AROUND THE WORLD OF ETFS

May 01, 2007

First Active ETF

The era of actively managed ETFs is set to begin. Bear Stearns became the first company to file a full prospectus for an actively managed ETF, submitting papers to the SEC on March 19 for a money-market-like fund called the "Bear Stearns Current Yield Fund." If approved, the fund will use active strategies in an attempt to deliver yields above and beyond the average money market account.

It will trade on the AMEX under the ticker symbol "YYY," and charge 28 basis points in expenses. While a number of fund companies have made plans for actively managed equity ETFs—Firsthand Funds, Managed ETFs, etc.—none have gone so far as to file a prospectus. Those companies have instead petitioned the SEC for "exemptive relief," asking the agency to waive or alter existing rules in such a way as to allow their actively managed ETF to list. Bear Stearns was able to sidestep that process because, as a money-market-like fund, YYY avoids most of the issues involved in creating an active ETF.

For one, many active fund managers are loath to unveil their full portfolio, for fear of front-running. That's not an issue in the short-term market, so Bear Stearns will simply open up the portfolio. A related issue is one of creation and redemptions. ETF shares are created when large investors buy the underlying securities and turn them into the fund for an equal value of ETF shares.

To do that, you have to know what's in the underlying securities. The Bear Stearns fund sidesteps this issue by allowing creations and redemptions in cash.

Low-Cost Bonds On Tap

Vanguard turned the heat up in the fixed-income space earlier this year by filing to launch ETFs tied to four of its bond funds: the Total Bond Market and the 1-5, 5-10 and Long Government/Credit index funds. The ETFs will charge just 11 basis points, compared with 15 basis points for the competing funds from Barclays Global Investors.

Vanguard International (With Canada)

Vanguard also put the pressure on iShares in the equity space, with the recent launch of the new FTSE All-World Ex-U.S. Index Fund. The fund is available in Institutional, Investor and ETF (AMEX: VEU) shares, and holds nearly 2,000 international equities from countries outside the United States, including both developed and developing markets.

The fund is unique among international ETFs for including exposure to Canada. The most popular international ETFs, such as the iShares MSCI EAFE ETF (AMEX: EFA), exclude Canada; the most-followed MSCI indexes consider Canada part of "North America." VEU's broader exposure could make the portfolio attractive to classic index investors. Another thing that could make the fund attractive is its expense ratio.

The ETF charges just 25 basis points. To achieve the same exposure with iShares, you would have to buy two ETFs: the iShares MSCI EAFE ETF (NYSE: EFA), with an expense ratio of 35 basis points, and the MSCI Emerging Markets ETF (NYSE: EEM), with an expense ratio of 75 basis points.

Pricey Mortgages

BGI continued the expansion of its fixed-income ETF lineup in March by launching the new iShares Lehman MBS Fixed Rate Bond ETF (AMEX: MBB) onto the American Stock Exchange (AMEX).

The launch came amid rising concern about delinquencies in the subprime loan market. The new ETF, however, only invests in mortgages from the three government-sponsored and/or chartered mortgage giants: Fannie Mae, Freddie Mac and Ginnie Mae.

Broadly speaking, these mortgages carry little risk. MBB charges 25 basis points in expenses, the highest for any bond ETF currently on the market.

Natural Gas Is Hot Hot Hot

The "other energy" is hot. Both BGI and Victoria Bay Asset Management (the group behind the $900 million United States Oil Fund [AMEX: USO]) have filed papers with the SEC for ETFs tied to the price of natural gas. Both funds would track the price of a rolling futures position, plus Treasury interest income.

The BGI fund would be tied to CERFs, which are custom-made, long-term derivatives that trade on the CME; the fund would charge 89 basis points. The United States Natural Gas Fund will buy natural gas futures from the New York Mercantile Exchange (NYMEX); exact fees have not been made clear, but they likely will be in line with BGI.

Taking a different approach, First Trust Advisors and the International Securities Exchange (ISE) have filed papers for an equity-based natural gas ETF. The First Trust ISE-Revere Natural Gas Index Fund (AMEX: FNG) will track an equal-weighted index of 30 companies that derive the bulk of their revenues from the natural gas business.

The index is quantitatively screened to select companies with good value characteristics and the potential to outperform the market.

Another Branch For WisdomTree

WisdomTree has branched out … into earnings.

Figure1

The company, famous for its dividend-weighted ETFs, has launched a second product family that weights stocks by earnings. WisdomTree president Bruce Lavine says that among all the potential fundamental factors, dividends provide the best risk-adjusted return, while earnings offer the best absolute return.

Figure2

The funds use S&P's measure of "core earnings," rather than reported earnings, to smooth the huge ebbs and flows that result from non-cash charges. The new earnings funds come with commendably low fees (see below). As WisdomTree builds out its earnings lineup, it will face a serious challenge in how to educate advisors and investors about the value of each product family.

Bet The Dollar

PowerShares added a pair of new tools to the arsenal of currency traders this spring by launching new funds tied to the value of the U.S. Dollar Index.

The PowerShares DB US Dollar Bullish Fund (AMEX: UUP) offers upside exposure to the index, while the PowerShares DB US Dollar Bearish Fund (AMEX: UDN) offers downside exposure. The popular U.S. Dollar Index (USDX) compares the value of the greenback against a group of foreign currencies.

The funds track the index using futures. Collateral cash is invested in U.S. Treasuries, allowing the funds to earn about 5 percent interest based on current rates.

Taxes Hit ProShares

The ProShares leveraged ETFs have been a huge success, but they have come with a price for tax-exposed shareholders: huge distributions. The chart above shows the 2006 tax payout for the four original long ProShares. A $5 gain on an $80 fund is quite something, especially in a market like ETFs, where any capital gain raises eyebrows. The payouts may be largely unavoidable—a feature of the fact that the funds use swaps and futures—but they still could surprise unsophisticated investors. "People are interested in our funds for the tactical uses and the gains they can receive," says Bill Seale, CIO at ProShares. "I think they are not as interested in tax efficiency as holders of traditional ETFs like an SPDR."

First Trust Cleans Up

First Trust Advisors, the Lisle, Ill.-based advisory with the quirky ETF lineup, added two new ETFs to its ever-expanding cadre: the Nasdaq-100 Ex-Tech (Nasdaq: QQXT) and Nasdaq Clean Edge U.S. Liquid Series (Nasdaq: QCLN). QQXT and QCLN both listed on the Nasdaq on February 15, 2007. With expense ratios of 60 basis points, both—as their names imply—track Nasdaq indexes. The Ex-Tech ETF holds the 58 companies in the Nasdaq-100 that are not technology firms. The Clean Edge fund packages 46 firms (regardless of exchange) that are involved in the alternative energy industry. First Trust also continues to file ETFs. In addition to the aforementioned natural gas ETF, the ETF company filed the:

• First Trust ISE Water Index Fund (AMEX: FWT): 36 large-cap water plays
• First Trust Chindia Index Fund (AMEX: FCI): 40 Chinese and Indian ADRs
• First Trust S&P REIT Index Fund (AMEX: FSR): Virtually all U.S.-listed REITs

From Water To Whatever

Claymore continues to file unusual one-off ETFs, with six "one-off " funds crossing the SEC's desk:

• Claymore/Clear Global Exchanges, Brokers & Asset Managers
• Claymore/Clear Global Vaccine Chain
• Claymore S&P Global Water
• Claymore/Sustainable Canadian Royale
• Claymore/Zacks Country Rotation
• Claymore/Zacks International Yield Hog

The most immediately promising of the filings may be the S&P Global Water fund, given the huge interest in the growing value of water in the modern world. The most unusual filing is the Canadian Royale fund, which is an "oil sands" play with a twist: When the price of oil is tracking up, the fund invests the bulk of its money in risky development plays; when the price of oil heads down, the fund switches the bulk of its funds to steady-eddy income trusts, the REITs of the Canadian oil market.

Much Ado About Nothing

Rydex Investments finally rounded out the lineup of its CurrencyShares funds with the launch of the CurrencyShares Japanese Yen Trust (NYSE: FXY). The new fund joins seven other CurrencyShares funds, as shown below.

Figure3

Note the "0.00 percent" yield in the yen column—that's not a misprint. The fund is designed to pay interest equal to the Bank of Japan Overnight Call Rate minus 27 basis points. At press time, the BoJ was paying 25 basis points, meaning that FXY earns zero income (rates don't go below zero).

Like all CurrencyShares, the fund charges 40 basis points in expenses. It will sell yen to cover the expenses until the BoJ's rate rises.

Claymore's Internationals (With A Twist)

Claymore Advisors launched two funds in March offering quantitative overlays on the international market. The new Claymore/Robeco Developed International Equity ETF (AMEX: EEN) and Claymore/Robeco Developed World Equity ETF (AMEX: EEW) use a mix of factors, including book-to-price, momentum, earnings revisions and share buybacks, to select companies from the broader market. Country weightings are based on market capitalization. The funds charge 74 basis points in expenses.

Relatively Interesting

After a major PR blitz, PowerShares launched a new "relative strength" ETF onto the NYSE this spring. The PowerShares DWA Technical Leaders Portfolio (NYSE: PDP) tracks a 100-stock index from Dorsey, Wright Associates that uses a trend-following system in an attempt to beat the market.

Relative strength strategies capitalize on the idea that a market or group of stocks moving in one direction will keep moving in that direction. The strategy does well when trends stay in place, and struggles when market leadership shifts.

At launch, the index was dominated by large-cap names, representing more than 70 percent of the fund. It also is diversified across multiple sectors, with the largest exposure to Financials (20 percent), Information Technology (16 percent), Consumer Discretionary (14 percent) and Health Care (13 percent).

Leo DiCaprio's Favorite ETF

First it was stocks. Then bonds. Then commodities. And now ... pollution?

In one of the more interesting bits of news to hit the ETF space in recent months, XShares Advisors has teamed up with the Chicago Climate Exchange to develop an ETF in the nascent carbon-trading market. The Chicago Climate Exchange (CCE) is the only market for trading greenhouse gas emissions in the U.S. The CCE is a voluntary program wherein private companies come together and agree to cut their emissions by a certain amount over a certain period of time.

It's not clear yet what form the ETF will take, or where the market will develop; XShares isn't talking details. The simplest structure that leaps to mind would be to simply allow individuals to purchase credits, each of which represents 100 metric tons of CO2 emissions.

Elliot Wave

XShares inked an agreement with Elliott Wave International to develop ETFs based on the Elliott Wave Principle of technical analysis, which is founded on the idea that investor sentiment sways back and forth between optimism and pessimism.

The developer of the system believed that these movements are cyclical, reflecting an innate, biological rhythm, and that they could be predicted and traded on using numerical strategies drawn out of Fibonacci sequences, fractals and other numerological oddities. Elliott Wavers talk frankly about 5-3 movements, grand supercycles and main and minor waves, and they use the principles to time the market. To the uninitiated, it sounds like mumbo jumbo.

Nonetheless, Elliott Wave Theory is the absolute gospel to market technicians; it is one of the two or three most popular technical analysis strategies in the world, and it has serious (and smart) proponents drawing very large paychecks at every investment bank from New York to Hong Kong. The best part about any ETF that results is that it will put the theory to the test.

First Trust Flips Another

The board of directors for the $280 million First Trust Value Line 100 (AMEX: FVL) closed-end fund (CEF) has voted to convert the fund into an ETF. The conversion, subject to shareholder approval, would make FVL the second CEF to convert to open-end status. The First Trust Value Line Dividend Fund (AMEX: FVD) made the switch last December.

For shareholders, converting to open-end status promises to eliminate the 8 to 15 percent discount to net asset value (NAV) that has historically plagued FVL. Indeed, following the board's decision, the fund jumped 6 percent in a single day. In addition, First Trust will lower the expense ratio on the fund.

The benefits for First Trust are less clear. Following the conversion of FVD, investors pulled $210 million out of the $540 million fund. Clearly, however, First Trust believes that, over the long term, assets will stabilize and perhaps begin to grow again.

Leveraged Sectors and Style

ProShares continued the expansion of its leveraged and inverse-leveraged ETFs by launching 22 new sector ETFs this spring. The ETFs provide 200 percent positive ("Ultra") and 200 percent negative ("UltraShort") exposure to the basic Dow Jones sector indexes.

ProShares also added 12 style ETFs to its lineup. The new funds are tied to Russell indexes, and offer 200 percent positive and 200 percent negative exposure to the style variants of the Russell 1000, Russell 2000 and Russell MidCap indexes. They are the first leveraged style funds to hit the market in the U.S.

The ProShares ETFs have been a huge hit with traders, racking up more than $3 billion in assets in the first few months on the market. The sector and style funds will likely be successful as well, as traders turn to the leveraged ETFs to get the most bang for their trading buck.

Europe, Inversed bad is good.

That's the thinking behind the new SGAM ETF Bear and SGAM ETF XBear ETFs from Societe General Asset Management (SGAM). Drawing a page from the experience of ProShares in the United States, SGAM has launched two new ETFs offering European investors inverse and inverse-leveraged exposure to the CAC 40 Index, the dominant index of large-cap French shares.

In a twist, the two ETFs will offer variable exposure that is reset quarterly. The SGAM ETF Bear, for example, can offer up to 100 percent inverse exposure, but for Q1 2007, that exposure is capped at 75 percent. Similarly, the SGAM ETF XBear can offer up to 200 percent inverse exposure, but for Q1 2007 that exposure is capped at 175 percent.

The ETFs also earn interest on collateral investments, with the Bear ETF earning 2X EONIA (the equivalent of the Fed funds rate) and the XBear earning up to 3X EONIA.

The funds will charge just 60 basis points in expenses, far below that of similar funds in the U.S.

Europe Goes Private

SGAM also launched a new private equity ETF. The SGAM ETF Private Equity LPX50 tracks an index of 50 companies whose "core activity is the allocation of private equity capital." The index's designers, LPX GmbH, specialize in private equity research, and say that over the past 20 years the underlying index has equaled or bested the performance of a diversified portfolio of closed-end private equity funds.

It is worth noting, of course, that many of the best private equity firms are exactly that—private—and they do not trade shares on the public market. The new SGAM fund is listed on Euronext Paris and charges 70 basis points in annual expenses. Its ticker is LPX, and its ISIN is FR0010413518.

From Russia, With Love

Van Eck laid plans to expand its fledgling ETF empire by filing papers with the SEC for two new funds, The Market Vectors - Global Alternative - Russia ETF

The Alternative Energy ETF will track the Ardour Global Alternative Energy Index, a 30-component index of global companies engaged in the production of alternative fuels. Compared with competing alternative energy ETFs, such as the PowerShares WilderHill Clean Energy ETF (AMEX: PBW), the Van Eck fund will have more global exposure: one-third of its current components, representing more than half of the total fund capitalization, are headquartered outside the U.S.

Figure4

The Russian ETF, meanwhile, will track the Deutsche Börse Russia Index, a modified market-cap-weighted index of globally available Russian equities. The fund will be the first Russia ETF to hit the market, and is likely to be a hit with investors.

Commodities? Oui

ETF Securities expanded its ETF franchise to Paris, launching its full suite of commodity ETFs in the City of Lights. The funds already trade in London, Amsterdam and Germany, where they have collectively gathered more than $400 million in assets.

The step-wise rollout of the funds across Europe showcases one of the unique aspects of that market. While the multiple listing requirements can be a regulatory headache (meaning multiple approvals, multiple offers, etc.), they also can foster innovation by allowing product developers to pick and choose where they want to list products.

Building The World

The new SPDR FTSE/Macquarie Global Infrastructure 100 ETF (AMEX: GII) from SSgA tracks an index of stocks involved in "infrastructure industries such as pipelines, transportation services, electricity, water and telecommunications." It covers both the developed and emerging markets.

A look at its holdings, however, reminds you that it pays to … look at the holdings. While the first thing you or I might think when someone says "global infrastructure" is China and India, the fund is almost entirely focused on the developed world. The top country weights are shown below:

As might be expected of a fund dominated by the Utilities sector, the fund combines a high dividend yield (3.1 percent) with relatively slow growth (8.4 percent five-year earnings growth).

Share The Health
HealthShares launched 14 of its planned 21 disease- and regional-focused health care funds onto the New York Stock Exchange (NYSE). In each case, the funds track an underlying index holding between 22 and 25 stocks, focused on one particular area: emerging cancer or ophthalmology.

There is a great deal of debate about whether these ETFs are too focused to succeed. HealthShares calls this "vertical investing," and says that it allows investors to focus exposure to the exact segments of the market they desire; others say that these will have only niche interest and will never develop real liquidity. The funds charge a uniform 75 basis points in annual expenses.

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