Wednesday 24th Jun, 2009

Business Times - 24 Jun 2009

MONEY MATTERS
Harnessing the ETF revolution

Exchange-traded funds now straddle virtually all asset classes and have become a global phenomenon

By JOSEPH CHONG

GLOBAL equity markets are roughly unchanged year to date. But this statistical calm masks a roller-coaster ride. Stocks fell 30 per cent until the second week of March - before rebounding 40 per cent. It was fear on a grand scale.

During this mayhem, we predicted in our column 'The paradox of thrift, and other thoughts' (BT, Feb 7, 2009) that things would soon sort themselves out.

Looking at big-picture data, we predicted that equities and hard assets such as precious metals and property would do well. So far, so good with our predictions.

Looking at forward indicators, most developed economies will be out of recession in the second half of 2009. This includes even Europe.

However, this recovery will be different from previous ones. The global economic landscape has changed markedly. Investors now need to scrutinise Chinese retail spending and PMI data as closely as they watch figures out of the United States. Ten years ago, few cared what the Chinese consumer spent.

Amid on-going fundamental shifts in the global economy, the money management industry is undergoing significant changes. And one factor behind the changing complexion of the wealth management business is the exchange-traded fund (ETF). Essentially, ETFs are open-end index funds that are listed and traded on exchanges - like stocks.

From the first humble listing in the US in 1993, ETFs now straddle virtually all asset classes - long and short - and have become a global phenomenon. There are currently more than 1,600 ETFs worldwide, with almost US$660 billion in assets. Twenty-five per cent of all trades on the New York Stock Exchange are driven by ETFs.

ETFs are also the choice instrument for macro bets by hedge fund managers. For example, when hedge fund manager John Paulson, the billionaire who made a fortune shorting the US sub-prime market, wanted to bet on gold recently, he did it through an ETF.

During the savage bear market of 2008, ETFs experienced net inflows, while unit trusts experienced net outflows. Indeed, most traditional unit trust managers see ETFs as one of the biggest threats to their business. Just as mutual funds did to bank deposits, ETFs are disintermediating traditional mutual funds as more investors chose to do away with the cost of active stock-picking work. Indeed, the ETF business is one of the main reasons Blackrock coughed up US$13 billion to buy Barclays Global Investors.

And on an infinitely more humble scale, that is why we soft-launched a new portfolio management service on June 1 to harness the global ETF revolution.

Utilising more than 1,000 ETFs traded on 22 exchanges around the world through one consolidated Internet account, we are providing clients with the flexibility to invest long and short in equities, fixed income, commodities and currencies globally. The goal is to achieve absolute returns regardless of market direction.

ETFs allow us to go long and short efficiently, while automatically achieving diversification and avoiding single-stock risks. But while avoiding single-stock risks, the investor can pursue targeted sectors as opportune.

Investment theory and practice show we can eliminate specific risk of individual securities by diversifying broadly, thus only having exposure to market risk - that is, the ups and downs of the market in general. Market risk cannot be diversified away in a long-only portfolio, unlike one that can go short.

Given the expected uneven nature of the recovery and eventual policy tightening by central banks around the world, the flexibility to go short is expected to be very useful.

The following is an example of a long-short strategy from the recent past. At the beginning of 2008, the outlook was poor for the US but benign for the rest of the world. Reflecting this, the US dollar was weak but US exports were growing because the rest of the world was still prosperous. Overall equity valuations in the rest of the world were not expensive.

One would, therefore, expect equities ex-US to outperform US equities, but US government bonds to do well. A typical strategy congruent with this outlook would be to invest in a global equity ETF but short (or eliminate) the US exposure by investing in an inverse US equity ETF.

Exposure to US government bonds would be through a US Treasury ETF with a maturity of around five years, which would be relatively stable. Therefore, the strategy would have been translated into three ETFs:

·  iShares S&P Global 100 Index (IOO) - 45 per cent of portfolio.

·  Short S&P500 ProShares (SH) - 25 per cent of portfolio.

·  iShares Barclays 3-7 Year Treasury Bond (IEI) - 30 per cent of portfolio.

Such a construction would position the portfolio for upside but provide protection on the downside. Despite the most horrendous year for global equities since the 1930s, this simple three-ETF portfolio would have lost only 1.8 per cent at the end of 2008.

Our new portfolio management service built around ETFs gives individuals the flexibility to invest like a hedge fund but at low cost and with real-time transparency.

It gives investors the scope of large institutions - without the need for massive portfolios and outlays. The advent of the Internet technology and the richness of ETF choices have made this possible. Investors and advisers tend to look at events through the lens of their mandate and available instrument choices. Hence, long-only mandates result in a bias to interpret events on the upside, unlike a strategy that can go both long and short - one that is indifferent to market direction.

Psychologically, this has important consequences for portfolio performance. The changing world suddenly looks less frightening when one can make money whether markets are up or down.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions