AIG Deal Death Blow To ETF Industry?

September 17, 2008

It's raining locusts and fire today, as the Republicans bail out another financial giant. Will ETFs bear the brunt of this socialism?

There you go ... I'm just doing my best to duplicate Hougan's sham headline on a SUREFIRE WAY TO MAKE TONS OF MONEY in this market. And then he goes and writes a lamo tax-loss-harvesting article.

First of all, can I get in a "What's good for AIG is good for America!" here just to get that out of my system? Congratulations American taxpayers, you are all now proud shareholders in AIG. They don't call it AMERICAN International Group for nothing. 

Second - IS it lights outs for ETFs and ETNs? It appears not. But there IS one big potential lesson to be gleaned from the last week's insanity. And that lesson is one about ... sector exposure.

You'd have trouble convincing me that the stock market is driven by ivory tower concepts of growth and value ... this week has highlighted the obvious point that it all happens in the sector trenches.

It's times like now when BIGTIME shifts are going on that small and large and growth and value fade into the background like Latin classes or Cartesian rationalism. It becomes clear that the markets are a street fight in the dimly lit alleyways of the sector neighborhoods. So bring out your brass knuckles, because there's a whole lot of pain going on.

What better time to break out the sector discussion once more. I recently had a lengthy email conversation with a reader (to remain nameless) who is trying to figure out ways to not let sector effect overrun his portfolio. Indeed, it's a great irony that some of the methodologies like the RAFI Fundamental indices or Wisdom Tree dividend-weighted funds, which are ostensibly DESIGNED to avoid such sector bubbles, have been some of the hardest hit funds in the turmoil around financials.

I recently debated the subject with our reader. His email started the conversation (his comments are in bold to help separate the discussion):

By now, you guys have got to be getting tired of my notes on sector matters but I'm going to go at it again anyway—on your article "The 15 Basis Point Portfolio and Bobo Collide."

The real story behind the performance in these portfolios is the obscene levels of exposure to financials. Period.

As inadequate as I believe much of Morningstar classification tools and approaches are, it's the only set that I've got for bucketing the assets and, so, I'll pass on what I gleaned from it. 

Nearly 26% of total holdings in the 7-ETF portfolio falls (quite literally, currently) into Morningstar's Financial Services bucket.

More than 24% total holdings in the 10-ETF portfolio resides in Financial Services.

And those proportions are after having already undertaken significant "rebalancings" in those ETFs since June 07executed, by the way, through massive relative losses of value.

As for the 8 "selected" ETFs for use in comparing the two portfolios, same deal regarding the equities pieces. The Morningstar report that I ran this morning shows VWO at 21% Financial Services!  And that's "o.k."?  (and how much was it in Financial Services in June 07?).  And 26% of EFA and 19% of IWM in Financial Services!

Clearly, style, capitalization and "total market" equity indexes, lacking meaningful sector constraints, have severely limited diversification potential as they rather "actively" and fully participate in extreme sector bubbles. Just as was the case with tech and telecom during 2000-2002, seeking to manage equities risk while allowing massive sector over-weightings is a pipe dream.  Was it "appropriate" for a "risk manager" to have 27% of equities exposure to financials, as was the case with the S&P in 2000, or more than 20% in financials in 2007?  While those numbers certainly corresponded to market cap weightings within a "broad" (but highly sector concentrated) index at the time, were they in any way truly relevant to the economy?  What fraction of GDP or GDP growth was represented by tech and telecom in 2000 and by financials in 2007?  27% and 20%?  I think not. And, no, I am not advocating an earnings or fractional GDP screen or weightings system. We've got sector alternatives today for relatively cleanly and systematically containing a substantial portion of risk inherent in most broad market and style and capitalization-based indexes.

Looking for the smoking gun on the portfolios reviewed? Try the sector composition. Were those concentrations an intended outcome of the allocation constructed? Whether intended or not, those allocations are nothing more than what I would call "sector bubble surfing."


It's hard to believe those numbers are still so high. The truth is, people are relatively oblivious to how the markets swing on sector weightings. But the story is...everything. I remember at one point a couple of years ago, the S&P had a NEGATIVE 5-year return, but if you took out technology, it was +5% or something.

It really is an amazingly underreported story, particularly among the "asset allocator" types. We're talking about the drivers of the economy - of markets, and it's like they don't even exist, save as speculative tools. Something is badly off there. I just feel like we need to get our hands around it ... to bring the numbers up more frequently, play around with mixing and matching of portfolios and tilts against sector overheating.



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