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The ETF Parade

Riding the wave of investor appetite for commodities, currencies and precious metals, the makers of exchange-traded funds (ETFs) continue to find new ways to slice and dice the market.

The instruments continue to proliferate and pull in money. In the last decade, assets under management at ETFs have soared 59% to $627.4 billion, according to research firm Morningstar Inc. Asset growth has slowed a bit recently, to just under 40% over the last three years, as the industry has gained a more substantial base.

But the massive asset gains have begun to slow slightly. Meanwhile, the number of new funds has grown. The last decade saw the number of new ETFs rise by 39.1%; over the past three years, that ramped up by 52.5%. Much of those gains were in 2006 and 2007, with that pace finally slackening this year as the markets became more unpredictable. (There were 787 ETFs based in the United States as of May 31, according to Morningstar.)

Issuers of the products “are less willing to do new issues,” says Kevin Farragher, managing director of Rydex’s ETF business line. He notes that fewer offerings have launched so far in 2008 than over the same period last year partly due to market saturation, as the most obvious market indices already have several products tracking them, and even the most mundane have at least one.

But Farragher also blames the fact that “there’s less seed capital to be had.” Traditionally, an issuer launched an ETF by getting money to start the fund from Wall Street firms known as authorized participants. The ETF issuer would give the firms shares in the ETF. And the institutions would act like a syndicate in an equity offering, selling the ETF shares from their inventories into the market.

Partly in reaction to their own financial circumstances, they are less willing to do new issues. “They want to do things that will be successful,” Farragher says. “There’s pressure on the issuers to be more judicious in choosing a benchmark around which to build.”

Nonetheless, the industry continues to crank out new products. As of May 31, there have been 131 new ETFs this year, or 16.6% of the 787 U.S.-based funds.

He said he expects the pace to slacken over the summer and for new issuance to slow in the coming year. Regarding the new issues this year, he says, “You’re not seeing the acceleration in new issues you saw the two or three preceding years. It’s holding flat. That’s because people are delivering on their 2008 plans as opposed to all of these new opportunities being discovered and acted upon quickly.”

The development has come from issuers creating even more specific instruments, from broad indices to specific market caps. Jeff Ptak, ETF analyst at Morningstar, cites this as the continuation of a trend toward more specific exposures to sectors and industries.

For example, there are some products in registration that give investors exposure to real estate in general and the housing market in particular.

Other ETFs track individual countries and geographic regions. Consider the recently launched ETF from Invesco PowerShares, called the MENA Frontier Countries Portfolio (ticker symbol: PMNA).

It’s based on the Nasdaq OMX Middle East North Africa Index, which is designed to measure the performance of the largest companies in the Middle Eastern and North African countries of Egypt, Morocco, Oman, Lebanon, Jordan, Kuwait, Bahrain, Qatar and the United Arab Emirates.

The index has 67 companies with market capitalizations between $243 million and $10.4 billion.

Bulls and Bears 

The areas that have seen the largest increase in interest are leveraged and inverse ETFs. These funds seek to give the investor bearish and bullish exposure to an index.

According to Morningstar, there are 77 leveraged and inverse ETFs, all based in the United States, holding $17.5 billion as of May 31. That outpaces the growth of the ETF industry overall, something Ptak describes as “no mean feat.”

He cites ProShares as one of the more successful managers when it comes to gathering new assets. One of the company’s popular strategies-on the positive side-has been the Ultra QQQ (which tracks the Nasdaq). But given the poorly performing markets, there have been many more bear hits lately: UltraShort S&P 500, UltraShort Oil and Gas, UltraShort Financials, and UltraShort Russell2000. In these cases, the ETF holder is betting on getting twice the inverse of the daily index return. So if the S&P 500 index loses 2%, the fund aims to deliver 4% on the day.

Gary Stroik, chief investment officer at WBI Investments in Little Silver, N.J., chairs his firm’s investment committee and uses mostly individual securities and ETFs. He likes ETFs for giving advisors access to tools that would otherwise be unavailable to the typical client in his $275 million practice, like commodities. “You could invest in Exxon-but not oil,” Stroik says. “You could invest in Newmont Mining-but not in gold. It’s a powerful tool, but like other powerful tools, you’ve got to be careful how you use it. It’s a chainsaw,” he says, alluding to the leveraged ETFs that give an investor double the exposure to a particular index or sector. He uses the term “double exposure funds” to describe them and says they can be dangerous.

For example, say an investor wants a $10,000 exposure to the S&P 500. He could could buy $5,000 worth of a double-exposure ETF, and safely stash the other half in a Treasury bill or money market fund. “I get a return in the case, get the same portfolio exposure and performance I wanted, and pocket the interest on the cash,” Stroik says. “On the other hand, if you put the entire $10,000 into the double exposure fund, you’d get twice the risk exposure and no cash cushion.”

Ptak says these ETFs are handy for making a bearish bet because of their ability to spread risk. “When you look at the risk-reward profile on a particular stock, and contrast that with the risk profile of shorting a basket of stocks, the latter choice is better,” he says. “You sacrifice some upside, but you spread uncertainty across lots of stocks.” Ptak points out that, unlike the old method of shorting-borrowing money from your broker on a margin account, which could lead to unlimited losses-the downside with bearish ETFs is limited to the investment in the ETF. “It’s a better mousetrap,” he says.

In addition, these products are especially useful when credit markets tighten. “Hedge funds in particular have taken a shine to these leveraged products because these ETFs will be there whether banks are lending or not,” Ptak says. A hedge fund manager can get 200% exposure to a particular index quickly and easily by buying a leveraged ETF, without drawing down a line of credit with their bank, or worrying about a margin call. It also saves the hedge fund manager from worrying about a nervous banker calling in all of the fund’s lines of credit when the bond markets start clamping down.

This is how it works. The typical ProShares ETF enters into a total return swap contract. The ProShares trust agrees to pay LIBOR (London Interbank Offered Rate) or a Treasury bill return plus some extra amount in exchange for the return of a specified index (or twice the return of a specified index).

Analysts are watching for growth from a new breed of complex derivative-style products that allow investors to buy risk. As yet still in the regulatory pipeline, these esoteric products would allow investors to access strategies previously available only to institutional investors. These risk-exposure products would be similar to credit default swaps (CDS), a sophisticated derivative instrument that gives the buyer a pure exposure to a company’s credit risk.

Buying a CDS differs from simply owning a corporate bond, which also exposes the investor to interest-rate risk, curve risk and prepayment risk. Credit default swaps have been popular with institutional investors for the investment precision they offered when constructing a portfolio. However, the CDS market was also hit hard in the painful credit crunch of last summer.

Little-known fund advisor CCM Partners has filed to manage four such ETF-like structures called ETSpreads, which will aim to track indices that are essentially baskets of CDS: a high-yield bond index and its inverse, and an investment-grade bond index and its inverse. These types of risk products would be most useful to the more sophisticated advisors with high-net-worth clients, such as corporate executives with large blocs of stock in their employer. Such clients have portfolios that are both large and complex enough to warrant precise removal of risk from certain stocks.

Similarly, there are other ETFs in registration aiming to zero in on very specific risks. Earlier this year, MacroShares registered a pair of products tied to the housing market: MacroShares Major Metro Housing Up and MacroShares Major Metro Housing Down. “These are large economic exposures that consumers and investors have day in and day out,” Ptak says.

Instead of providing an indirect exposure to a specific risk, products like MacroShares attempt to focus on the risk with pinpoint precision. “We’re getting much more narrowly focused niche-type products, in which ETFs divvy up risks and exposures into ever-thinner slices,” Ptak says.

Indeed, the same company also has a pair of ETFs in registration that give the investor exposure to the risk of medical price inflation. The MacroShares Medical Inflation Up Shares and MacroShares Medical Inflation Down Shares, its bearish sister, will track the medical care component of the Consumer Price Index. This strategy allows investors a great degree of precision, in case they want to take a strong stand on a particular industry. If you thought medical inflation would go up, before these ETFs, the natural bet would be to buy shares in an index holding the big pharmaceutical stocks, or an actively managed sector fund, or an ETF such as the Vanguard Health Care ETF. But often those indices hold extraneous companies. Plus, there are other influences between consumers and inflation, such as the company. With the new structure, the investor does not have to think about what’s going on in the company, only medical inflation.

MacroShares already has a pair of funds that do the same for oil prices, but they are being closed down. They were created with a kind of self-destruct mechanism that triggered a termination clause when the price of oil hit $120 a barrel. The company is liquidating the funds by giving a cash redemption to investors, similar to mutual fund liquidations.

Hitting the Right Note

Meanwhile, exchange-traded notes continue to be much discussed because of their advantageous tax status. But the Internal Revenue Service still may remove that beneficial tax treatment at some point in the future. (The agency has already removed the tax breaks from one specific type of ETN; those tracking single currencies.)

For a non-single-currency ETN, the only taxable event for an investor is when the note is redeemed. If the investor sells after a year, there are only 15% capital gains. Compare that with an ETF, which sees 60% of its gains taxed at long-term rates and 40% taxed at short-term rates. Those taxes get passed on to the investor regardless of how long he held the ETF.

Regardless of how the IRS rules, though, ETNs are still a very efficient way to own currently hot asset classes like commodities and currencies that were difficult to own before. Part of the reason for their efficiency is their structure.

They are notes, or debt instruments, which are tied to the performance of a particular benchmark, rather than a trust that holds a basket of securities, as with an ETF. As in a traditional bond, the issuer of an ETN promises to pay the investor that index return. That means all the investor has to worry about is the credit risk of the issuing bank. And because one of the biggest issuers of these new instruments is banking giant Barclays, Ptak regards the credit risk aspect of many ETNs as fairly safe.

What investors do not have to worry about is the transaction costs within the ETN, as compared to an ETF in which managers buy and sell securities. So the ETN structure eliminates two of the main problems with investing in commodities, currencies and precious metals: transaction costs and tracking error.

But, investors should note that ETNs are not as cheap as the cheapest ETFs. The median expense ratio on ETNs is 75 basis points. The cheapest tracked by Morningstar costs 30 basis points, and the priciest runs 1.25%. But as with all ETFs, ETNs carry the same transaction costs for the investor as a stock. So, frequent trading can erode gains.

Still, in spite of the question mark over their tax treatment, ETNs are becoming popular ways to get a piece of the energy and commodity action. Plus, they are relatively cheap for issuers to launch and run, compared with ETFs, according to Ptak. That makes for a lot of new products. As of May 31, there were 78 ETNs holding $6.5 billion-with 52 having been launched so far this year, according to Morningstar.

At the moment the majority of the wealth is concentrated in a handful of names, including the iPath series from Barclays, the biggest issuer at the moment, with 17 ETNs holding 54% of U.S.-listed assets.

One of the biggest winners among ETNs is the iPath Dow JonesAIG Commodity Index, the biggest commodity instrument among ETNs and ETFs. It held $3.5 billion as of May 31. The next largest ETN is the iPath MSCI India, which holds $739 million in assets. The assets in the rest of the pack drop off rapidly, with 42 of the 78 ETNs holding less than $10 million.

“A lot of them just came online, and they haven’t had an opportunity to gain traction on the market,” Ptak says.

Elizabeth Wine is an author with On Wall Street magazine. For more information about this article, please visit http://www.onwallstreet.com

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