.9%
OPTI Canada Inc.	0.8%
COSMO OIL COMPANY, LIMITED	0.6%
Petroleum Geo-Services	0.5%
Westernzagros Res	0.0%

Again, this is merely an approximation. But it should give you a feel for the composition of these funds. Though they're not unique--WisdomTree already offers a suite of foreign sector funds--they'll be distinctive in that they weight stocks by market-cap (WisdomTree dividend-weights the names in its various foreign sector ETFs). In addition, whereas WisdomTree omits Canadian stocks from its foreign sector indexes, it appears the SPDR family will include them.

Geronimooooo! Direxion Registers 34 ETFs That Will Provide 3x Market Exposure

2008-04-30T18:28:14Z

Rafferty Asset Management, the advisor to the Direxion family of mutual funds, entered the ETF market with a bang on Wednesday. The firm registered 34 ETFs, all of which would aim to deliver 3x the daily return (or inverse) of various market indexes. The ETFs, which would trade under the Direxion banner, are as follows:

Domestic Market

Dow 30Bear 3X Shares (Dow 30 Index)
Dow 30Bull 3X Shares (Dow 30 Index)
Mid Cap Bear 3X Shares (S&P Mid Cap 400 Index)
Mid Cap Bull 3X Shares (S&P Mid Cap 400 Index)
Nasdaq-100 Bear 3X Shares (NASDAQ 100 Index)
Nasdaq-100 Bull 3X Shares (NASDAQ 100 Index)
Russell 2000 Bear 3X Shares (Russell 2000 Index)
Russell 2000 Bull 3X Shares (Russell 2000 Index)
S&P 500 Bear 3X Shares (S&P 500 Index)
S&P 500 Bull 3X Shares (S&P 500 Index)
Total Market Bear 3X Shares (MSCI Broad Market Index)
Total Market Bull 3X Shares (MSCI Broad Market Index)

Developed Market

Developed Markets Bear 3X Shares (MSCI EAFE Index)
Developed Markets Bull 3X Shares (MSCI EAFE Index)
Japan Bear 3X Shares (Nikkei 225 Index)
Japan Bull 3X Shares (Nikkei 225 Index)

Developing Market

BRIC Bear 3X Shares (S&P BRIC 40 Index)
BRIC Bull 3X Shares (S&P BRIC 40 Index)
China Bear 3X Shares (FTSE/Xinhua China 25 Index)
China Bull 3X Shares (FTSE/Xinhua China 25 Index)
Emerging Markets Bear 3X Shares (MSCI Emerging Markets)
Emerging Markets Bull 3X Shares (MSCI Emerging Markets)
India Bear 3X Shares (Indus India Index)
India Bull 3X Shares (Indus India Index)
Latin America Bear 3X Shares (S&P Latin America Index)
Latin America Bull 3X Shares (S&P Latin America Index)

Sector

Energy Bear 3X Shares (S&P Energy Select Sector Index)
Energy Bull 3X Shares (S&P Energy Select Sector Index)
Financial Bear 3X Shares (S&P Financial Select Sector Index)
Financial Bull 3X Shares (S&P Financial Select Sector Index)
Homebuilders Bear 3X Shares (S&P Homebuilding Select Index)
Homebuilders Bull 3X Shares (S&P Homebuilding Select Index)
Real Estate Bear 3X Shares (Dow Jones U.S. Real Estate Index)
Real Estate Bull 3X Shares (Dow Jones U.S. Real Estate Index)

Commodity

Commodity Bear 3X Shares (Morgan Stanley Commodity Index)
Commodity Bull 3X Shares (Morgan Stanley Commodity Index)

Our take? Call us prudes, luddites, shrinking violets...these are insane. Yeah, they fill a niche, as ETF investors are 'stuck' with ETFs--from ProShares and Rydex--that deliver only 2x the market, or parts thereof, shutting out raging bulls and bears looking to triple their money in one fell swoop. But we'd avoid them.

If you are hellbent on using leveraged products like these, we'd suggest ratcheting up your margin of safety accordingly. For instance, if you'd normally invest in a diversified stock ETF like iShares S&P 500 Index when it's trading at an 8% or greater discount to what you think it's worth, double that margin of safety when you're investing in an ETF that aims to deliver 2x the S&P 500's return (i.e., buy only when the S&P is trading at a 16% or greater discount to what you think it's worth).

One could apply that same calculus to these forthcoming Direxion ETFs. For instance, swoop into Direxion Dow 30 Bull 3x when the Dow is trading at a 24% discount to what you think it's worth, and so forth.

That said, bear in mind that the provider is only offering to deliver twice or thrice the daily return of the index concerned. In other words, if the index gains 10% in a year, you're not guaranteed 20% or 30%. The 2x or 3x math only holds from sunup to sundown. That should tell you something about the intended audience for these products--daytraders and speculators who love to roll the dice.

If you don't fit that profile, stick to the conventional ETFs.

The 'Little ETF That Beats the Market'?

2008-03-24T20:18:26Z

In riffing on another fund, Gratio Value, it occurred to me that no one, to my knowledge, had licensed Joel Greenblatt's 'magic formula' for use in an ETF.

If you're unfamiliar, Greenblatt is a celebrated author--most recently of the best-selling 'Little Book That Beats the Market'--and accomplished investor. He also maintains a companion website, Magic Formula Investing, that allows users to screen firms using on the 'magic formula' that is the focal point of the 'Little Book'. The site has become very popular in investing circles, with many value hounds using it as a cheat-sheet of sorts.

Given that the 'magic formula' is completely formulaic (rank stocks based on earnings yield and returns on invested capital) and transparent (earnings yield and ROIC can be easily calculated), it seems like it would lend itself very nicely to an index. And that index, in turn, could be licensed by an ETF provider.

That doesn't mean such a product would sell, mind you. But Greenblatt has amassed a terrific record over time by employing a strategy very similar to the 'magic formula'. So it's not as if it isn't proven. Also, part of the reason that Greenblatt's approach has caught on is its simplicity and accessibility. Those qualities would likely resonate with ETF investors as well, though selling a book and selling a fund are obviously very different endeavors.

I'm not sure a name like 'SPDR Magic Formula' would pass the sniff test with the regulators. But I'm sure that Greenblatt--who has a flair for the Vaudevillean--would have no trouble coming up with something.

Barclays Cuts Fees on iShares Brazil; No Such Luck for iShares Emerging Mkts

2008-04-29T18:50:26Z

On Monday, Barclays Global Fund Advisers (BGFA), the manager behind the very popular iShares family of ETFs, disclosed that it's cutting the fees the firm levies on iShares MSCI Brazil, iShares MSCI S. Africa, iShares MSCI S. Korea, and iShares MSCI Taiwan. BGFA also changed the management fee schedule for its very large iShares MSCI Emerging Markets Fund. However, that change won't immediately yield cost savings, as the fee cut is contingent on further growth of that fund and its stablemate, iShares MSCI BRIC. We explain the changes in further detail below.

iShares MSCI Emerging Markets and iShares MSCI BRIC

As mentioned, BGFA isn't immediately cutting the 0.74% expense ratio that it levies on iShares MSCI Emerging Markets and iShares MSCI BRIC. Instead, the firm has added an additional 'breakpoint' to the fee schedule that dictates the management fee that's charged. Previously, BGFA charged 0.75% on each dollar of assets below $14 billion and 0.68% on each dollar exceeding $14 billion. (For purposes of the calculation, BGFA defines 'assets' as the sum of iShares MSCI Emerging Markets Fund's assets and iShares MSCI BRIC's assets.) Now, BGFA is charging 0.75% on each dollar below $14 billion, 0.68% between $14 billion and $28 billion, and 0.61% on each dollar above $28 billion. Thus, as the funds' asset grow and eventually surpass the $28 billion mark, the 0.61% fee breakpoint will take hold, bringing the total management fee down.

The breakpoint won't take immediate effect, though, because the emerging markets and BRIC funds' combined assets fall shy of the $28 billion threshold. As of Monday, according to iShares' website, those funds held a combined $26.5 billion in assets. In fact, investors aren't likely to see a single basis point in additional savings until the funds' combined assets approach $31 billion, which by our calculations is when the management fee would fall to 0.70%.

What kind of sacrifice is BGFA making in instituting the new breakpoint? Here's how the fees pile up under the old and new schedules: (cue the violins...)

Assets (MM)	Mgt. Fees -- Old (MM)	Mgt. Fees -- New (MM)	Difference (MM)	% Difference
$ 30,000	$ 213.80	$ 212.40	$ 1.40	0.7%
$ 40,000	$ 281.80	$ 273.40	$ 8.40	3.0%
$ 50,000	$ 349.80	$ 334.40	$ 15.40	4.4%
$ 75,000	$ 519.80	$ 486.90	$ 32.90	6.3%
$ 100,000	$ 689.80	$ 639.40	$ 50.40	7.3%

In other words, when the funds' combined assets hit $50 million, BGFA stands to pull down $334.4 million in management fees under the new schedule, versus $349.8 million under the old schedule, a 4.4% difference. That's chump change, especially when you consider the relative profitability of each incremental dollar of assets that comes through the door (that's the beauty of positive operating leverage). Investors deserve breakpoints that start earlier, cut deeper, and extend farther across the asset range.

Vanguard Emerging Markets ETF, by the way, tracks the very same benchmark as iShares MSCI Emerging Markets, yet is roughly one-third the cost.

iShares MSCI Brazil, iShares MSCI S. Africa, iShares MSCI S. Korea, and iShares MSCI Taiwan

At least BGFA is cutting investors in these ETFs a break: The management fee is slated to fall 3 basis points at each of these funds, effectively immediately.

The circumstances are essentially identical to those surrounding iShares MSCI Emerging Markets--BGFA has added a breakpoint to the fee schedule (0.64% for each dollar of assets above $8 billion). The difference in this case is that the funds' combined assets--$15.6 billion as of Monday--exceed the $8 billion threshold, meaning that the new breakpoint will immediately take hold, lowering the fee.

PowerShares Registers Middle East and Africa ETF

2008-04-22T13:24:27Z

PowerShares registered on Monday to launch an ETF that will invest in companies domiciled in 10 Middle Eastern and North African countries. The ETF, which is provisionally being called the "PowerShares MENA Frontier Countries Portfolio", will track an as-yet-unnamed index that will hold "approximately 50 companies" the majority of whose assets reside within the following countries--Nigeria, Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar and United Arab Emirates.

The index will weight stocks by free-float adjusted market-cap. No word on country allocations, though the prospectus indicates that no country's weight can exceed 20% of the index and the index will hold no more than five stocks from a single country (hence the 'approximately 50 companies', I guess). To qualify for inclusion in the index, each stock must have "at least $500 million in float-adjusted market capitalization and a minimum average daily value traded of $1 million for the period of six months prior to inclusion". One country that is conspicuous by its absence from the index is Saudi Arabia, which appears not to have made the cut.

Nevertheless, the fund is remarkable insofar as it would be the first ETF to target these regions specifically. While there are a few ETFs, such as SPDR S&P Emerging Middle East and Africa, that focus on portions of the African continent and the Middle East, they tend to tread heavily in more-developed countries like Israel and S. Africa. This fund, by contrast, provides exposure to a host of oil rich, if less-established, markets.

With this filing, PowerShares joins Claymore in the race to list the first "frontier" ETF on a U.S. exchange. Though the forthcoming Claymore ETF, which is also in registration, will invest in a wider swath of countries than the PowerShares fund, it'll hardly be a stranger to the Middle East and African continents, as its index sweeps in names in Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, United Arab Emirates, Egypt, Ghana, Kenya, Malawi, Mauritius, Morocco, Nigeria, Tunisia, and Zimbabwe. However, only Egpyt (27% weighting as of Jan. 31, 2008), Bahrain (4.7% weighting), and Lebanon (4.5% weighting) figured prominently in that index. Thus, the PowerShares ETF would ostensibly be unique in providing dedicated exposure to the so-called "MENA" (Middle East and North Africa) countries.

SSGA Registers Local Currency Emerging Markets Bond ETF

2008-04-25T14:00:03Z

On Thursday, SSGA registered SPDR Lehman Emerging Markets Local Sovereign Debt, an ETF that will invest in the local currency denominated bonds issued by governments in 18 eligible developing countries. Should the fund launch, it would be the first of its kind, as the other two emerging markets bonds ETFs--iShares JP Morgan USD Emerging Markets Bond and PowerShares Emerging Markets Sovereign Debt--invest exclusively in U.S.-dollar denominated paper.

Local currency denominated emerging markets funds have been a hot commodity in the open-ended mutual fund arena. For instance, PIMCO Developing Local Markets Bond has grown into a $5 billion offering in under three years, while stablemate PIMCO Emerging Local Bond is hauling around $1.7 billion for its part. But local-currency EM bond funds are hardly plentiful. Further, the dominant players--namely, PIMCO's funds--aren't exactly inexpensive to own. That would seem to create an opening for this forthcoming SPDR fund, which--for a time at least--will have the entire ETF field to itself.

Here's a comparison of the SPDR fund to the iShares and PowerShares ETFs...

	PowerShares	IShares	SPDR
Index	DB Emerging Market USD Liquid Balanced	JPMorgan EMBI Global Core	Lehman Brothers Emerging Markets Local Capped
Eligible Countries	(22) Argentina, Bulgaria, Brazil, Chile, China, Columbia, Indonesia, Korea, Mexico, Panama, Peru, Philippines, Poland, Quatar, Russia, South Africa, Turkey, Ukraine, Uruguay, El Salvador, Vietnam and Venezuela	(26) Argentina, Brazil, Bulgaria, Chile, China, Colombia, Ecuador, Egypt, El Salvador, Hungary, Indonesia, Iraq, Lebanon, Malaysia, Mexico, Panama, Peru, Philippines, Poland, Russia, Serbia, South Africa, Turkey, Ukraine, Uruguay and Venezuela	(18) Brazil, China, Columbia, Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Poland, Russia, Singapore, Slovakia, South Africa, South Korea, Taiwan, Thailand and Turkey
Currency Denomination	U.S. Dollar	U.S. Dollar	Local currency
# of Bonds	25	36	?
Minimum Maturity	3 years	2 years	1 year
Coupon Type	Fixed only	Fixed and floating	Fixed only
Minimum Issue Size	$500 million	$1 billion	?
Weighting Scheme	Equal weighting	Market value	Modified market value
Rebalancing Frequency	Quarterly	Monthly	Monthly
Index Strategy	Quasi-active (i.e., seeks to outperform pure passive)	Passive	Passive

Market Vectors Launches Another Solar ETF

2008-04-22T18:33:08Z

Market Vectors Ardour Solar Energy (ticker KWT) began trading today. It's the second solar ETF to launch in the last few weeks, Claymore/MAC Global Solar Energy (ticker TAN) being the other.

At first blush, the two funds look pretty similar, down to the stocks they own and the proportions in which they invest in them. Here's a comparison of the fund's holdings (the Market Vectors holdings list might be a bit dated...the most recent list on their site was as of 4/11...but you get the idea)...

	Market Vectors	Claymore
Q-Cells AG	10.74%	6.41%
First Solar Inc.	10.43%	8.83%
Renewable Energy Corp. ASA	9.81%	7.51%
SolarWorld AG	9.54%	5.39%
Suntech Power Holdings Co. Ltd. ADS	4.90%	6.29%
SunPower Corp. Cl A	4.85%	5.00%
JA Solar Holdings Co. Ltd. ADS	4.80%	5.45%
LDK Solar Co. Ltd. ADS	4.75%	4.77%
Yingli Green Energy Holding Co. Ltd. ADS	4.55%	5.02%
Solaria Energia y Medio Ambiente S.A.	4.52%	3.71%
Trina Solar Ltd. ADS	4.49%	3.35%
Evergreen Solar Inc.	4.43%	2.91%
Solon AG fuer Solartechnik	3.90%	2.79%
ErSol Solar Energy AG	3.13%	3.07%
Conergy AG	2.73%	2.17%
CANADIAN SOLAR INC	1.51%	2.96%
CHINA SUNERGY CO LTD-ADR	0.92%	3.42%
SOLARFUN POWER HOLD-SPON ADR	0.80%	3.06%
Solar Millennium AG	2.71%
Phoenix Solar AG	2.25%
ARISE Technologies Corp.	1.53%
Solar-Fabrik AG	0.69%
Spire Corp.	0.59%
Sunways AG	0.57%
Centrosolar Group AG	0.45%
DayStar Technologies Inc.	0.42%
MEMC ELECTRONIC MATERIALS INC		4.63%
ENERGY CONVERSION DEVICES		3.27%
MEYER BURGER TECHNOLOGY AG		2.48%
ROTH & RAU AG		2.20%
MANZ AUTOMATION AG		2.07%
CHINA SUNERGY CO LTD		1.99%
EMCORE CORP		1.68%

All told, the funds share roughly 80% - 90% of their assets in common. Here's some other data, as of Mar. 31, 2008, that I pulled off the fund companies' websites...

	Market Vectors	Claymore
# of stocks	26	25

Mkt Cap:
Lg Cap	20.0%	27.7%
Md Cap	42.5%	29.7%
Sm Cap	37.5%	42.7%

Country:
Germany	36.7%	29.9%
China	24.3%	29.0%
U.S.	24.3%	26.3%
Norway	10.0%	7.3%
Spain	3.9%	4.3%

Again, some modest differences, but I wouldn't expect the funds to have markedly different risk/reward profiles.

So what's it going to come down to? Ordinary in a situation like this I'd say 'expense ratio, expense ratio, expense ratio'. But both funds cost the same to own--0.65%. One would naturally expect the Claymore fund to enjoy a head-start in terms of liquidity and spreads--in fact, the fund's daily trading volume has averaged around 500,000 shares since it launched on 4/15, an impressive tally considering that there are only slightly more than one million shares outstanding.

Which to choose? How about 'neither'. Generally speaking, our analysts are not especially fond of these businesses, many of which depend heavily on government subsidies and all of which are vulnerable to disruptive technologies given the low-barrier-to-entry nature of the solar business. Consequently, none of the dozen or so pure-play solar firms that our analysts cover--many of which, like First Solar, figure prominently in both of these portfolios--has managed to trench out a durable competitive advantage of any kind.

Further, given the sensitivity of these firms to the vagaries of crude oil prices, government largesse, and input costs (principally, raw polysilicone), they've been hugely volatile. In fact, after soaring in recent years, many of these names are now getting crushed. Take SunPower, which rose 251% last year, but fell 51% in this year's first quarter alone. Given these risks, we'd only invest in these firms with a healthy margin of safety--they'd have to be trading at least 20% below our fair value estimates to get us interested.

We're nowhere near that threshold right now. For instance, the dozen of so stocks in the Claymore portfolio that we cover were recently trading at a hefty 30% premium to our estimate of their aggregate fair value. MEMC Electronic, First Solar, JA Solar, and Yingli Green Energy were all trading well above our estimates of those firms' intrinsic worth.

And it's not like we're being prudes in forecasting these businesses' future growth. For instance, we're projecting 41% annualized top-line growth for First Solar from 2007 - 2014. But the question remains--what price growth? The answer for First Solar was recently '147 times trailing earnings'. Viewed against the backdrop of numerous solar-related IPOs in recent months, which is rarely an encouraging portent, solar has 'froth' written all over it at the moment.

We'd stand on the sidelines until prices get more reasonable.

The Case for Performance-Based Fees: Benefits (Part 2 of 3)

2008-04-16T17:03:16Z

In a previous post, I ran through the manifold challenges that asset managers are likely to face in the years ahead and argued that non-incumbent managers should adopt performance-based fees.

Now, that'll probably sound like hari kari to the average fund manager. Why hop off the gravy train, they might argue, when it's merely slowing, not screeching to a halt? Here are a few reasons:

Apart from eating one's own cooking, there is no better way to align a firm with the success of a given investment strategy.

If the firm's profitability rides on adding alpha, as opposed to simply gathering assets or coasting on a market tailwind, then you better believe the fee structure is going to have a catalyzing effect on firm culture. Getting the job done for the investor is literally job one.

It promotes good research and product development.

When adding value is the cornerstone of a firm's very existence, rigorous research is going to be placed front and center, where it belongs. Further, the investment approach will coalesce around what makes sense, rather than what's likely to resonate loudly in the market. How so? Let us count the ways: regarding stocks as ownership in a business, not pieces of paper; focusing on the long-term, over which economic value is created or destroyed, rather than anchoring on the short-term based on what one thinks the market will pay; retreating from, not chasing, the latest trend. These are the hallmarks of disciplined product development, which a performance-based incentive system promotes, for anything short of that will burn a hole in the firm's pocket.

There's a collateral benefit as well: Management fees are likely to decline. Why? Retail management fees are routinely marked-up on the assumption that for every product that's a hit, there will be two or three others that fail to gain traction. In effect, more-successful products subsidize less-successful ones. The less-disciplined product development, the lower the ‘hit' ratio, the more pressing the need to build a buffer into the management fee. This ends up inflating management fees across the board.

But with more disciplined product development, there's less need for that buffer. Thus, management fees should gradually trend down.

The fee structure removes disincentives to close strategies before capacity gets out of hand.

As it stands, a manager who pulls down a fixed management fee isn't going to be chomping at the bit to close a strategy given that it will throttle growth. (Firms like Wasatch and Bridgeway, which routinely close funds well before asset bloat sets-in, are a rarity.) By contrast, the manager who employs a fee structure like the one I'm describing has a huge incentive to close a strategy in a thoughtful, timely manner-it ensures that the strategy continues to add value, which is the manager's paramount concern.

Yeah, lock-ups give hedge fund and private equity managers the luxury of closing a strategy at a given level-after all, those assets aren't going anywhere. But it's more fundamental than that - closing the strategy preserves its effectiveness, or at least lowers the odds that performance will revert to the mean as assets flood in, thereby limiting the manager's opportunity set.

It's cheaper to the client.

Say what? That's right - it's cheaper to the client. Here's why: The use of a traditional, flat basis-points-on-assets fee structure discourages, rather than promotes, judicious risk-taking. It's a business model that stresses asset growth, not performance for performance-sake. Thus, managers take what, in the grand scheme of things, are pretty modest bets in hopes of riding the market tailwind and then inching past peers and, maybe, the benchmark after fees and transaction costs are factored in. The upshot is that returns generally vary within a pretty tight range about the benchmark.

(Incidentally, I'd also argue that this volume-driven business model has been the seedbed for other counterproductive ‘innovations', such as the 12b-1 fee...the business imperative for which becomes much less compelling once you start rethinking the fee structure...you don't necessarily need to incent an army of brokers to push your product if the performance fee does most of the heavy lifting. Yeah, you better add value for the client over the long haul, or else. But isn't that why you're in this business in the first place?)

The trouble, as it were, with this approach is that it has tended not to work. And when it doesn't work-i.e., when the fund has hovered near or skirted its benchmark index's returns-it's a bum deal for the shareholder. For instance, the fund matches the benchmark pre-fee. The manager gets his take-say, a 50 basis point management fee-and you or I get squat (actually, we get 0.50% worth of underperformance...gee, thanks). Or suppose the fund lags the benchmark by a percentage point. Again, we incur every last basis point of pre-fee underperformance and yet the manager still gets his taste, deepening the shortfall.

Now contrast that with a performance-based fee. Suppose that the fund levies a 0.20% base management fee and a performance adjustment equal to 50% of any outperformance/ underperformance versus the benchmark outside of a specified corridor, say 1.5%. (More on this structure in a bit) If the fund matches the benchmark, then the manager gets its 0.20% but no performance adjustment, putting him in the same boat as you or I, the lowly shareholder.

Then let's suppose the fund lags the benchmark by three percentage points. In that case, the manager will have to cough up 0.55% and pay it to the fund (0.20% base management fee less a 75 basis point performance adjustment equal to 50% of the 150 basis point underperformance outside of the corridor). In that case, the manager is actually feeling some of the shareholder's pain-he shoulders 55 basis points of the 300 basis point underperformance.

Now, one can argue that this begins to break down when we're talking about significant outperformance under a traditional fee structure. In such cases, a flat percentage fee lets you or I keep the lion's share of those excess returns. The manager levying a flat 50 basis point fee in such a scenario is getting just that - 50 basis points. But with the performance-based fee structure, the manager is going to share in the good times, leaving investors with less of the spoils.

But the point is that funds, by and large, rarely deliver these types of returns. And I'd argue that that failure is at least partly attributable to the traditional fee structure, which discourages the kind of judicious risk-taking that's needed to garner such outperformance in the first place.

So, to borrow from Warren Buffett, it seems far preferable to adopt a system that enhances the investor's odds of gaining a lesser share of something (or, for you pessimists, of losing a lesser share of something) than inheriting a larger share of nothing or, worse yet, a deficit.

It forces fund companies to reckon with the way they define "management" fee.

One of the great misconceptions is that a fund's management fee pays solely for the portfolio managers, analysts, and research resources that are behind a given portfolio. Not so. It pays for a lot more than that-namely, "SG&A".

SG&A is always most significant in a fund manager's retail channel, where you've got to pay for wholesalers and phone reps and maybe make hard-dollar payments to wirehouses, etc. The reason SG&A is more significant in the fund world? The customer base is much more diffuse in dollar terms. Contrast that with the institutional channel, where managers can reach well-heeled prospects without having to haul around a large selling apparatus.

Ever wonder why fund managers charge a lower management fee to run an identical strategy for an institutional client (in a separately managed account), or as part of a subadvisory mandate? The dirty little secret is that they don't have to pad the management fee to cover SG&A, as they either aren't incurring those types of expenses (as with a separately managed institutional account) or another manager is bearing the costs (as with a subadvisory mandate).

What does that have to do with performance-based fees? Managers have a clear incentive not to pad their management fee, as a higher management fee represents a higher hurdle that the fund has to clear before reaping any performance adjustment. Also, as previously mentioned, because a business model tied to investment performance isn't dependent on volume-i.e., keeping the sales engine humming to drive asset growth-then SG&A becomes a less significant part of a manager's cost structure.

Also, it forces the manager to think more carefully (honestly?) about the economics of running money. When I used to cover asset managers, my glib response to the question ‘just how scalable is this business?' was ‘as scalable as managers want it to be'. (For those seeking an example, writ large, of the business's profit potential, check out the financials for quantitative manager LSV Asset Management, which is a unit of SEI Investments. Helllloooo 90%-plus operating margins.) That is, in an intellectual capital-centric business like asset management, you know compensation is going to be the biggest cost, bonus in particular. But there's no immutable law that holds a manager must pay out x% of each incremental fee dollar in comp just...because. A performance-fee structure imposes a form of discipline in the sense that managers must be more mindful of the management fee they're charging.

Again, the management fee is a mixed blessing. Yes, it's a comparatively stable revenue source. But it also stands as a hurdle between the manager and the most lucrative portion of the revenue stream-the performance fee adjustment. Thus, the higher the management fee, the higher that hurdle. In that sense, it forces managers to think more honestly about the economics of the management fee-how much operating leverage is in the business, does the fee's size jibe with that, and does it terrace down appropriately as assets grow.

Here's where I'll sound like a fund industry shill: Performance-based fees would help to differentiate funds from other investment products.

You're sending a powerful message to investors when your fee structure essentially says ‘we're in the same boat'. It reinforces an important (and inescapable) facet of the industry's identity-active management--and underscores its mission-to add value.

Also, it most certainly would help to combat the growing perception that active managers are grossly overpaid for their services by dint of their high correlation to the broader market (exposure that investors could get through a low-cost index mutual fund or ETF).

And, finally, it would foster a healthy dialogue about the true cost of outperformance, especially when compared to the typical hedge fund manager's fee. That comparison is likely to reflect well on the fund industry (i.e., the low base fee, the relatively modest performance adjustment, the symmetry of the adjustment, etc.).

Now, there's always a catch. And you know that an area as technical as performance-based fees is going to stir-up a number of implementation questions. So, in our next and final installment, we'll address some of those issues and concerns.

Interesting Mutual Funds in the Offing

2008-04-18T15:03:00Z

As I've mentioned previously, one of my dweebish hobbies is scouring my Edgar-parser for new filings. Here are a few of the more interesting mutual funds that have entered the registration queue in recent days:

Champlain Mid Cap: Champlain Small Company has been nothing short of terrific in its first few years of existence. This forthcoming mid cap fund will be run by the same crew, led by Scott Brayman. They've been running a mid cap strategy in private accounts for some time now ($43 million in total as of 2007). So, it's not as if they just hatched this idea, which is encouraging. The longer-term concern is insuring that there's not too much blurring of the lines between the mid cap and small cap funds, as that would invite capacity constraints. But Champlain has been unusually forthcoming about its plans to close products before asset growth gets out of hand. I would expect they've been just as circumspect in planning this fund's launch. It's slated to cost 1.30% after expense waivers.
PIMCO Fixed Income Unconstrained: Apart from the name (which is awful in all of its literal glory...should we think of PIMCO Total Return Return as 'PIMCO Handcuffed'...'PIMCO Throttled'...?), this looks intriguing. I'm not a big bond-head, but the strategy description, excerpts of which I've pasted below, makes it sound like something akin to Dan Fuss' freewheeling approach at Loomis Sales Bond Fund. I would expect PIMCO to excel with this kind of mandate given the sheer information advantage the firm enjoys by dint of its scale and global reach. Also, given the very wide duration corridor, it seems tailor made to serve as an expression of PIMCO's tactical views on the global bond markets--views which are rarely unremarkable. Chris Dialynas will run the fund. No word on expenses, though I wouldn't expect a strategy like this one to come cheap (and PIMCO is not the first name in retail bond fund cost leadership). All the same, an interesting option for investors employing, say, a core-satellite approach on the fixed income side of their asset allocation.

The Fund seeks to achieve its investment objective by investing under normal circumstances at least 80% of its assets in a diversified portfolio of Fixed Income Instruments of varying maturities, which may be represented by forwards or derivatives such as options, futures contracts, or swap agreements. The Fund intends to utilize various investment strategies in a broad array of fixed income sectors to achieve its investment objective. The average portfolio duration of this Fund will normally vary from negative 3 years to positive 8 years based on PIMCO’s forecast for interest rates.

The Fund may invest up to 40% of its total assets in high yield securities (“junk bonds”) rated below Ba by Moody’s, or equivalently rated by S&P or Fitch, or, if unrated, determined by PIMCO to be of comparable quality. The Fund may also invest without limitation in securities denominated in foreign currencies and in U.S. dollar-denominated securities of foreign issuers. In addition, the Fund may invest up to 50% of its total assets in securities and instruments that are economically tied to emerging market countries. The Fund will normally limit its foreign currency exposure (from non-U.S. dollar-denominated securities or currencies) to 35% of its total assets.

The Fund may invest all of its assets in derivative instruments, such as options, futures contracts or swap agreements, or in mortgage- or asset-backed securities. The Fund may, without limitation, seek to obtain market exposure to the securities in which it primarily invests by entering into a series of purchase and sale contracts or by using other investment techniques (such as buy backs or dollar rolls). The total return sought by the Fund consists of income earned on the Fund’s investments, plus capital appreciation, if any, which generally arises from decreases in interest rates or improving credit fundamentals for a particular sector or security.

PIMCO Global Advantage: I can sum-up this fund's potential allure in one word--El-Erian. The onetime manager of stalwart PIMCO Emerging Markets Bond, Mohamed El-Erian was vaulted to rock-star status when Harvard tapped him to succeed Jack Meyer in heading-up the college's huge (and uber-successful) endowment warchest. PIMCO recently lured El-Erian back into the fold by offering him the plum post of heir-apparent to Bill Gross. He is, by all accounts, a supremely brilliant man and his record at his previous charges is very impressive. This fund will mark El-Erian's return to the mutual fund realm. He's never run a mutual fund strategy as wide-ranging as this one's will be, though there's no reason to believe that he's not up to the task. Following are excerpts of the strategy description (the portfolio's duration can range from 0 - 8 years; credit quality between B and AAA; no cap on foreign bond holdings). The prospectus doesn't set forth the fund's fees. Suffice it to say that this is another strong candidate for the 'satellite' or 'alpha' traunch of a fixed-income asset allocation.

The Fund seeks to achieve its investment objective by investing under normal circumstances at least 65% of its total assets in a diversified portfolio of Fixed Income Instruments that are economically tied to at least three countries (one of which may be the United States), which may be represented by forwards or derivatives such as options, futures contracts, or swap agreements.

PIMCO selects the Fund’s foreign country and currency compositions based on an evaluation of various factors, including, but not limited to, relative interest rates, exchange rates, monetary and fiscal policies, and trade and current account balances. The Fund may invest without limitation in securities denominated in foreign currencies and in U.S. dollar-denominated securities of foreign issuers. The Fund may invest, without limitation, in securities and instruments that are economically tied to emerging market countries. In addition, the Fund may invest in both investment-grade securities and high yield securities (“junk bonds”) rated B or higher by Moody’s, or equivalently rated by S&P or Fitch, or, if unrated, determined by PIMCO to be of comparable quality. The average portfolio duration of this Fund varies based on PIMCO’s forecast for interest rates and, under normal market conditions, is not expected to exceed eight years.

The Fund may invest all of its assets in derivative instruments, such as options, futures contracts or swap agreements, or in mortgage- or asset-backed securities. The Fund may, without limitation, seek to obtain market exposure to the securities in which it primarily invests by entering into a series of purchase and sale contracts or by using other investment techniques (such as buy backs or dollar rolls). The “total return” sought by the Fund consists of income earned on the Fund’s investments, plus capital appreciation, if any, which generally arises from decreases in interest rates or improving credit fundamentals for a particular sector or security.

The fund analysts will have the last word on these funds' bona fides once they pick up coverage. But they look very promising to my eyes.