Fundamentals based ETFs finally arrive

In the US there’s a huge battle of ideas raging between some of the titans of modern investment. Some academics, investors and writers like Jeremy Siegel reckon they’ve stumbled upon the NEXT BIG THING. They think that modern stockmarket indices based around the market cap of a firm are fundamentally flawed. They think the clever thing to do in current markets is to build indices based on a fundamental measures instead i.e weight your indices towards companies that pay more dividends for instance rather than just the value of the company.

Dozens of funds have been launched to test out the effectiveness of these new strategies and the results have been pretty impressive – one provider called Wisdom Tree has launched a range of US ETFs that have consistently beaten the market. The key insight here is that these providers think that the market doesn’t always get it right and sometimes consistently misprices say value stocks.

Ranged against this new wave of fundamental indexers is the mighty John Bogle, one of the most successful investors ever, founder of the huge Vanguard fund management group and a fan of index tracking. He thinks that trying to outwit Mr Market by using fundamentals measures is a fools errand and that most investors should ignore this modern numbers based alchemy and stick to tracking the markets.

This debate has been all a bit academic for British investors as the number of ‘style’ or ‘fundamentals’ based ETFs has been minimal – up until recently the only proper fundamentals ETFs came from iShares via their high dividend funds. Then last month Deutsche came along and issued two competing dividend funds based on high dividend yielding European and Global mega-caps. Now though the battle is really about to begin as newcomer SPA hits the markets with four ETFs that track indices that use a hugely advanced form of fundamentals screening.

The SPA ETFs use a platform called MarketGrader that focuses in on a number of key fundamentals based measures like earnings growth, return on equity and operating margins. In the USA this strategy has been tested pretty much to destruction and so far has produced some pretty amazing results. Using a backtest run by SPA, the MarketGrader Small Cap strategy has yielded a cumulative return of 145% since January 2003 (and 140% for the large cap version). The real star though has been the SPA MarketGrader 40 index (comprising the best 40 stocks) which has returned 214% since 2003. By comparison, the S&P 500 has risen a miserly 65% over the same period.

These new ETFs are also not likely to be the only fundamentals based funds on the market over the next few months – there are rumours of new launches that use alternative strategies like the FTSE RAFI. And if past results are anything to go by, these fundamental index funds should be a huge success, but there a number of important caveats.

1. The SPA MarketGrader ETfs invest in US shares and they’re priced in dollars. That’s risky to say the least and arguably a bit of distraction for UK based investors – a more appealing alternative would be ETFs that screen for UK shares

2. These strategies might not work in the future. Screening the market for successful strategies can and does work but not all the time – back-testing is all fine and dandy except that the future might be a very different place where shares react to fundamentals in very different ways

3. These fundamentals based screened ETFs are challenging the very intellectual underpinning of ETF investing – you invest in index funds because they’re cheap and dumb. Traditional ETFs are not second guessing the markets just following them. The whole point of index fund investing is that you’re not betting on alpha i.e the ability to beat the market

4. The expense ration on these funds has been capped at 0.85% which is reasonable but not exactly ultra-cheap

5. In the last year these funds have tended to perform poorly according to the SPA backtest. The MarketGrader 40 for instance has returned just 6.87% so far while the small cap fund has returned just 0.07%.

In the next few weeks we’ll be issuing more detailed briefings on these new SPA ETFs, so watch this space.

Dawnay Day Quantum

Dawnay Day Quantum has just closed yet another tranche of its European Stockmarket Maximiser range. We’ve already featured this product before but it’s worth repeating some of the big positives....

• 1000% or 10X participation in the upside of the Euorland Dj EuroSTOXX 50 index upto a maximum 60% return
• Followed by 175% participation in the index growth above 60%
• Plus 100% capital protected unless the index falls by more than 50% from its initial level
• No currency risk#6 year term with the strike date on September 14th 2007 and maturity 16th September 2013
  

It’s important to say at this point that this is NOT a listed product – you can’t go to your stockbroker and deal on this product in the open market (as you can with competitor Merrill Lynch who do offer a secondary market in their products). This is an enormous disappointment because the terms on this product are just so good – we don’t see how you could design a better fund that will offer growth from Europe.

To be fair to Dawnay Day it does offer some listed funds that can be dealt via stockbrokers but these are sold in units of £250,000 or more – we’ll report back on these funds next week. But in the meantime if you want access to this deal you’ll have to talk to your IFA and buy the product like you would any other high street structured product.

Which brings us very quickly to our central point – here’s a cracking product, with a superb risk profile and participation rates offered through IFAs. There should be nothing surprising about this statement except that in our humble opinion just about every structured product offered through an IFA (and not listed on the market) is rubbish.

This may seem a sweeping statement but the Tracker101 website doesn’t bother to write about non-listed products because in our view they’re not worth the bother. The participation rates are usually terrible (you’ll be lucky to get above 100%) and you’re locked in for the full term of five or more years with no secondary listing. In our view almost without exception you’ll get better deals from more specialist listed products – they’ll require a little more legwork and badgering of your broker but the effort is worth it. Listed structured products – our Tracker Plus products – are usually aimed at high net worth individuals who are more discerning and more demanding than high street investors – they wouldn’t dream of accepting the deals on offer on the high street. They want flexibility and decent terms – if they don;t get they won’t invest or they’ll sell in the open secondary market. High street investors by contrast are offered poorer terms by IFAs who don’t really understand the products and oversell the ‘capital guarantees’. Every once in a while though a really good high street structured product like the Dawnay Day Quantum product slips through the net and we’ll comment on it – otherwise if you want advise on IFA introduced structured products look to the excellent website maintained by Ian Lowes , up in Newcastle, at HYPERLINK "http://www.lowes.co.uk" www.lowes.co.uk which is full of incisive comment based on real knowledge and experience.

The commodity tracker scene goes red hot with launch of new futures funds

Commodity tracker specialist ETF Securities has just launched a huge new range of exchange traded commodities or ETCs (their alternative to ETFs) focussing in on the futures markets for key indices and commodities. In all 29 new funds will be issued over the next few weeks, all of them focussed in the future price of either key commodities like gold, zinc or sugar or of a composite index such as Livestock or Precious Metals.
The first batch of ten index based funds has just been launched and they’re all listed in the table below.

Forward index commodity securities	LSE code	Reuters	Bloomberg	ISIN	SEDOL
ETFS Forward All Commodities DJ-AIGCI-F3SM	FAIG	FAIG.L	FAIG LN EQUITY	JE00B24DMC49	B24DMC4
ETFS Forward Energy DJ-AIGCI-F3SM	ENEF	ENEF.L	ENEF LN EQUITY	JE00B24DMD55	B24DMD5
ETFS Forward Petroleum DJ-AIGCI-F3SM	FPET	FPET.L	FPET LN EQUITY	JE00B24DMF79	B24DMF7
ETFS Forward Ex-Energy DJ-AIGCI-F3SM	EXEF	EXEF.L	EXEF LN EQUITY	JE00B24DMG86	B24DMG8
ETFS Forward Precious Metals DJ-AIGCI-F3SM	FPRE	FPRE.L	FPRE LN EQUITY	JE00B24DMH93	B24DMH9

Over the next few weeks ETF Securities will be launching a further 19 funds this time concentrating on individual commodities – the list of expected funds is below.

• ETFS Forward Aluminium
• ETFS Forward Coffee
• ETFS Forward Copper
• ETFS Forward Corn
• ETFS Forward Cotton
• ETFS Forward Crude Oil
• ETFS Forward Gasoline
• ETFS Forward Gold
• ETFS Forward Heating Oil
• ETFS Forward Lean Hogs
• ETFS Forward Live Cattle
• ETFS Forward Natural Gas
• ETFS Forward Nickel
• ETFS Forward Silver
• ETFS Forward Soybean Oil
• ETFS Forward Soybeans
• ETFS Forward Sugar
• ETFS Forward Wheat
• ETFS Forward Zinc
  

What’s the logic behind this massive range of new funds ? Quite simply ETF Securities is inviting investors to take part in THE new game in speculating (as practised by scores of hedge funds and major investment banks) – backwardation. Now to be fair to the hedge fund boys a lot of money has been made in recent years out of betting on futures price and backwardation.

Academics have been crunching the numbers for a quite a few years and they’ve proved that the real money in commodities is not really to be made on spot prices – they’re too volatile - but on playing futures prices. One study by Profs. Edwin Elton, Martin Gruber and Joel Rentzler (“The Risks and Returns of Commodity Funds,” in the April 1987 AAII Journal) found that only 1% of total returns in the last few decades from commodities investing could be explained by the returns of either the commodity spot index or commodity futures index. What mattered was how well or badly the fund manager played the index or developed options strategies.

Another working paper by Gary Gorton and Geert Rouwenhorst of Wharton and Yale unpicked the total returns between 1959 and 2004 from a basket of commodities – the annual return was just 3.47%. Next they calculated that the equally weighted and annually rebalanced futures contracts for those assets which yielded a return of 11.18%. The authors found that most of this second return was from backwardation.

In laymans terms backwardation describes how markets try to price in future risk.

This is how it works...
Farmers want to protect themselves in the future against future price falls from their output. That means they sell future output to brokers at a discount to protect their income. That discount is effectively a profit to a bunch of speculators who were willing to offer price protection to a bunch of timid commodity producers worried about future prices. But what happens if producers suddenly decide that prices are NOT likely to fall in a few months, but in fact RISE ! Maybe they’ll cotton onto the fact that huge financial institutions have been making a huge fortune from holding onto these forward contracts in a time of rising prices. It gets worse. Maybe the producers will work out that not only have these institutions made a profit from the time discount, they’ve also been investing the underlying money to pay for the futures contracts in bonds that have yielded a tidy income on top.

Suddenly backwardation could, well, go backwards…..

As one leading economist pointed out “ in a market whose major propelling force is the demand for insurance against inflation, those who supply it will demand a premium. Goodbye Keynesian normal backwardation, hello . . . . forwardation? “

Or contango as it’s called, which is exactly what’s happening in key commodity markets around the world . Oil markets for instance look at the moment like they might be poised to enter a contango phase – with potentially disastrous affects on investors in backwardation contracts. Or maybe not – nobody in truth really knows for certain what will happen next but an awful lot of smart money is on backwardation diminishing.

Where that leaves this range of products from ETF Securities is anyone’s guess. They absolutely fulfil a key function in the commodity markets – allowing investors to make money on forwards contracts. The key question is whether this is the right time for private investors to start playing the game and that is a moot point - we suspect the prime consumers of these new products will be those hedge funds and investment bank traders.

Brace yourself...

A massive battle is about to erupt in the ETF sector offering private investors a huge new array of cheap, effective funds that invest in everything from fast expanding Indian mega-caps through to global value stocks. The days of 1% or even 1.5% annual fees for managing specialist funds that fail to track the key indices could soon be a thing of the past if new providers like Lyxor and Deutsche Bank have their way – they’re launching a slew of new funds that’s bound to cause market leader Barclay’s iShares unit to react with yet more new offerings, possibly even kicking off a price battle with asset managers falling over themselves to cut the fees charged to private investors.

This battle has been a long time in the making. In the US investing in market traded index fund vehicles – exchange traded funds or ETFs – is absolutely huge amongst private investors with providers like iShares and Vanguard bagging countless hundreds of billions in funds under management off the back of a fast expanding market boasting over 550 funds and fees that are sometimes as low as 0.10% per annum. In the UK iShares pretty much had the market to themselves until 2006 , marketing their wide range of products mainly to institutions and high net worth individuals tempted by annual management fees that varied between 0.2% (for their bond and gilt funds) and 0.75% for their more specialist funds. Then in the summer of 2006* *the competition finally arrived in town. First on the scene was a small company called ETF Securities which launched a series of funds that focussed on the commodities sector. Then back in spring of this year SocGen’s big European specialist Lyxor launched the first ETF tracker that followed the FTSE All Share index. Lyxor are now poised to rapidly expand – expect at least 8 new funds in the next month or two – and they’ve been followed by Deutsche bank which has also just launched 18 different ETFs onto the UK market.

The humble private investor should be the biggest beneficiary of this intense new competition. The first big plus will be lower costs – not one of the new trackers launched charges 1% or more in annual expenses (most charge less than 0.5%) and there are no initial charges. Compare those fees with most unit trust tracker funds that charge at least 1% per annum (although there are some big exceptions like the Fidelity UK Moneybuilder tracker fund that charges only 0.1% pa for tracking the FTSE All) and active fund managers who charge anything between 1.5 and 2% per annum plus an initial charge. Frankly in the crucial FTSE 100 market for instance, there’s no good reason now why you need to pay more than 0.3% in fees every year to a fund provider.

Index funds like ETFs also possess another killer advantage – unlike active fund managers you’re not buying into the risk of your fund manager making the wrong decisions. ETFs effectively buy the market through one fund at low cost and the only risk is that the tracking error might start to creep up because of inefficiencies in the process. Luckily most of the big providers seem to be fairly adept at controlling even this risk – iShares FTSE 100 tracker over the last four months for instance has under-performed the index by only 0.47% (annualized) while Lyxor’s FTSE 100 ETF has a tracking error of only 0.01%.

ETF’s are also opening up a stunning array of new markets and indices that should appeal to the more experienced investor.

· *India.* This is perhaps the most exciting new market on offer via Lyxor and Deutsche – they’re both offering ETFs that track the crucial S&P /CNX Nifty Fifty index of top Indian mega-caps like Reliance, Infosys and Tata (the annual expense ratio in both cases is 0.85% ). These top 50 companies cover 25 sectors and account for over 55% of the entire market cap of Indian companies. Annual returns over the last 7 years have been around 14% and 40% over the last three years although the index is pretty volatile and arguably rather expensive in PE terms

· *Africa and the Middle East*. Lyxor is to launch a fund that tracks the South African FTSE /JSE Top 40 index of top South African giants (the TER is 0.85% again) while Deutsche has also just launched an ETF ‘snappily’ called MSCI EM EMEA ETF (surely enough acronyms, Ed) which tracks the top companies in the emerging markets of Eastern Europe and the Mid East and Africa (the TER on XMEA is just 0.7%)

· One theme that seems to be especially popular with index fund providers is *renewable energy* and *green *markets. SocGen’s structured product team has for instance in the past few weeks launched not one but four products that track green indices ; the European Renewables fund tracks the top 10 players in the hydro power, solar and wind power sector ; The World Bioenergy fund tracks players around the world in products like bio-ethanol ; The World Solar index fund tracks the leading the solar energy equipment makers and the World Uranium fund tracks big players in the mining and processing of , guess what….uranium. All four funds are not actually exchange traded funds as such – they’re traded notes that don’t pay out any dividends from holding shares in the index which is provided via DowJones and a specialist firm called SAM – and the expense ratio is a little high at 1% per annum. iShares has also launched funds that track similar markets but via a different index provider – two new launches include a Global Water index fund and a Global Clean energy fund, both using indices from S&P, and both with expense ratio’s of 0.65%. Mainstream green funds typically tend to target the same kinds of companies – though not the same indices – and charge 1.5% or more per annum plus high initial charges or the privilege.

· *Value shares*. A big debate currently rages in the academic community about the virtues of tracking indices that don’t weight according to market size but company fundamentals. Purists of efficient markets argue that these indices are the artificial creations of marketing departments that don’t really reflect true market fundamentals. Enthusiasts simply point out that value indices for instance consistently out-perform the wider markets and can provide income investors with a fantastic steady income plus capital gains. Currently iShares has the best ETF in this space by far – their UK Dividend Plus pays around 4% per annum – and targets the highest dividend payers of the FTSE 350 – its Total expense ratio is also a very reasonable 0.4% per annum. But Deutsche are clearly muscling in on this space with two new funds – the DJ STOXX Global Select Dividends 100 fund that pays out 3.52$ from holding the worlds leading large cap, high yield stocks (TER is 0.5%) and the even more select DJ EuroSTOXX 50 Dividend 30 fund that targets the top European dividend payers (the yield is 2.93% and the TER is a very reasonable 0.3%).

· *Commodities*. ETF Securities isn’t about to be left behind though in this rush of new products though. They’ve recently launched a highly innovative ETF that holds a physical basket of precious metals – gold, silver, platinum and palladium feature in the fund which offers investors direct exposure to spot prices with an average expense ratio of just 0.43% pa. It’s also launched a series of funds that track changes in the future price of oil – funds invest in 1, 2 and 3 year futures prices for Brent oil and West Texas crude.

· *Global Sectors*. iShares itself has also been busy, launching a series of funds that target global sectors like Water, global utilities and infra-structure companies plus their own version of a listed global private equity index that invests in companies like 3i and SVG. Lyxor have also responded with their own listed private equity ETF – but theirs tracks an alternative index called the Privex developed with Dow Jones.

· The FTSE All Share. Bizarrely competition to provide an index tracker in this sector has largely been left to unit trust trackers that have tended with some big exceptions (such as Fidelity and F&C at 0.1% and 0.3% respectively) to charge annual fees of 1% or more. Now the ETF providers are busting into the market. Lyxor was first off the mark with a fund that charged just 0.4% and now Deutsche have weighed in with their own fund that also charges 0.4%.