Wednesday, November 18, 2009

The exciting new world of ETFs

The ETF world is becoming more crowded and competitive every day. ETFs have become an extremely popular product with both the individual investors as well as various institutional players. The reasons are plentiful - from instant access to index exposure, to an easy way to enter markets such as China, to a simple way to take a macro view (for example in commodities), or to simply obtain leverage. One of the key reasons institutions love ETFs is liquidity. SPY (S&P DEP RECEIPTS) for example has a trading volume of 100-300 million shares a day, making it one of the most liquid exchange traded instruments in the world. In contrast for example, IBM volume is under 10 million shares a day.

With all this demand, institutions are cranking out new ETF at what seems to be a weekly basis. And each tries to add their bells an whistles to get traction in this competitive landscape. Schwab for example just created a bunch of new equity index ETFs (such as the Schwab U.S. Large-Cap, Small-Cap, etc.), and looking at the ETf universe, one might say zzzzzzzz.... But the spice here is that if you have a Schwab trading account, you can trade these things comission-free -supposedly forever. So if someone allocates a few hundred bucks a month to this strategy, this zero comission offer definitely helps.

But how far are fund companies going to push these products? Well, here is the latest ETF form iShares: ticker symbol ALT. "ALT" stands for alternative investments. That's right, this ETF is a hedge fund. Don't have a few mil to plow into a hedge fund, here is what you can get with the exchange traded ALT:

The objective of the Trust is to maximize absolute returns from investments with historically low correlation to traditional asset classes while seeking to control the risks and volatility inherent in futures and forward contracts by taking long and short positions in historically correlated assets.

Feels, sounds, and might behave like a hedge fund. Here are the 3 strategies ALT manager will trade:

The Trust utilizes investment strategies relating to relative value. Relative value strategies seek to profit from the mispricing of financial instruments, capturing spreads between assets and asset categories that deviate from the fair value or historical norms. The following three general strategies are considered as sources of return:

1. Yield and Futures Curve Arbitrage Strategies
Seek to take advantage of interest rate and futures contract price differentials by simultaneously entering into long and short positions in various bond futures contracts, interest rates futures contracts, commodity futures contracts and/or currency forward contracts that the Trust determines to be mispriced relative to one another. The Trust will enter into long positions in contracts whose underlying assets are deemed relatively inexpensive and will enter into short positions on contracts whose underlying assets are deemed relatively expensive.

2. Technical Strategies — Momentum/Reversal
Seek to take advantage of a comparison between assets' historical returns and their recent performance. Technical strategies are based on the theory that past price history may be predictive of asset value, and so technical strategies may be used to capture returns arising from price changes over time. For example, if recent performance of an asset exceeds historical performance, then a long "momentum" trade opportunity to buy may arise. If the historical performance of an asset exceeds recent performance, then a short "reversal" trade opportunity may arise.

3. Fundamental Relative Value Strategies
Seek returns by attempting to identify instances where there are discrepancies between the market and fundamental values of an asset. Comparing current price to fundamental value may provide a measure of mispricing, or opportunity, which can be compared across markets to provide a metric of relative misevaluation. The Trust's relative value strategies tend to buy in markets that appear inexpensive on a relative basis, and sell in markets that appear expensive, trading long or short positions in the relevant assets.

So if you get bored with US equity index ETFs, or BRIC ETFs, or gold ETFs, of even 3x leverage ETFs, ALT is here to add some hedge fund excitement. But don't bet on this ETF as always being uncorrelated to the equity markets. As we discussed before, correlation can show up in a stressed market with little warning.
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