Morningstar hosted its second ETF Invest Conference Sept. 22-23 in Chicago.
Wesbury: We're Afflicted With Economic Hypochondria
Brian Wesbury kicked off Morningstar's 2011 ETF Invest conference with an energetic argument that irrational fear is creating an environment of unfounded pessimism around the economy. Macroeconomic indicators such as corporate price/earnings ratios, personal-consumption levels, and projected decreases in government spending, he said, actually paint a picture of an economy on the brink of a major boom.
The First Trust Advisors chief economist and frequent media contributor said conventional wisdom believes the 2008 economic collapse and struggles since were the fault of predatory mortgage lending and the resulting derivative investment vehicles. Conventional wisdom also holds, he said, that the United States' response, including the Troubled-Asset Relief Program, is all that saved the U.S. and global economies from an irreversible catastrophe.
Conventional wisdom is wrong on both counts, Wesbury argued. For decades, policymakers have aggressively pursued creative initiatives to improve Americans' ability to own homes, cultivating a culture of personal debt waiting for an eventual collapse. "Everyone in Washington wanted [all Americans] in a house," he said. "There is no person without sin in Washington."
And as much as government efforts contributed to the collapse, he said, they're impeding recovery. "When government spending is cut, yes, GDP will go down, but consumer spending goes up. The bigger the government is as the share of the economy, the smaller the private sector is."
Wesbury predicted that legislative efforts to reduce government spending are the start of a major downshift in public expenditures. The commercial sector will swell to replace the reduced government role in GDP, simultaneously stimulating job and income growth.
"The size of government has a massive impact on the dynamism of an economy. . The bigger the government is, the less dynamic the private sector is," he said, "... robbing the economy of its ability to increase productivity."
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ETFs' Rise Pressures Industry to Improve Education
While exchange-traded funds have exploded in visibility and popularity in recent years, the education necessary to use them effectively and the understanding of how they operate are lagging, according to a panel of industry leaders. Van Eck's Adam Phillips, State Street Global Advisors' Anthony Rochte, BlackRock's Sue Thompson, and Vanguard's Rick Genoni kicked off the second day of Morningstar's 2011 ETF Invest conference by taking turns responding to concerns about the industry and sharing their ideas about the best ways to evolve the vehicle.
"[ETF trading activity] is so advisor-dependent," rather than merely targeted to institutions, Thompson said, that BlackRock has bulked up its educational capabilities to keep up--especially when it comes to options and fixed income. "Advisors want to understand how fixed-income ETFs trade and how they work," she said. "I would've thought we'd be finished with that by now, but there's still a lot of work to be done there."
Rochte said a complicating factor when it comes to education is the variety of clients ETFs cater to in contrast to mutual funds. "In the ETF world, we have hedge funds, pensions, foundations, endowments, and now individual investors are getting to know ETFs," he said. "In the institutional world, we're seeing demand for expertise in trading."
Phillips said a growing percentage of his clients know very well how ETFs can be effectively deployed as part of an overall investment strategy. Clients knowing what they want, however, isn't the same thing as knowing how to make it happen. Tactical issues can become a problem.
"It's a growing market so there are always new clients using these products," said Phillips. "The clients who have been using ETFs for a longer period of time are more savvy . and now they need even more help with trading."
ETF Expert Debunks Five ETF Myths
David Abner is known in the exchange-traded fund industry for a dense tome on ETF mechanics and valuation, so he's well-situated to comment on five big "ETF myths." He works as WisdomTree's head of institutional sales, so he's not a disinterested source. But he's clearly an expert on his subject with a long career in ETF trading and arbitrage. He makes a spirited defense of ETFs.
The five big myths:
1) "There are too many ETF products."
Abner's response here is wanting, as is the question in the first place. It's a straw man; what is the "right" number of ETFs? We don't know exactly, but, under our capitalist system, it's the number set by supply and demand. Bad ETF ideas tend to die out--maybe not in a final sense but instead consigned to irrelevance with miniscule assets. In fact, the bulk of ETF assets are in a handful of low-cost, ultraliquid passive vehicles. We can re-interpret the "myth" to be: "There are more ETFs than there are assets there to support them." This may be true. Abner points to rapid growth in the number of ETFs versus ETF aggregate assets; this doesn't debunk the myth, as a handful of big ETFs can (and do) drive growth in ETF assets.
2) "No liquidity in many ETFs."
Abner is at his best describing ETF liquidity. It's not as simple as looking at the ETF's volume; a better approximation is the liquidity of its underlying holdings. Even this isn't the whole picture, as market-makers and traders can use correlating assets such as options, other ETFs, and customized stock baskets to off-set an exposure to an ETF. The real principle is how liquid and cheap and good are all hedging options out there for an ETF? Sadly, this discussion will remain theoretical, as this information is kept locked up in traders' proprietary systems.
3) "ETFs caused the flash crash."
The SEC and the FCC released a report pinning the blame on a mutual fund company, Waddell & Reed, and an ill-advised dumping of S&P 500 e-minis futures.
4) "ETFs can collapse from too much short-selling."
Abner stresses that only a handful of ETFs have more short-interest than assets--16 out of more than 1,300 by his count. So, even if true, the possibility of collapse wouldn't affect most investors. He argues that the creation/redemption mechanism allows supply of ETF shares to expand elastically to cover all the short interest. The argument wasn't the most fleshed out, as the collapse scenario occurs when there is naked short-selling. Abner didn't satisfactorily address that issue.
5) "Settlement fails are a cause for concern."
ETFs disproportionately account for settlement fails, which occur when actual securities are not delivered to counterparties within the stated period, usually three days after the trade date (T+3). Abner lists three reasons why this isn't cause for concern. One, authorized participants, the institutions that can actually create and redeem shares with ETF sponsors, operate under T+5, leading to natural mismatches. There's some stock loan latency; the loan market dries up at 3 p.m. EST, whereas much high-frequency ETF trading occurs at the end of day, leading to delays. Finally, sometimes there are creation/redemption delays with ETF sponsors that push back delivery a day.
Morningstar Bullish On Big Pharma, Most Health-Care ETFs
With 160 equity analysts covering more than 2,000 stocks, Morningstar is in a unique position to offer fundamental, stock-level research to help investors select exchange-traded funds. This complements our ETF research, which is more focused on explaining how to use ETFs in a diversified portfolio and providing analysis on the structure, costs, and risks of exchange-traded products.
Thursday at our ETF Invest conference, we invited Alex Morozov, director of global health-care research and Damien Conover, associate director of pharmaceuticals analysis from our Morningstar equity-research team to discuss their outlook for the health-care sector.
The health-care team is currently bullish on big pharma, which generally accounts for about 45% of popular health-care ETFs such as Health Care Select Sector SPDR XLV and Vanguard Health Care ETF VHT. The group also has 5-star ratings for large caps such as Abbott Laboratories ABT, Pfizer PFE, and Novartis NVS. While expiring patents have been a major weight on big pharma's valuations, Conover expects cost cutting and new drug launches to offset some of the losses from expiring patents on high-margin drugs. New drugs are also likelier to be in more-niche areas, which should result in better reimbursements. He also sees emerging markets as an attractive growth area for the group. As for valuations, pharmaceutical companies are trading at a price/earnings ratios of around 10 times, versus a mid-teen multiple in the past decade. While Conover does not expect valuations to return to those levels, he does expect to see some multiple expansion to around 12.5 times.
Medical devices, another significant subsector holding in health-care ETFs, are trading at attractive valuations, with several high-quality companies--including Medtronic MDT, Stryker SYK, Zimmer Holdings ZMH, and St. Jude's Medical STJ--trading at sizable discounts to our fair value estimates. However, a headwind in the near term is a weak economy, as medical-device companies have more exposure to elective procedures. In addition, the team thinks the health-care-reform bill will be slightly negative to the subsector, due to higher costs, with minimal volume upside.
In the biotech space, mergers and acquisitions continues to be the major theme. According to Morozov, firms in niche therapeutic areas represent attractive takeout targets. He also notes that after a huge sell-off in August, small-cap biotechs, on average, are trading at a discount to larger peers. To play the M&A theme, he recommends an equal-weight ETF such as First Trust NYSE Arca Biotech FBT. The benefit of an equal-weight ETF is that it provides better exposure to small caps (companies likelier to take out candidates) relative to a market-cap weighted ETF. There is also another equal-weight biotech ETF--SPDR S&P Biotech XBI--but we prefer FBT given its higher exposure to 4- and 5-star stocks (which account for 45% of FBT's portfolio, and 23% of XBI's). However, small-cap biotech firms are certainly a more volatile segment of the health-care industry.
Finally, while valuations for the sector are attractive, the team cautions that health-care spending remains challenging in the near term, with weak patient demand, due to high unemployment and the expiration of Cobra subsidies, along with ongoing regulatory uncertainty.
-- Patricia Oey
Inflation, Inflation Everywhere, So Let's All Find a
The three panelists on the new-wave alterative panel all shared their views on how and why investors are crossing into the alternatives frontier. With little agreement among them on what constitutes an alternative asset, Joanne Hill of PowerShares Advisors explained that the definition has changed over time. The current push to alternative investments is partially attributable to strategies heavily employed by endowments for more than a decade. Investors who fear outliving their assets see optimism in the newest lineup of ETFs that offer tools once exclusively reserved for large intuitional players.
A new breed of ETFs attempts to change the playing field by hedging "real" world inflation, explains Adam Patti of Index IQ. Investors can buy the CPI (an ETF) to provide investors a real world hedging tool. Tim Edwards of Barclays Capital noted that CPI (the index, not the ETF) doesn't rise fast enough and hasn't accurately tracked typical household expenses such as housing or college. When hedging, Patti believes a common mistake investors make is buying TIPS, or indexed CPI Treasury bonds, as a lattered portfolio is an inadequate hedge. He believes the correct way to hedge is to use a multiasset approach, which encompasses certain types of equities, commodities, and other alternative assets.
As more investors move into the alternatives space, products such as hedge-fund-replication and yield-curve-flatting ETFs will garner more attention. Patti stated that the dirty secret of hedge funds is that they don't trade very often. Hill looked at past SEC fillings and found that the average holding period for hedge funds is 18 months. Armed with past hedge fund data and multifactor models, firms constructed hedge-fund-replication ETFs that mimic the asset class; many have a profile similar to the HFRI. Yield-curve plays are also gaining in popularity, and Barclays now offers two ETFs that allow investors to play the flattening and steeping of the yield curve: FLAT and STPP.
The bull market in bonds for the past 30 is reason for Edwards to believe that past returns in the bond market are not repeatable. Alternative investment products now allow investors to capture yield, but without the interest-rate risk. Volatility is also a concern for many investors, and Edwards notes that investors are turning to the VXE for a longer-term volatility hedge.
What Will Happen With Greece?
"At the current spread, Greece has already defaulted," noted PIMCO fund manager Vineer Bhansali, a panalist Thursday at Morningstar's ETF Invest conference in Chicago. Prior to the euro, added Kenneth Volpert of Vangaurd, Greece could have devalued its currency, but that's no longer possible. The lack of banking centralization in the European banking system means there is no one to bail out these countries. Weak governments can't support their weak banks. Moreover, many European banks are very interdependent, similar to American banks in 2008.
The key, said BlackRock's Stephen Laipply, is for the European central bank to facilitate solutions. "It would be fairly messy if Greece withdrew from the European Union," he said. But, as Bhansali noted, markets have lost confidence that there is a solution. Even though U.S. banks do not hold a substantial amount of European debt, defaults can result from lack of confidence.
When asked about the biggest risk factors faced by fixed-income investors, Bhansali, who specializes in hedging tail risk, said default risk and loss of capital was most prevalent in the short term. The long term, however, faces a different risk. If investors believe that an expansion of the monetary base will work in stimulating the economy, then inflation is a concern for time horizons longer than one year.
Treasury Inflation-Protected Securities could be one potential vehicle for hedging against inflation, but as Volpert pointed out TIPS have been underperformers in the past few years. If the economy recovers, high-yield and corporate bonds would provide higher levels of real income. Bhansali concurred, noting that a successful hedging strategy depends on how inflation affects the economy.
The conversation then turned to emerging markets as a way to gain diversified currency exposure. The panel noted that, when considering emerging-markets bonds, investors can gain exposure to either local-currency bonds or bonds denominated in U.S. dollars. When investing in the former, investors must consider currency risk, as well as the country's credit risk. In the short term, Bhansali added, U.S.-denominated debt is much stabler. However, if the United States is forced to devalue its currency in the long term, local-currency bonds might be a better option.
Amid Chatter About Investments and Markets, a Few Moments for
In a break from the technical aspects of exchange-traded fund investing at Morningstar's ETF Invest conference this week in Chicago, author and Wall Street Journal columnist Jeffrey Zaslow entertained attendees with a funny, moving, and inspirational talk about living your best life. The mood was lighthearted yet somber, reminding us that life is short. We should not take it too seriously and should make time for the ones we love.
Zaslow has co-authored many books including the recently released Highest Duty, about the life of airline pilot Sully Sullenberger, who famously landed an airplane in the middle of the Hudson River, saving the lives of everyone on board. Sullenberger has said that he flew thousands of planes in his life, but that he will be remembered and judged for that single flight. While we cannot know when our "singular moment" will present itself, we can be prepared. Sullenberger studied flight-accident reports avidly and was prepared to react. In doing so, he saved hundreds of lives.
Zaslow's best-selling book The Last Lecture was released in April 2008. The book was co-written with Randy Pausch who, in the fall of 2007, gave a lecture to students and colleagues at Carnegie Mellon titled "Really Achieving Your Childhood Dreams." At the time of the lecture, Pausch had been diagnosed with terminal pancreatic cancer and died shortly after the book was published. The lecture was videotaped for Pausch's children and made its way to the Internet and has since been viewed millions of times. Following the explosion of the lecture, Paucsh found himself sitting on a couch next to Oprah, playing football with a professional NFL team, and appearing numerous times on Good Morning America with Diane Sawyer.
Despite his terminal disease and newfound fame, Pausch spent much of his time with his wife and kids, making memories that would last a lifetime. It's an often-heard but seldom-learned lesson: Life is not about money and things; it's about people and experiences. This is especially important to remember as the economy and the stock market take us on a seemingly never-ending rollercoaster ride--up big one day and down big the next. It's easy to get swept up in the doom-and-gloom-the-world-is-ending talk that dominates the airwaves. This political and market volatility will likely continue, and as it does, it becomes even more important to look past these hysterical market swings towards long-term investment goals that can help us create a more meaningful life.
Zaslow closed with a video from Good Morning America in which Pausch states that his family is about to be pushed off a cliff and he will not be there to catch them. But, he can spend what time he has left building a net to cushion the fall. Life takes many twists and turns, over most of which we have no control. But we can control the manner in which we live our life as well as our level of preparedness and reactions to life's unexpected events.
-- Cara Esser
Commodities: They Are a-Changin'
There's no denying that commodities markets have rapidly evolved in the past few years. Emphasizing that point, Timothy Andriesen of the CME Group kicked-off a panel Thursday afternoon at Morningstar's ETF Invest conference with a playful word of "thanks" to Geert Rouwenhorst of SummerHaven for transforming his gold-trading strategy into a "mainstream asset class."
Less than a decade ago investors seeking commodities data or research typically found themselves out of luck. In 2004 Rouwenhorst set out to change this. In doing so, he found that commodities have some surprising benefits:
1) Attractive returns: Commodity returns over the past 50 years have been roughly the same as the S&P 500 (with dividends reinvested).
2) Diversification: Correlations between commodities and traditional assets have been very low, usually close to zero, and occasionally negative.
3) Inflation hedging: Although not a perfect hedge, commodities have been more highly correlated to inflation than stocks and bonds.
Since then, we've witnessed a financialization of commodities and seen correlations between equities and commodities spike to levels unseen during the past 50 years. While correlations typically rise during recessionary times, reasons for this extended and unusually high spike remain in part unclear, even to the panelists. Although history suggests correlation levels will eventually normalize, these recent trends still throw a wrench at diversification arguments.
To ease these concerns, the panelists paralleled this evolution in the commodities market to the recent transformation of emerging markets. Attracted by promises of portfolio diversification, investors poured money into emerging-markets equities only to find correlations higher than expected in the current decade. Yet even with correlations between developed- and emerging-markets equities approaching 0.8 today, investors haven't been deterred. There are still diversification benefits to be had, and Rouwenhorst believes it's the same story with commodities.
Conversation then turned to the often-daunting question of portfolio implementation and allocation. Andriesen noted that while a broad commodity index exchange-traded fund effectively enhances diversification, investors might require a more active, single-commodity strategy to juice returns. In terms of allocation, Rouwenhorst hesitated to cite a specific allotment, noting only that for most investors the optimal amount is "certainly greater than zero." But despite the proliferation of commodity-focused ETFs over the past few years, it appears not all investors have caught on just yet. Many remain entirely unexposed to this new asset class. Considering the slew of still-relevant benefits that Rouwenhorst and Andriesen laid out, there's certainly room for improvement on that front.
Five Steps to Incorporate ETFs in Strategic Asset-Allocation
One of the key drivers of portfolio returns is asset allocation. Jared Watts, senior consultant from Morningstar's Ibbotson Associates, discussed the approach to construct a portfolio using exchange-traded funds from an institutional perspective.
Step 1: Develop Asset-Class Inputs
One question often asked by financial advisors is how many asset classes should be put into a portfolio to achieve diversification. Modern portfolio theory demonstrates that the efficient frontier is pushed higher every time a new asset class is introduced into the portfolio. However, in the real world, it is not necessarily true that the more the better. Ibbotson research finds that 15 asset classes in a portfolio are enough to achieve a robust diversification effect. Once the number of asset classes reaches 20, the diversification benefits become very marginal due to the trading costs incurred.
Step 2: Create Asset-Class Models
Using the inputs from Step 1, Ibbotson creates asset-class models that aim to maximize returns for a given level of risk. Extreme market events are actually 10 times likelier to happen than a normal distribution model would predict, a result of the skewness and kurtosis. Ibbotson employs sensitivity analysis and mean-conditional value-at-risk optimization approaches to correct the fat-tail-model bias.
Step 3: Analyze the ETF Universe
ETFs do produce alpha, which is characterized by the tracking error, although in the long run the alpha is expected to be negative due to the fees the ETFs charge. The traditional way of capturing the tracking error is to compare the net asset value and the construction index. Morningstar introduces data points such as tracking volatility and estimated holding costs. In addition, Ibbotson uses ETF market returns versus blended benchmark returns to better reflect the value added by the ETF manager.
Cost is certainly an essential consideration. The total costs can be divided into front-end expenses and ongoing expenses. The sum of the commission, bid-ask spread, premium/discount, and market impact are categorized as the front-end cost. The expense ratio and taxes are parts of the ongoing costs. An ETF's total liquidity is determined by both the secondary-market liquidity, which is the liquidity from the trading of the ETF and the underlying security liquidity, which is linked to the securities that make up the basket.
Step 4: Portfolio Construction
The previous steps ensure the investment vehicles are the optimal representations of the target asset classes. With the optimized inputs, Ibbotson considers market exposures, alpha-tracking error and alpha correlations between different ETF managers to create a fund portfolio with the aim of maximizing the alpha per unit of tracking error.
Step 5: Monitor and Review
How often should the strategic asset allocation model be reviewed and updated? Ibbotson research shows that the optimized frequency is annually. Advisors should also consider the changing conditions of clients, new investment products available and performance attributions of existing ETFs in their monitor-and-review process.
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Arnott and the '3D Hurricane'
From the title of Rob Arnott's talk, "RAFI Strategies: Five Years Later," I was expecting an overly long (and frankly premature) victory lap for fundamental indexing. There was some of that, but the meat of the talk was on the "3D hurricane"--deficits, debts, and demographics. He laid out a powerful case that the United States and other rich-world nations are in deep trouble. Certainly the black to Brian Wesbury's white.
On deficits, Arnott said U.S. government deficits have been understated for decades: Under GAAP accounting, the kind applied to corporations, the U.S. has been running yearly deficits of 10% of GDP over the past several decades. He likened the U.S. government's accounting to Enron's. Zing.
On debts, the picture gets scary. Almost every developed nation has run up massive debts. Emerging markets are creditors. In the U.S., Social Security, Medicare, and Medicaid liabilities bring up government liabilities to over 500% of GDP, a point made by Laurence Kotlikoff and Scott Burns in 2004. Of course, long-run projections are imprecise, and small changes in assumptions can result in huge changes in the results spit out by net present value equations. Arnott does acknowledge that Social Security, Medicare, and Medicaid aren't real debts in that they can be cut without defaulting. In fact, he thinks they will be dramatically pared down in the coming decade, and major political battles will revolve around it. One reason why liabilities are so high is because lots of Americans are going to hit retirement age soon--an issue of demographics, the final leg of his doomsday trinity.
Arnott argues age distribution strongly affects GDP growth, drawing upon a paper he published with Denis Chaves. The rich world is losing its most productive workers as baby boomers retire. The sweet spot for GDP growth is when the share of 20- to 40-year-olds increases, as they go from GDP consumers to increasingly productive workers. Brazil and India are hitting their sweet spots; China is going to run into a demographic wave of elderly because of the one-child policy, but it's a ways off and not as bad as the United States.
Politicians take a lot of heat from Arnott. They probably won't rise up to the challenge of tackling these problems head-on. We'll probably default by hook or crook, via inflation and straight-up abrogation. He pegs the risk of double-digit inflation over the next 10 years at 50%. Implicit in his argument is that he thinks the endgame won't play out as long as it has for Japan. His record on inflation forecasting isn't great; he was calling for inflation protection three years ago, while the break-even rate has fallen. I think this is the biggest bone of contention between Arnott and me.
His recommendations for this aging, debt-ridden world? Get inflation protection. Expect asset prices to come under pressure as retirees begin selling them en masse to a relatively small pool of buyers. Look for opportunities in emerging markets. These are all reasonable, but very long-run projections.
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Factors That Affect Bond ETF Pricing
The final session of the Morningstar 2011 ETFInvest conference was titled, "Fixed-Income ETF Premium and Discount Myths Exposed." The panel focused on explaining the unique mechanics of fixed-income ETF trading.
Investors in fixed-income ETFs have noticed the premiums and discounts away from net asset value are a common occurrence. One of the main reasons for this is that the underlying bond market is illiquid. Bonds trade on the over-the-counter, or OTC, market where most trades still happen through phone calls. Many bonds trade infrequently, and when they do trade, they are priced with wide bid-ask spreads. Since the underlying bonds trade with wide spreads, the ETFs that track fixed income trade within the range of the underlying portfolio's bid-ask spread. In some sectors this spread can be as wide as 0.8%. The main reason fixed-income ETFs have premiums and discounts is because the bond market is inefficient and illiquid.
The panel also discussed that, in volatile markets, a bond ETF's market price will react more quickly to new information then the ETF's net asset value. Bond ETFs use "matrix pricing," which estimates the value of bonds in an index that haven't traded in a particular day. This pricing is applied to the net asset value on a daily basis. During calm markets the methodology works well, but during volatile periods the estimation process is not as efficient. During these fast-moving markets, the ETF's market price is the best estimate of the portfolio's "true" value. Since real-time price discovery is happening in the market price, it may look like the ETF is trading with very high premiums or discounts. In actuality, the net asset value is just slow to react to the new information in the market.
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What should the price of gold be? "Higher," Goolgasian
During the first sleeve of breakout sessions, Morningstar ETF Invest 2011 conference attendees were treated to a rather bullish view of gold. State Street Global Advisor's Chris Goolgasian opened with an intuitive run-through of the problems that underpinned today's most popular gold-pricing metrics. Weather it be the inflation-adjusted peak gold price, the Dow-to-gold ratio, the gold-to-oil ratio, or the gold-reserve/monetary-base ratio, the metrics are all backward-looking. Goolgasian noted that while all aforementioned pricing metrics offer interesting insights, they don't offer causal evidence for a solid price target.
The argument really is quite intuitive. While much of the sell-side research pushing gold uses the peak values for these metrics to infer a current price target, at best they only provide a reference for how far today's prices might run. In contrast, Goolgasian uses what he calls "observables," not to set gold-price estimates, but rather to provide an indication of directional movement. The observables that Goolgasian exhibited to attendees offered qualitative assessments of current market sentiment and pressures. While he never picks price targets, when asked where gold should be, his answer is merely, "Higher."
The discussion moved to the topic of bubbles. Are we in one with respect to gold? Goolgasian seems to think not. He noteed that bubbles pop when supply adjusts to satisfy demand. In the case of gold, supply will have a hard time. Gold miners have been hard at work ramping up production, but it is a long and drudging process. Goolgasian posited to the audience that gold production is not as easy as it once was. He shed light on the fact that oil discovery and production has become a difficult process, as we drill to new and strikingly deeper depths with each passing year, but that we've been digging for gold for far longer.
In addition to the fact that supply is constrained, Goolgasian notes that sentiment is still negative. The plethora of varying outlooks for the metal indicates that not everyone is on the bandwagon. Goolgasian said that when the gold market is in a bubble and ready to pop, the media will not be spouting negative outlooks on the price of the metal. According to Goolgasian, "Bubbles occur [and pop] when everyone is on the bandwagon."
Near the end of the discussion he added that the U.S. fiscal and monetary action have only worked to kick the can of economic troubles further down the road. Recent political developments have been and should continue to be good for the gold price, which, again, as Goolgasian puts it, should be "higher."
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Two Income-Generating Ideas
Thursday's "Income Focus: Where's the Yield?" breakout session considered the issue of how to generate yield in your portfolio using equity strategies.
Kenny Feng, president and CEO of Alerian Capital Management, discussed the use of master limited partnerships, or MLPs, to boost yield. Purchasing MLPs individually can lead to tax headaches, as investors should file taxes in every state in which the MLP operates. Gaining access to MLPs through a package, such as an ETF, not only removes the tax-filing headache (because investors get a regular 1099 form), it also gives investors professional management and diversification. MLPs make their money primarily by charging tariffs on the volume of product flowing through their pipelines. These tariffs increase every year at the rate of the producer price index plus 2.65 percentage points. In other words, the tariffs are cost-indexed, giving investors a built-in inflation hedge. Kenny went on to compare MLPs with REITs (both have hard asset value, but MLPs have the further advantage of inelasticity of energy demand) and with utilities (both have inelastic demand but MLPs enjoy a much more constructive regulatory environment). Growth in the industry is coming from building pipelines to new areas of energy development (the Marcellus Shale, for instance) and from replacing old infrastructure. Thus, MLPs offer investors both an inflation hedge and growth prospects. They also offer low correlation to bonds, broad equity indexes, utility stocks, and energy. As for allocation, Kenny believes that if investors follow the S&P 500 Index allocation of 2% in utilities, they should have a similar allocation to MLPs.
The yield on most MLPs is in the range of 5% to 7%. ALPS Alerian MLP ETF AMLP currently has a 12-month yield of 6.36%, while exchange-traded note JPMorgan Alerian MLP Index AMJ has a 5.26% yield.
Feng's portion of the discussion was to detail tactics for using an asset sector to bolster yield. Rudi Aguilera of Ironclad Managed Risk IRONX discussed ways to use a strategy to bolster income.
Aguilera's strategy is to sell covered puts on equity indexes and ETFs. He made the point that the high-volume of shares traded in the largest ETFs corresponds to high liquidity in those ETFs' options. The benefits of investing in a risky asset, such as equities, is their potential returns. But to realize those returns investors need to ride out the volatility (the risk) that comes with such a strategy. Selling covered puts is one way to do this. By selling puts, investors get the premiums from the sales, which can help augment a portfolio's income generation. This income offsets the volatility. If the underlying asset on the put declines, there is a risk that he will have to sell his underlying holdings at a loss, but, again, the income gained from the sale of the put can offset this. This strategy isn't for everybody, and it is fairly sophisticated. Rudi pointed the audience to the CBOE's website, which has research papers showing the benefits of incorporating this strategy into portfolios.
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Active vs. Passive Investing: So Happy Together
Scott Burns--director of exchange-traded funds, closed-end funds, and alternatives research at Morningstar--playfully reminded conference attendees yesterday morning that "investing is hard." That reality certainly hits home--despite our best efforts to select winning investments, research shows that few active managers consistently beat their benchmark. Passive investors are quick to jump on that point, highlighting a wealth of compelling data supporting index-based strategies.
Even so, Hal Ratner, senior research consultant and portfolio manager at Morningstar Investment Management, advised attendees not to count out active management. Like many other advocates of active investing, he recommended reserving active managers for those strategy sleeves in which investors lack sufficient expertise (for example, managed futures, distressed debt, or high yield). The opportunity to generate alpha through active management in these areas undoubtedly remains much higher. He continued on to recommend passive investments for more efficient asset classes, such as U.S. large-cap or investment-grade debt, where active managers will struggle to add value and overcome expenses.
Also compelling was Ratner's main argument that combining the two approaches in a portfolio enhances a fund of fund manager's ability to manage risk. Active managers are often difficult to manage a risk budget, particularly because it may take them weeks to unwind positions in times of rising market volatility. Furthermore, moving money like this to satisfy a risk budget can lead active managers to hold high cash positions or invest inconsistently with their style or mandate, definitely not what you're paying those high fees for. To combat these challenges, Ratner recommends investing in a core of active managers and using ETFs or futures to adjust beta exposure.
When constructing the portfolio, the first step is to define the "normal portfolio," or the portfolio that a money manager would ordinarily select had he no view on the market. After that, the fund of fund manager should establish beta and volatility targets and select the appropriate investment media for adjusting beta exposure when necessary (likely futures, ETFs, or swaps). Rather than moving in and out of active managers, the fund of fund can instead employ a "tradable beta" approach and manage the portfolio's risk exposure through buying and selling these derivative instruments. These instruments should be sufficiently liquid and cost-effective for the approach to work.
The discussion of active versus passive investing has been one of the most topical themes at the Morningstar 2011 ETF Invest conference and will likely remain hotly debated as the fund industry continues to evolve. While there's plenty of staunch advocates on both sides, Ratner's more moderate view of combining both approaches in a dynamic asset allocation resonated well with attendees.
Three Out of Three Analysts Agree: We All Need More
You know the saying that begins, "When you assume ..."?
The need for investors to replace assumptions with education was a theme permeating Morningstar's ETF Invest conference this week. Don Phillips, Morningstar's president of fund research, pointed out the bashing the exchange-traded funds have taken as a result of the recent UBS and Goldman Sachs scandals, events that were repeatedly referenced during the conference as attendees looked to panelists for insight beyond the press headlines that seemed bent on blaming ETFs.
During Friday's ETF analyst roundtable Paul Justice, Morningstar's director of North American ETF research, advised the audience to not assume to know the structure and composition of an ETF just from its name. According to Charles Schwab's Michael Iachini, the need for education inside this label, rather than just regulation, should be the primary focus of the ETF marketplace to ensure the best positive investor experience.
The takeaway is that education never ends. Demand persists for two tracks of education to address a dichotomy in ETF investing. Newcomers to ETFs (a term some are using too broadly, glossing over material differences among some products, according to panelist Dodd Kittsley from iShares) need the basic education of the mechanics beyond "It's like mutual fund that trades like a stock." At the same time, those further along the learning curve, the longtime, model-building power-users are looking ahead to the impact of increased granularity (moderator Chuck Jaffe's buzz-word for the conference) in the space and would benefit from a higher-level of analysis.
Justice observed that the ETF market's growth can sometime blind users like blinking lights in a casino. Product offerings come in all colors and sizes these days, and the growing popularity can be a temptation to or push many to be invested in the "it" part of the market.
But that shouldn't be the case. Take a step back, take a deep breath, and remember what the purpose is in making any investment decision. That clarity will ensure that decisions are made for the right reasons.
Dim Sum and Then Some
Friday's emerging-markets outlook panel at the 2011 Morningstar ETF Invest Conference covered quite a bit of ground. Rick Harper of WisdomTree opined on emerging-markets debt, including the new "dim sum" bonds--debt denominated in Chinese Yuan issued outside of mainland China, and therefore accessible to foreign investors. Two ETFs investing in this fledging, highly illiquid asset class have recently launched, and more are in registration. Harper is bullish on the prospects of these new securities, as well as emerging-markets debt in general, even though it has been hit hard in recent weeks. The JP Morgan EMBI Global Index is down 3.2% for the month to date through Sept. 22, versus the BarCap U.S. Aggregate Bond Index, which has risen 1.6%.
Emerging-markets equities have performed even worse, but "we've seen this movie before," said Angus Shillington of Van Eck. Shillington believes that even though emerging markets are experiencing short-term pain (the MSCI Emerging Markets GR Index has experienced a 15.2% month-to-date drop, double that of the S&P 500), the long-term prospects for emerging-markets stocks remain quite positive, especially relative to developed markets. Shillington discussed his favorite bottom-up plays, which include consumer-finance companies in India, retailers in Russia, and auto manufacturers in China and Indonesia. Shillington says that he prefers mid-capitalization stocks, because larger caps are plagued by somewhat unrelated global macroeconomic issues. In terms of risks, Shillington advises investors against the highest-growth, highest-price stocks, which tend to be the "first-movers" in a particular industry. When competition heats up, these companies cannot sustain the high-growth levels of their early years, which may be linearly priced into the stock.
Roger Aliaga-Diaz, Ph.D., economist for Vanguard, raises more red flags. He believes the "tail-risk" in emerging markets is slower or declining export growth, as forecasts have been revised down recently. Furthermore, the fuel for the big 2000-07 emerging-markets boom, namely U.S. and E.U. consumption, has dried up. Both Harper and Shillington believe that internal consumption will drive emerging markets going forward, however, and that stronger Asian currencies relative to the U.S. dollar support this phenomenon. Still, Aliaga-Diaz believes that investors must be aware of what is already priced into emerging-markets securities, which is a high-bar growth rate, making it difficult for this asset class as a whole to outperform. Because emerging markets are a much larger part of the global economy than they once were, though, Aliaga-Diaz recommends a sizeable allocation, simply for diversification purposes.
-- Nadia Papagiannis,