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ETFs We Would Like to See in 2010

Three ideas that would help investors in the new year.

Bradley Kay, 12/31/2009

We had another ETF bonanza this year, as 135 new exchange-traded funds and notes entered the market so far in 2009. As usual, these new investments ran the gamut. Some broke entirely new ground for individual investors, such as iPath S&P 500 VIX Short-Term Futures ETN VXX. Some covered the same asset classes we've seen dozens of times before but tried to do it better and cheaper, such as Schwab's new ETF lineup. Others rounded out the lineup of available ETFs with useful variations on existing products. A number just made us wonder why. (The much-mocked Oklahoma ETF OOK comes to mind). But that is a story for next week, when we review 2009 by the numbers and discuss some of the best, worst, and most interesting ETF developments from the past year. For this last article of the year, we are going to talk about the future.

Morningstar data shows 926 ETFs and ETNs currently trading in the U.S. market, an imposing variety. When fund companies start issuing index funds based on niches like Chinese technology firms, surely we've hit the limit of how global capital markets can be sliced and diced? Yet our team has identified three ideas for new index funds we would like to see in a liquid, ultra-low-cost ETF package. So here they are, our ideas for new ETFs we would like to see in 2010.

International Credit Bonds
One very surprisingly sparse sector in the ETF universe is non-U.S. dollar bonds. Only five U.S. ETFs fall into the world bond category, all of which invest solely in sovereign bonds issued by foreign governments. Two more ETFs invest in sovereign bonds issued by emerging-markets countries. Only seven funds invest in foreign bonds. There are just as many ETFs devoted to tracking the price of gold and its futures.

We would like to see foreign credit bonds available in a low-cost ETF. This exposure would not only provide the diversification of foreign currency exposure and interest rates, but would also allow U.S. ETF investors to tap into overseas credit risk. Credit risk in corporate bonds provides one of the best ways to benefit from macroeconomic growth and stability elsewhere in the world, without taking on all the risk of international equity investments.

Best of all, foreign corporate bonds are becoming a much more liquid and diverse asset class these days. As banks shore up their capital and scale back on lending worldwide, European and Asian firms that previously would have relied on bank loans have instead turned toward newly revitalized bond markets. Trading costs have fallen, the number and variety of issuers have gone up, and the diversification benefits of foreign corporate bonds will surely rise as well. This is probably the single largest asset class still untouched by the U.S. ETF market, and providers such as iShares already carry euro and pound-based corporate bond funds in their European ETF offerings. Here's hoping that some of these funds cross the pond in 2010.PAGEBREAK

International Quality Stocks
The stock market rallies in 2009 were strongest among the most marginal businesses that just managed to hang tough through the worst of last fall and winter. As a result, these mediocre businesses often trade at valuations similar to, or even richer than, quality companies that produce juicy profits year in and year out. These quality companies, whose wide moats and superior operations have traditionally generated greater returns over long periods, look like one of the few bargains left in the global stock market.

In the U.S., ETF investors can tap into these companies using our analyst favorite Vanguard Dividend Appreciation VIG, which holds stocks of companies whose strong earnings and secure balance sheet have supported 10 consecutive years of dividend increases and look primed to keep it up in the future. Unfortunately, no ETF captures a similar variety of high-quality companies outside the United States for such a low cost. PowerShares International Dividend Achievers PID comes closest, with a similar dividend screen for its holdings, but it can only hold ADR shares of foreign companies and has some downright odd portfolio weightings. (Mexican regional airport operator Grupo Aeroportuario del Sureste takes up 4.7% of the assets, while global mega-bank HSBC HBC takes up only 1.3%.)

We would love to skew our portfolio toward quality stocks for the long run, but we don't want to give up our international-equity diversification. Especially not when foreign stocks look cheaper by most valuation metrics. ETF providers, please give us a low-cost way to buy the Nestlés, the Toyotas, and the BHP Billitons of the world in one sensible fund.

Leverage Done Right
This may seem like an odd suggestion from Morningstar, when our own Paul Justice helped lead the charge against ETFs that use daily leverage, but we've said time and again that we do not have any inherent hatred of leverage. We just don't think that the leveraged ETF products are of any use to individual investors. The volatility drag and confounding effects of compounding daily leverage just make these funds too difficult to predict and frequently too poorly performing to hold for the long term, while individual investors would get eaten alive by the trading costs necessary to keep their position sizes in line.

However, we acknowledge the desire that led so many investors into these products. After all, stock markets do tend to rise eventually (though this past decade proves that "eventually" can be a very open-ended term). Those with very long time horizons can afford to take on vastly higher risk in the interest of higher returns. Plus, leverage is fairly expensive for the individual investor. Margin accounts from most brokerages charge high rates of interest, options contracts have high trading commissions and wide bid-ask spreads to overcome, while futures contracts have very high minimums that make them difficult for any but the largest investors to access. Here, ETFs provide a possible solution, as the aggregated assets in the fund provide sufficient scale to tap into leverage at excellent financing rates whether through swap contracts or exchange-traded futures and then make those rates available to any investor who can buy a share.

When we thought about how a leveraged ETF could work for individual investors, we came up with a few big rules. First, it would have to change leverage monthly rather than daily, in order to reduce the negative effects of frequent compounding. Second, its underlying index should have minimal volatility in order to avoid the returns drag from compounding leverage on a wildly swinging portfolio. Third, the degree of leverage should stay fairly low, because the compounding effects and volatility drag increase vastly as you move from 2x to 3x or higher. Finally, the index and ETF should be as transparent as possible, with little counterparty risk.

So here is our idea that meets all three criteria: a moderate-allocation portfolio with 1.5x or 2x leverage compounded monthly, based upon exchange-traded futures listed on a major futures exchange. The moderate-allocation portfolio will keep volatility tamped way down, and conforms with modern portfolio theory's assertion that investors should find the portfolio with the best risk-return trade-off (such as a balanced portfolio of global stocks and bonds) and then lever it up to get higher returns rather than shifting toward riskier assets. The exchange-traded futures will provide greater transparency, as investors will know precisely what their ETF holds and those futures prices are public information given with some delay on the exchange's Web sites. The monthly roll of exchange-traded futures contracts will also align well with our monthly compounding, so that the number of contracts represented by each creation unit of the ETF remains fairly steady through the month. Finally, counterparty risk will be minimized because exchanges use central clearinghouses that have never defaulted on a contract, rather than the over-the-counter swap agreements with investment banks that can fall apart in the case of bankruptcy.

ETF providers: We're not going to pound the table for this last idea quite so hard. Compounding leverage remains a tricky thing no matter how much we try to limit its effects. Still, if individual investors can ever find a leveraged ETF that works, we believe it will look something like this.

Bradley Kay is an ETF analyst at Morningstar and contributor to Morningstar ETFInvestor

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, 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. .

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