United States Commodity Funds' new ETF, the U.S. 12-Month Natural Gas Fund (NYSEArca: UNL), began trading yesterday, offering investors another easy access point to the natural gas market. But let's hope it sees smoother sailing than its controversial cousin, the U.S. Natural Gas Fund (NYSEArca: UNG).

Not only have regulators vociferously blamed UNG for distorting the commodity markets earlier this year, the fund has also performed dismally to date, dropping a whopping 61.24 percent since the beginning of the year. And it's not because investors have lost their taste for the fund: Last month, UNG still saw brisk inflows of $308 million, even as its net assets dropped $263 million.

Record-low natural gas prices have played their part in slashing UNG's returns, of course, but the big anvil weighing the fund down is the market's nasty case of contango. For the better part of the year, the front-month NYMEX natural gas futures contract has stayed cheaper than those with later delivery dates. And since UNG buys only the front-month contract, selling it near its expiration date to purchase the next-nearest month's contract, the fund has been stuck in a wicked cycle of "sell low, buy high" for months now.

UNL, on the other hand, may be able to avoid some (but not all) of the same pricing sting. Instead of focusing solely on the front-month contract, UNL purchases an equally weighted basket of futures contracts with delivery dates in each of the next 12 months. Two weeks from rollover time, the fund sells the front-month contract and buys the one 12 months out, essentially pushing the basket forward in time.

Given that currently UNG must absorb losses across 100 percent of its contracts during rollover, while UNL only experiences losses in 1/12^th of its portfolio, this methodology should protect the latter somewhat from contango's vicious sting. But it can't make UNL entirely immune, considering the furthest-out contracts are still priced substantially above the front-month contract: Yesterday, the December 2009 contract closed at $4.254, while the December 2010 contract closed 45.7 percent higher, at $6.199.

Also consider that at 0.75 percent, UNL's expense ratio is a mite bigger than UNG's (0.60 percent), so when the contango lessens, any cost savings from choosing the former over the latter would naturally erode. And should the natural gas market flip to backwardation, UNL's staggered buying strategy would actually put it at a disadvantage to UNG.

But backwardation's not likely to happen in natural gas—at least, not anytime soon. To see inversion occur, we'd need to start seeing shortages in the physical commodity, yet natural gas stocks just hit an all-time high. In fact, the International Energy Agency recently predicted that even if demand rebounds, due to an extra-cold winter and economic recovery, we'll still see a natural gas surplus that will depress prices until 2015.

Will UNL ultimately outperform UNG until then? Obviously only time will tell, but we may be able to divine some clues from USCF's other 12-Month Oil Fund (NYSEArca: USL) and its UNG-analogous partner, the U.S. Oil Fund (NYSEArca: USO). Despite oil's price recovery, the commodity has also experienced heavy contango recently, and year-to-date, USL is up 38.84 percent, while USO is only up 22.87 percent.

Still, while I'm always happy to have more tools in the box, when it comes to natural gas, I'm not yet sure whether a flathead or a Phillips screwdriver would be better.

The new ETF (NYSEArca: MNA) launched today, as Cinthia covered in the news. She does a good job laying out the core objective: Buy the stocks of companies that will be gobbled up, and short out a bit of broad market exposure, thus capturing only a theoretical premium of the merger companies.

There’s nothing inherently flawed in the idea here, and I have no doubt that the IndexIQ guys will deliver on the letter of the prospectus. I’m just unconvinced this is a strategy that needs an ETF.

Like most niche ETFs, MNA tracks an essentially self-referential index: the IQ Arb Merger Arbitrage Index. This index is a quantitatively based stock-picking index, which selects stocks based on a public methodology available here.

The idea behind the methodology is to perform the function of a hedge fund manager mechanically. Here’s how the methodology works.

1. Look at every company on dozens of international markets, and make a big list of those that are the subject of an announced merger, acquisition, LBO or private equity investment where more than 50 percent of the company is on the block.
2. At the beginning of every month, when the index is rebalanced, look at the price of the offer in the market, the actual price of the stock, and the price of the stock way back before the deal was announced. Based on those factors, include or exclude each company from the index. The logic is fairly straightforward—companies with offers outstanding over the current price have a higher probability of completing a merge to the upside; companies in the opposite position are stinkers. There’s some nuance, but ultimately, it’s cocktail-napkin logic.
3. These stocks are then weighted based on average trading volume. Companies that are hotly traded get a big slice of the pie. Companies (even big companies, theoretically) that have low liquidity get small weights.
4. Cap every stock at 15 percent, then scale the whole portfolio down to make room for a 10 percent short position using inverse and leverage-inverse ETFs.
5. Any money left over goes in short-term bond ETFs.

Let’s look at the index portfolio this mechanical process currently generates, as of 11/16/2009:

There are obviously a handful of other holdings as well, but the weights drop precariously from here.

The problem I have with this portfolio isn’t that it’s somehow “bad”—I’m not an M&A specialist. Maybe Starent and BJ Services are screaming buys. The problem I have is that by definition, the kind of arbitrage that an active hedge fund manager seeks to exploit is based on asymmetrical information. Many, many smart investors have already weighed the probabilities of, for example, Oracle’s proposal to buy Sun Microsystems. They’re evaluating the books, and perhaps most importantly, responding to news. In the case of nearly every M&A situation, there are blockades that arise and dissolve on a daily basis (in the case of Sun, concerns from European regulators). Those news items often ping-pong a stock’s price back and forth around a hanging offer.

Because an index by definition has to follow certain rules, its hands are tied when circumstances change.

To be sure, there are plenty of loopholes in the methodology to allow IndexIQ to avoid being in stocks that are no longer relevant. But fundamentally, this kind of arbitrage is the most active of active management. It’s about constantly assessing probabilities based on public news flow and private conversations. I remain unconvinced an algorithm, especially a relatively simple one, can capture that.

And last, I hate paying someone to manage my cash. I understand that the ETF needs to have the flexibility to simply not be in the market when there are no opportunities, but that’s not why I’m paying a 75 basis point management fee.

Sorry guys. I understand the intent, and I’m sure the academic finance backs up the algorithm, but I’m not sure I buy it.

[Note: This post originally included discussion of the wisdom of using ProShares ETFs as the vehicle for gaining short exposure. While the index has been constructed using ETFs, the actual portfolio is using futures—a far more sensible and efficient strategy.]

In case you missed it, ProShares announced today that it will pay zero capital gains on its complete family of ETFs in 2009. That’s shocking, given the huge cap-gains payouts by inverse ETFs in 2008. I would have thought, given the huge run in the market this year, that leveraged funds would have accumulated large distributions.

In fact, I had a half-written blog warning investors to sell out of leveraged ETFs ahead of the 2009 distribution announcements. I was worried that investors would get stuck with large distributions yet again, and didn’t want to see that happen. It was lucky timing that the ProShares announcement jumped ahead of me publishing that blog.

The question now is, will other leveraged and inverse ETF providers like Rydex and Direxion Shares follow suit?

On one level, I think the answer is yes. Given the zero gains at ProShares, it’s unlikely we’ll see the kinds of distributions we saw in 2008, where funds paid upward of 30 percent (and in one case more than 80 percent) of their net asset values in capital gains.

But I wouldn’t look for zero capital gains across the whole universe. The largest gains in 2008 were concentrated in smaller funds, and if I were a tax-sensitive investor, I’d be worried about funds with small assets under management going into the 2009 distribution season.

There are lots of things that ETF providers can do to manage tax distributions, including using the creation/redemption facility to effectively distribute gains to institutional investors during the course of the year. But smaller funds that have less creation/redemption activity are limited in their ability to do this.

My guess is that we’ll still see some capital gains distributions in the leveraged space in 2009, but they will be nothing like what we saw in 2008, and will be focused on the smaller, less-loved funds.

Leveraged and inverse ETFs are most appropriate for traders who may not care about capital gains distributions. But investors in leveraged ETFs outside of the ProShares family may still want to be on their toes as we move into distribution season.

Deutsche Boerse and SIX Swiss Exchange have announced that they are buying out Dow Jones’ one-third stake in Stoxx for a consideration of 206.1 million euros, or $306 million.

Following the transaction’s completion, which is due to take place early next year, Deutsche Boerse will have a controlling stake in Stoxx of 50 percent plus one share and will fully consolidate it for accounting purposes.

In addition, SIX and Deutsche Boerse will set up a new entity to perform index calculations, in which SIX will own 50 percent plus one share.

According to a Stoxx press release, the transaction will allow both Deutsche Boerse and SIX to significantly expand their positions in the international index business, complementing their established DAX and SMI index families.

The sale could be a precursor to the long-rumored sale of Dow Jones Indexes. The Wall Street Journal reported in August that News Corp. was considering selling the venerable index provider, which has annual revenues of approximately $130 million to $170 million.

I’m going to ignore Matt’s twitter-length rebuttal of my last post, and instead point to an excellent set of data that just appeared in my inbox. State Street Global Advisors publishes (as many firms do) a monthly report on the ETF industry. What grabbed me this time was the short-interest report.

It should come as no surprise that ETFs are heavily shorted. After all, one of the great things about ETFs is that phrase “exchange-traded.” It means you can fold, twist and mutilate an ETF just like you can any other stock, and that means that if you can find it to borrow, you can short it. And since many ETFs are phenomenally liquid, they can be pretty easy to locate for shorting.

Overall, short interest in ETFs as reported on Oct. 15 was 11.84 percent. This is substantially higher than the number for the market as a whole; NYSE short interest was 3.51 percent overall. It’s worth nothing that this is a fairly high historical level for the NYSE—it hovers a bit above 2 percent over the last 10 or so years. Given the recent rally in many segments of the market, I’d actually expect it to be high. But what I wasn’t expecting was the extraordinary short-interest levels in certain sectors of the market:

Let’s cut through the haze here a bit. The “Size: Large-Cap” means the S&P 500 SPDR (NYSEArca: SPY). It is—as of the end of October—the most heavily shorted issue on the NYSE, with some 287 million shares short at the end of October. With some 700 million shares outstanding, this explains the lion’s share of that line item. I was equally unsurprised to see the heavy short position in financials, a figure dominated by the sizable short interest in the Financial Select Sector SPDF (NYSEArca: XLF), or small-cap stocks (explained primarily by a huge short interest in iShares Russell 2000 ETF (NYSEArca: IWM), as they’re up nearly 75 percent from the March lows.

But consumer staples? Consumer staples, most easily tracked by the Select Sector SPDR of the same name (NYSEArca: XLP) or the competitive iShares product (NYSEArca: KXI), has been a laggard in the recent stock market rally. While consumer discretionary stocks have been on a tear, putting that sector up 43 percent in the last year, consumer staples—which includes stocks like Procter & Gamble and Wal-Mart—are up just over 10 percent. From the March lows, of course, all did better, but no matter how you slice it, staples have been a laggard, not a leader.

Granted, you can only call something that has rallied 40 percent a “laggard” with a bit of a wink, but compared with the near-double of consumer discretionary stocks? This surprising bearishness is completely borne out in the options market, where there are 12,611 puts outstanding for November, vs. just 2,759 calls (for a 4.5:1 put/call ratio). By contrast, in XLY, there are 19,471 November puts outstanding to 7,264 calls (or 2.7:1).

Personally, I don’t generally play around with rotating sectors, but this did come as a shock to me. Since ETF shares are destroyed and created based on trading and investment demand, the implication here is that three out of every four shares of XLP exist at the whim of people making negative bets on the sector (of course, those three shares also represent someone else’s long bet, since every short position has an offsetting long somewhere out there.

With all the daily blather about moving averages, double-tops and candlestick formations, this is one indicator I can put some faith in, because it’s a reasonable representation of real traders’ sentiment, and a substantial amount of pent-up purchasing should those shorts decide to cover.

More realistic would be something like $5 billion. But let’s put the over/under at $10 billion by 12/31/2009 and put something interesting on the line, shall we?

Seriously. One-hundred billion would make Schwab the third-largest ETF provider in the world at current levels, surging past ProShares, PowerShares and Vanguard and nipping at the heels of State Street Global Investors. Having a built-in distribution system is a good thing, but it isn’t THAT much of a good thing.

And I’ll say this: They better get busy if they’re even going to reach $10 billion. We’re one week into the project and they’re sitting on a combined $17 million spread among four products.

Obviously, one week is not a legitimate test. My point is that Schwab moving into ETFs isn’t like flipping a switch. The bigger impact will be felt as they educate a broader audience of retail investors and financial advisers on the virtues of ETFs in general. That will take time. Eventually, those investors will start to dip their toes into the water with SCHB, maybe build assets in that over time and then branch out as well into a broader pool of ETFs. That’s why I think Schwab will help significantly grow the ETF industry, even above and beyond whatever assets they attract themselves.

I do think Schwab could eventually be a major player in the ETF industry. But it’s not going to happen overnight, and it’s not going to happen to the tune of $100 billion in a year, either.

Zecco? Really Matt? Honestly, for investors who are holding big accounts at Zecco, Schwab isn’t likely to be an issue in any case. Zecco, for those who don’t know the firm, is a super-low-discount broker, offering everything from bargain basement foreign exchange trading to $5 options. A few ETFs are unlikely to even be on the radar of Zecco customers.

I think the real target for Schwab’s new ETFs is the money Schwab’s existing customers have in ETFs.

Schwab’s huge. They custody $1.3 trillion for their 5.3 million customers, and process over 300,000 trades each and every day. Perhaps most importantly, Schwab acts as the back end for over 6,000 independent advisers in their adviser services business.

It’s a mistake to think that Schwab, as a broker, is in the transaction business. Fundamentally, they’re in the banking business. Schwab makes 35-40 percent of its revenue, quarter in and quarter out, by loaning money to its customers on margin and by investing cash balances for better rates than they have to pay through in margin balances. Another 25 percent of their revenue comes just from investment management fees (with another 10 percent from the annual fees mutual funds pay to be in their OneSource program). Commissionable transactions make up just 20 percent of their revenue stream.

Now, you and I both know that exchange-traded funds are the future. I can easily see a world five-10 years from now when ETFs have become such a dominant force that direct mutual fund accounts are seen as a quaint throwback for folks who just can’t give up their opaque active management addiction. But this rise in ETFs does absolutely nothing for Schwab’s bottom line. They’re facing a terrible margin environment in their biggest revenue line, and the death of the mutual fund industry for that other 35 percent. Every Schwab client who moves away from mutual funds and into ETFs is a flat-out money loser for them, now and forever.

Schwab’s move is a tacit acknowledgment that this is where the money is. Ten basis points may not seem like much, but for a company pushing trillions around, a billion here and there is big business. Schwab, like most asset management firms, has been suffering from declining asset balances. This move aims to recapture a large portion of existing client assets through marketing, low fees, and, yes, no transaction costs.

Why does the transaction cost matter? Because it means a financial adviser can start dribbling her client’s cash back into the market without showing any costs for the transaction. The more I talk to advisers, the more I’m convinced that those $15 transaction costs have a deleterious effect on their client relations out of proportion―many zeros out of proportion―to their actual impact on their clients’ wealth.

And how big could the Schwab move be? Well, let’s assume for a moment that Schwab has 20 percent of all ETF assets under custody. That’s not an unreasonable guess, since they have about 20 percent of the retail market (I’m ignoring the large institutional presence in ETFs for this, I admit). This would mean that—just to pick two-bit ETFs—Schwab is holding some $20 billion in the SPDR S&P 500 (NYSEArca: SPY) and iShares S&P 500 (NYSEArca: IVV) ETFs. I think it’s entirely reasonable that this move could recapture at least half that position, putting $10 billion in Schwab’s Large-Cap ETF (NYSEArca: SCHX). If you run the same math on the rest of the large-cap ETFs, and the ETFs in the other seven asset classes Schwab’s competing in, I think it’s in the realm of possibility that they’ll have gathered $100 billion in assets by the end of next year, solely from poaching off existing ETF assets in existing Schwab accounts.

And this, of course, is only a fraction of their real target market.

No, Schwab won’t be grabbing Zecco customers by the handful. They’ll do just fine getting a big fat slice of their own customers’ pie.

I’ve been thinking about the Schwab ETF launch all week, trying to figure out if it’s a game-changing event or an overblown bit of marketing. I think it’s a bit of both.

The big news, of course, is that Schwab is entering the ETF market and breaking new ground on fees. It has launched four ETFs that offer the lowest expense ratios in the world: As low as 0.08 percent for U.S. broad market exposure. The new Schwab Total Market ETF (NYSEArca: SCHB) and Schwab Large Cap Equity ETF (NYSEArca: SCHX) are now the lowest-cost mutual funds available to retail investors.

What’s more, Schwab is offering zero commissions for Schwab customers who buy or sell the ETFs.

That’s a big deal. Commissions are a huge hurdle for retail investors looking to allocate to ETFs. A retail investor placing $1,000 at a time should think carefully before buying ETFs: Even low commissions of $10/trade can eat up returns. A $10 commission on a $1,000 purchase is equivalent to paying a 1 percent load. For most investors, that cost can overwhelm the advantages ETFs offer in terms of low expense ratios and tax efficiency.

I’ve been writing about the importance of eliminating this commission hurdle for years, and I applaud Schwab for doing it.

(Of course, Schwab isn’t the first to eliminate commissions: Zecco offers zero commission trading, and both Wells Fargo and Bank of America will let you trade for free if you keep $25,000 in their money market funds. But Schwab is a well-established brand with a huge client base and a built-in distribution system. For it to offer zero commission trading with no major “catch” is a big deal.)

So it’s with a bit of hesitation that I say that, at least out of the gate, I do not expect these ETFs to gain a huge amount of assets.

We’ve seen firms like Fidelity and E*Trade try to swoop into the indexing world before with ultra-low-cost mutual funds, only to fail. I’m not sure retail investors brook much difference between expense ratios of 8 basis points and 10 basis points. At a certain point, for retail investors, you end up talking small numbers.

Those differences in expense ratios can be overwhelmed by factors like how well the funds track their benchmarks and whether the sponsoring firms arrogate securities-lending revenues on the portfolios. Schwab does have the skills to run excellent index funds, but it will have to prove itself as an operator of these ETFs for a while before people buy in en masse.

For larger investors, the critical question is how these funds will trade.

There will be huge swaths of ETF investors who will not go near these funds until they’ve established a large asset base and can provide the kind of limitless instant liquidity offered by funds like the S&P 500 (NYSEArca: SPY): Hedge funds, other mutual funds, day traders and the like will be willing to pay commissions to ensure access to the deep pools of liquidity these funds provide. So far, the Schwab ETFs have been trading at decent spreads. But larger investors may still be concerned about the costs and time involved in moving large block trades near fair value. There are ways to do it with any ETF, but it will be harder in SCHX than it is in SPY for some time.

At least initially, Schwab ETF assets will be driven more by long-term buy-and-hold investors. It’s ironic given that the funds’ key selling point is “free trading,” but I think that’s true. And the simple truth is that buy-and-hold assets grow slower than fast-money trading assets. So look for a slow build on the Schwab ETFs rather than any runaway asset train.

There is one thing, however, that’s for certain: Schwab’s huge push to market these ETFs to its clients and to the retail investing public will drive increased awareness of the ETFs in general. In that sense, I think the Schwab ETFs absolutely will help drive the next major leap in growth for the ETF assets.

And over time, I expect the Schwab funds will gain significant assets. It just won’t happen overnight.

Paul did a great job covering the credit risk, although I tend to side more with Matt on that part of the argument. But my real problem with ETNs is trading them.

We can argue about chicken/egg all you like, but the reality is this: The very most interesting ETNs, the ones that would be tough to deliver in an ETF package, are the ones with the worst trading problems. Right now, the top of the league table in “holy cow, look at the spreads” is dominated by ETNs.

The reasons for this are simple: While it’s true that an Authorized Participant can roll up 50,000 shares of any ETN (at least the iPath ETNs) and turn those in for cash at NAV, that AP has to go get those shares from somewhere. When the trading volume plummets, that means it’ll be tough to get on the open market. To make matters worse, most of the fun ETNs are interesting precisely because their underlying markets (individual industrial metals, carbon credits, emerging market currencies, etc.) are difficult to get at.

The real reason these products trade so poorly is that they are truly forgotten. I don’t care how much you love them, Matt; when you can’t even find the documents for the Barclays GEMS Index ETN (NYSEArca: JEM) anymore (unless you go hunting at the SEC), how are investors supposed to have any confidence? There’s no arb mechanism in place to keep JEM near its index value, because nobody in their right mind is going to put on a 15-way currency forward contract in order to offset the risk of handing someone their ETN shares. Instead, JEM will simply trade all over the place until it finally, blissfully expires in 2038, or until Barclays Capital decides to put it out of its misery.

And this is a product that was launched just 20 months ago. Let’s be clear: With the note issued, and the full value of that note presumably hedged on a ledger somewhere in London, there is zero incentive for Barclays to ever pay attention to JEM again. Instead, they can just happily collect their 89 basis points until it trades itself into the ground. With just over $3 million left in the notes, that’s not much money―about $30,000 by my HP 12c. But that may be more money than it would cost in lawyers’ fees to actually shut the thing down.

I don’t mean to pick on Barclays―every issuer has their great products and their forgotten ones. I could make the same case for virtually all the ETN issuers. With most ETF products (with a few notable exceptions in illiquid asset classes), investors can be reasonably sure that if they exercise some basic common sense, they can get in and out of smaller ETFs, because the arbitrage mechanism for even the craziest one-off U.S. equity idea will still work.

These particular forgotten stepchildren, though, are land mines for the unwary.

Matt’s argument is that “most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath ETNs) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.”

In other words, even if you become concerned about the credit risk of the issuer and there is insufficient liquidity in the secondary market for you to trade, you can get out of a position by selling it back to the ETN issuer.

I agree with Matt that the tax treatment of ETNs gives them a huge advantage for US investors (ETNs are taxed at long-term capital gains tax rates and only on a deferred basis when sold, rather than annually like ETFs). ETNs also offer superior tracking ability since the issuer bank guarantees to pay you the relevant index return.

It’s also undoubtedly true that the credit risk component in banks’ unsecured debt (of which ETNs are a part) has dropped substantially this year, as can be easily seen by plotting a chart of credit spreads or from a glance at the counterparty risk index, so the market is telling investors that the risks of ETNs are nowhere near as large as they were (less than a third the levels of February this year, in fact, if you look at an average of issuers’ CDS spreads).

All the same, I’m a little uneasy about his argument.

Matt’s reassurance that you can put back an ETN holding to the issuer within two days, giving you time to get out if there are problems, sounds fine in theory but may not offer you full protection in practice.

There was a fascinating article yesterday on Bloomberg in which reporters Richard Teitelbaum and Hugh Son tell us that during the summer months of last year, AIG was trying to write down – by up to 40% – the value of credit default swaps it had written to banks.

The central thrust of the Bloomberg article is that the Fed, which paid out AIG’s unsecured creditors at par, was more generous than it needed to be by paying out counterparties in full rather than enforcing a “haircut”.

The reporters quote Janet Tavakoli, a credit market specialist, as saying, “There’s no way they should have paid at par. AIG was basically bankrupt.” As an example of a haircut being applied in similar circumstances, the article cites a case involving Citigroup Inc., which last year agreed to accept about 60 cents on the dollar from New York-based bond insurer Ambac Financial Group Inc. to retire protection on a US$1.4 billion CDO.

What’s the relevance of all this to ETNs? Well, the whole question of whether unsecured bank creditors (such as ETN holders) should be protected by the authorities or forced to accept some cut in the amount they are due if the institution concerned gets into difficulties (or, for example, to suffer a forced conversion into equity) has been swept under the carpet since credit market concerns peaked earlier this year, but it hasn’t gone away.

If anything, given public disquiet at the way banks have gone back to “normal” in their pay policies while still relying on taxpayer support, I’d argue that it would be much harder for governments to convince the public that financial institutions must be saved at all cost should we enter a second round of the credit crisis.

But, more importantly, the Bloomberg article tells us that a writedown of creditors’ claims against AIG could quite conceivably have been negotiated and then imposed across the board with little or no warning. Such negotiations were apparently going on in private and, while they didn’t lead to any settlement, it would be foolish to imagine that such a scenario could not happen again.

So, all in all, Matt, while I agree that unsecured debt exposure to banks via ETNs may well make sense for a number of reasons, this type of investment instrument is likely to remain a poor cousin to ETFs in the tracker market. With almost all ETFs, investors are collateralised and shouldn’t have to lose sleep at night over credit risk.

[This blog originally appeared on IndexUniverse.eu, the leading source for insight and analysis into the European ETF market.]

According to the National Stock Exchange, U.S. ETNs had $6.9 billion in assets at the end of September. ETFs were literally 100 times more prevalent, with $697 billion in assets. That included $62 billion just in long commodity ETFs.

That’s just crazy. And it highlights investors’ irrational fear of the ETN product structure.

I remember when ETNs first came to market in 2006: Investors couldn’t get enough of them. Barclays Capital launched the iPath Dow Jones-UBS Commodity Index ETN (NYSEArca: DJP) and it quickly gathered assets.

The reason was simple: ETNs offered two huge advantages over commodity ETFs.

First, they promised perfect tracking. If you bought an ETN, you would receive the full return of the benchmark, minus the fund’s expenses. Period. That’s handy, since commodity ETFs have been more prone to tracking error than most equity funds.

But the real advantage of commodity ETNs was (and remains) their tax treatment. The prospectus said (and still says) that ETNs can be treated basically like zero-dividend stocks for tax purposes. If you hold a commodity ETN for longer than a year, you only pay 15 percent long-term capital gains taxes when you sell. What’s more, you don’t have to pay any taxes until you sell.

By comparison, futures-based commodity ETFs like the PowerShares DB Commodity ETF (NYSEArca: DBC) are treated like futures by the IRS. That means that gains are marked-to-market each year, and investors must pay taxes on those gains at a blended 60 percent/40 percent long-term/short-term capital gains tax rate. For a high-earning investor, that puts the blended tax rate at 23 percent, payable every year.

That’s a huge difference. An ETN investor pays a 15 percent tax rate, deferrable until the ETN is sold; the ETF investor pays a 23 percent tax rate, due annually.

Risk Factor

Why don’t we see more assets flow into ETNs? The only possible reason (short of simple ignorance) is the credit risk.

The N in ETN stands for note, and that’s what they are: unsecured debt notes. Like any other uninsured promise-to-pay, their entire value depends on the credit of the issuing bank. If you buy a Deutsche Bank ETN and Deutsche Bank goes bankrupt, you lose all your money.

It’s not a theoretical fear. The very few people who held the three Lehman Brothers ETNs to the bitter end lost their money when the firm went bankrupt. It’s obvious, looking at the numbers, that the credit crisis stopped the growth of ETNs in their tracks.

But let’s be honest: For an investor who is paying attention, the likelihood of losing money in an ETN is vanishingly small. Most ETNs offer daily redemptions at net asset value, meaning that (even ignoring the quoted market) an investor of size (50,000 shares in the case of iPath) can sell out of the product within 48 hours and get the full net asset value of the note from the issuer.

So ask yourself: How likely is it that Barclays Capital or Deutsche Bank, or whomever is underwriting a particular ETN, will go bankrupt with less than 48 hours’ warning? Or to put a margin of safety on it, how likely is it that they will go bankrupt in the next week?

The answer right now is: not very.

For taxable investors who pay attention to the market, read the newspaper, monitor stock quotes, etc., the likelihood of being caught out on an ETN is tiny. Meanwhile, the risk of overpaying the IRS if you buy and hold a commodity ETF is 100 percent.

ETNs don’t make sense for all investors. In nontaxable accounts, I actually prefer ETFs. If you want a truly fire-and-forget investment, where you can walk away for a year or two, ETFs are the way to go. But for taxable investors who pay close attention to their accounts, there’s a lot to be said for the ETN structure.

(One caveat here: There is a risk that the CFTC’s plan to enact new regulations in the commodities market will force some ETNs to shut down. If that happens, investors would get their money back, but they could be hit with short-term capital gains if they’ve held a note for less than a year. It’s tough to gauge how large a risk this is, but it’s legitimate.)

A new ETF giving access to Chinese A shares is to be launched in Singapore next month.

The United FTSE Xinhua China A50 ETF, to be offered by the asset management subsidiary of United Overseas Bank (UOB), will be the first China A-shares fund to be denominated and traded in Singapore dollars.

Chinese A shares are denominated and traded in Chinese yuan and listed on the Shanghai or Shenzhen stock exchanges. Historically, access to the A-shares market in China has been limited to Chinese nationals and qualified foreign institutional investors (QFIIs) approved by the China Securities Regulatory Commission (CSRC).

The FTSE Xinhua China A50 Index is designed to measure the performance of the 50 largest China A-shares companies, based on market capitalization.

ETFs tracking A shares are already dominant in the Asian market. The Hong Kong-listed iShares Asia Trust, which also tracks the FTSE Xinhua A50 Index, is the largest Asian ETF, with $6.7 billion under management. The China 50 ETF, which tracks the Shanghai Stock Exchange 50 Index, has $3.2 billion under management and is the most heavily traded Asian ETF, with an average daily volume of $200 million in the week ending Oct. 16.

According to Singapore’s Business Times, while the upper limit on the QFII quota for any single investor to invest in China stocks is $1 billion, the quota available for the United FTSE Xinhua China A50 ETF is $100 million, as UOB and Rabobank—the counterparty and designated market maker for this ETF—each have a QFII quota of $50 million.

The iShares Asia Trust does not hold A shares directly; rather, it holds Chinese A-Shares access products (CAAPs) issued by a connected person of a QFII. A CAAP is a security (such as a warrant, note or participation certificate) linked to an A share that synthetically replicates the economic benefit of the relevant A share but carries counterparty risk to the CAAP issuer.

Because of the existence of QFII quotas, A-share ETFs have often traded at premiums to net asset value during periods of significant investor demand.

Outside Asia, investors are generally restricted to ETFs tracking H shares (firms that are incorporated in China but listed in Hong Kong); Red Chips (firms incorporated in Hong Kong with substantial mainland interests, controlled by the Chinese government); P Chips (Hong Kong-incorporated firms with substantial mainland interests that are not under government control); and China-related shares listed on overseas stock exchanges. (IndexUniverse.eu recently published a feature on the range of options available to investors interested in the Chinese stock markets.)

According to the issuer, the total expense ratio for the United FTSE Xinhua China A50 ETF is estimated to be 0.95 percent. The iShares Asia Trust has a TER of 1.39 percent and the China 50 ETF has a TER of 0.50 percent, as per the latest edition of Deutsche Bank’s ETF Liquidity Trends report.

Matt, I know you love it when issuers come up with creative ways to game the arbitrage process to increase liquidity and narrow tracking error, but the problem here is really more fundamental. The way I see it, bond ETFs will always be fighting two uphill battles.

The first problem is just woolly thinking with regard to premiums and discounts. The reality is that at any given point in time, the true NAV of any portfolio (ETFs included) is a moving target. The way I think about it, there are actually three claimants to the title of “true NAV”:

1. There’s the rollup of all the “bids” in the underlying securities. This would be what the ETF basket would sell for if you could shove the portfolio through the top of the market.
2. There’s the rollup of all the “asks” in the underlying securities. This is what an AP would pay if he had to go buy the basket to deliver to the issuer to make new ETF shares.
3. There’s the rollup of the last traded price on the tape for the underlying securities. This is what gets used to create the NAV at the end of the day.

Each of these NAVs is actually completely fictitious, of course, but they’re the best we have. They’re fictitious because they don’t represent the true market value of one share of an ETF, or the true market value of the entire ETF. The fact that the NAV is essentially always wrong is what allows market makers to stay in business.

Think of it this way: If I have 1,000 shares of IBM stock, it’s not worth exactly the same amount per share as a 100,000-share trade printed last night at 4 p.m. It’s worth whatever I can actually sell it for when I go to sell it. Yet I measure my portfolio against a collection of these best guesses. When we talk about premiums and discounts in any ETF, we’re usually looking at these end-of-day NAVs compared against the end-of-day bid/ask midpoint for the ETF.

Honestly, unless there is a wide disparity between these two (which we’ve certainly seen in some ETFs, notably the U.S. Natural Gas Fund (NYSEArca: UNG) and some high-yield funds like the iShares iBoxx High Yield Corporate Bond Fund (NYSEArca: HYG)) or there’s a consistent premium/discount, I think it’s a bit silly to get hung up on the numbers.

Trends? Sure. But a day or two here or there where there’s a 1 or 2 percent gap between two numbers you can’t trade at? Sorry, not going to sweat it.

The second problem is simply that these funds are bond ETFs. Bond funds have to deal with the same NAV issues as equity funds, but with far more underlying uncertainty. Not only are they extremely optimized―as we’ve mentioned previously in our discussion this week―but the prices for bonds themselves are largely a matter of voodoo and tea leaves.

For something like Treasuries, it’s no big deal―the bonds trade constantly. For corporates, issuers are almost entirely reliant on pricing services that make up imaginary prices for bonds that haven’t traded in minutes, hours, days or weeks based on models that combine the current yield curve, credit ratings, recent trades, sunspot activity and the price of tea.

Again, I’m not saying there’s a magic solution. I actually think the current system works remarkably well. But bonds are simply noisy.

Add the noise of bonds to the noise of doing premium/discount calculations, and the idea that you can get any kind of real, short-term information from a spot-check seems spurious. Bond investors should be thinking long term, and their analysis of bond ETF spreads and discounts should take the long view too.

Idea No. 1: Optimize The Creation Basket (At Least Sometimes)

The first idea is drawn from the way Vanguard manages its bond ETFs. You touched on this in your blog, but you really didn’t get to the core of what makes their bond ETFs interesting.

In the Vanguard structure, ETFs are one share class of a broader mutual fund. One advantage of this, as you mentioned, is that an ETF like the Vanguard Total Bond Market ETF (NYSEArca: BND) gets to tap into a much broader portfolio of securities. While a fund like the iShares Barclays Aggregate Bond Fund (NYSEArca: AGG) holds 247 bonds, BND is part of a larger mutual fund that holds more than 3,000.

That’s good in general: The more diversified portfolio, the better. But it’s good in a more interesting way, too.

Vanguard can’t ask Authorized Participants who are creating new shares of BND to go out and buy tiny slivers of all 3,000-plus bonds in the portfolio. Instead, they ask for a small subset of those: about 50 or so. Those 50 are chosen so that their performance will generally match up to the performance of the broader portfolio. Over time, Vanguard can either rotate the creation/redemption basket or use fund flows from other share classes to diversify its portfolio so that it doesn’t become overly concentrated in these 50 names.

By contrast, AGG’s creation basket is nearly the same size as its fund: APs must buy up 200 or so bonds to create new shares. So the creation process is more difficult, even as the end-portfolio is narrower.

I’m not saying all ETF providers should switch to the Vanguard model; it has its own issues. But maybe non-Vanguard ETFs should look at optimizing the creation/redemption basket to streamline the arbitrage process. Maybe they could rotate that basket frequently to make it more difficult for others to front-run the trades. It’s an idea worth considering at least.

Idea No. 2: Allow Cash Creations And Maybe Redemptions

Another thing providers could do to limit the premium/discount issue is to allow cash-based creations and redemptions―if not all the time, then in special situations. We know from the muni bond ETFs that cash-based creations largely eliminate the problem of premiums (although they do nothing for discounts). They may raise the internal costs of the ETF slightly, but that is debatable.

Allowing cash-based redemptions would be difficult, because the sponsor would be stuck with the risk of holding the bonds in an illiquid market. You couldn’t do it on a one-for-one basis. But perhaps you could implement a high fee to execute a cash-based redemption: Charge APs the equivalent of 2 percent or so to execute a cash-based redemption. That would at least limit the size of potential discounts, and the net risk to the sponsor would be limited, and in many cases, could be hedged in the derivatives market.

Idea No. 3: Use Swap-Based Structures

I’m traveling in London right now, so here’s an idea from across the pond: What about removing the risk of tracking error and creations/redemptions altogether by moving illiquid bond categories to a swaps-based structure?

I know the answer: This would go absolutely nowhere commercially, as investors are rightfully afraid of anything with “swap” in the name. But the truth is that swaps can be managed with very little true counterparty risk. If you “true-up” the swap on a daily or weekly basis, and if you have multiple swap counterparties, you can get the real credit risk down toward 5 percent or less of total assets. If it were handled transparently and on a rules-based basis, I think it would offer a real alternative to the replication structure that dominates in the U.S.

I Like Bond Index Funds And ETFs

I received a lot of emails about my last blog, so let me clear up a few things. First, I believe in bond indexing: The data are unequivocal that almost all active bond managers trail their benchmarks. I hold bond index funds in my own portfolio. But I don’t think they’re perfect, and I think there are simple ways they could be improved.

I also like bond ETFs, with a few caveats. The Treasury, international Treasury and TIPS bond ETFs seem to work just about perfectly. As ETFs start to incorporate corporate bonds, things get more challenging, as premiums and discounts start to rise.

I don’t think the problems are intractable. I just think they should be recognized, understood by investors and tackled head-on.

Recent filings with the Securities and Exchange Commission indicate that Barclays Global Investors (soon to come under ownership by BlackRock) is looking to launch a family of municipal bond exchange-traded funds targeting certain maturity dates.

Each fund would hold the underlying securities from its respective index to full maturity, at which point the fund would simply retain a cash position. When the last holding of each fund reaches maturity, presumably on or about Aug. 31 of the targeted year, the fund’s assets will be distributed to shareholders, much like the underlying bonds themselves.

The funds would track indexes in the recently launched S&P AMT-Free Municipal Bond Index Series. The indexes target investment-grade muni bonds that mature between June 1 and Aug. 31 of a specific year. Eight individual indexes cover the years 2012 through 2019, though the fund filings so far only cover 2012 to 2017. For example, the iShares 2012 S&P AMT-Free Municipal Series ETF would track the S&P AMT-Free Municipal Series 2012 Index.

While exchange-traded notes come with maturity dates, and the MacroShares products also have set distribution dates, these are the first ETFs to target securities whose maturities fall within a specific date range. Essentially, they will act almost like muni bonds themselves, given that they will make tax-exempt distributions and return an investor’s entire investment on a specific date. However, any risk would be spread out over an entire portfolio of bonds, likely adding further appeal for investors who like munis’ lower-risk profile.

The funds could be particularly useful for people looking to implement fixed-income laddering strategies or park their cash in a relatively low-risk investment for a set period of time. Certainly, they seem like they could be useful tools for investors using highly customized strategies. It will be interesting to see what kinds of assets they attract and if more funds with later target maturities follow.

The proposed family includes the following (click on the fund to view the prospectus):

iShares 2012 S&P AMT-Free Municipal Series

iShares 2013 S&P AMT-Free Municipal Series

iShares 2014 S&P AMT-Free Municipal Series

iShares 2015 S&P AMT-Free Municipal Series

iShares 2016 S&P AMT-Free Municipal Series

iShares 2017 S&P AMT-Free Municipal Series

The projected fees were not disclosed in the filing.

The Death Of The Dollar?, the November/December 2009 issue of the Journal Of Indexes, focuses on currency and related strategies, with contributions from Invesco PowerShares' Bruce Bond, the International Securities Exchange's Steve Meizinger and Marc Chandler and Jeffrey McCarthy of Brown Brothers Harriman, not to mention a currency primer by Index Publications' own Dave Nadig, Matt Hougan and Lara Crigger.

Other articles in the publication include a look at how EMH weathered the financial crisis of 2008 by David Blitzer, the first installment of a three-part series on improving fund evaluation techniques by Gary Gastineau and a study from David Blanchett on how to figure out the "passive" portion of an actively managed portfolio. And let's not forget the ETF crossword puzzle on the back page!

You can view the entire issue here.

I don’t disagree that the big bond indexes are busted. The problem is that (despite what you read on the Web sites) the big bond indexes share far more in common with the Dow than they do with the S&P 500.

The Lehman Aggregate and its various offshoots (and Barclays Capital rebrandings) were really designed to represent what was happening in bonds, not to be a buy-list. This isn’t news to any bond investor really—none of the big bond ETFs owns anything like the actual composition of the indexes they purport to track. The performance of the iShares and SPDR versions of the Barclays Aggregate (NYSEArca: AGG and NYSEArca: LAG, respectively) can at best be considered correlated, but hardly perfect matches.

And for obvious reasons. AGG holds 247 out of a potential 10,000 bonds in the actual index, LAG just 191. And while there’s obviously a lot of overlap, little differences matter in fixed income. Checking yesterday, AGG’s largest holding was a 4.7 percent allocation to a 30-year AAA-rated government bond with a 4.5 percent coupon, while LAG had 8.13 percent of its assets in a similarly rated 30-year bond with a 5.5 percent coupon. LAG counts a Citigroup bond due in 2011 in its top 10 holdings, whereas AGG’s Citi exposure is measured in basis points.

While neither fund is likely to blow up over these variations, they are going to perform differently.

All this noise is why the conventional wisdom has so long remained that bonds were the one corner of the market where active management made sense. Let’s face it, the decision to have Citi at 2.57 percent of the LAG portfolio is fundamentally an active call, regardless of the algorithm or policy that drove it. It’s also a stark contrast to the Vanguard model, where the shared portfolio with the institutional and retail fund products means there’s actually a 12,000 bond portfolio underneath the Vanguard Total Bond Market ETF (NYSEArca: BND). It helps that the ETF invests alongside all the other Vanguard share classes, and thus has 23 years of accumulation history and $63 billion to play with.

The real issue here is that the idea of monolithic bond indexes just doesn’t work. There may only be one security called “MSFT” in the S&P 500, but how many dozens of flavors of Citigroup bonds are still floating out there? I count 83. Do the math on the number of potential issuers out there and it’s a nearly intractable problem.

Simply calling on the spirit of Rob Arnott to invent a better index isn’t the answer. Arnott and his posse have already done the heavy lifting here: They published a paper in 2008 which did exactly what you want them to do—apply all the fundamentals to creating a new index. They found that while the fundamental indexes they posit do backtest better than the simple cap-weighting systems currently used, they have a huge matching problem: Only 65 percent of corporate bonds match up well with a corporate entity on which fundamental valuation techniques can be used.

That doesn’t mean it doesn’t work—it just means that a fundamental corporate bond index brings a pile of flaws all its own to the table, yet another source of noise in an already noisy marketplace.

Fixed income has been the fastest-growing corner of the ETF market this year, pulling in $31.5 billion in new capital through September. Those inflows worry me, for a number of reasons.

First, as I’ve written about previously, those inflows have forced some corporate bond ETFs to trade at large premiums to their net asset values. Those premiums are sustainable so long as investors continue to buy. Unfortunately, like all ETF premiums, if fund flows reverse, those premiums can collapse and turn into discounts, and investors will be left holding the bag. (See related story here.)

But there’s an even more fundamental problem with corporate bond ETFs, which stems from the way their indexes are constructed. This is the elephant in the room in corporate bond indexing, and it amazes me that it is rarely discussed.

Ready? Most corporate bond indexes weight holdings based on their total debt outstanding. To put it more bluntly, the more debt a company has, the higher its weight in the index.

On the face of it, this is crazy. The idea that investors want to pile more money into the most indebted companies flies in the face of common sense. Where are the fundamental indexers when you need them?

This isn’t a new insight. Laurence Siegel of the Ford Foundation has been writing about it for years. It’s called the “bums problem”: Bond indexes tend to overweight corporate bums that run up huge levels of debt.

A look at the holdings of corporate bond ETFs like the SPDRs Barclays Capital High Yield ETF (NYSEArca: JNK) confirms these fears. Among the top 10 holdings by weight are gems like AIG, GMAC, Harrah’s and Intelsat.

I realize that the idea of junk bond indexing is to buy into notes that pay high yields, but there’s risk and then there’s RISK. Overweighting companies that issue more and more debt just seems absurd.

I’m not sure how you get around the bums problem. Some have suggested equal-weighting as a preferred methodology, but that “hands-off” approach has never appealed to me. There must be a way that combines liquidity, ability to repay and true credit quality.

As a way of measuring the market, weighting an index by debt outstanding makes sense. But as a way of investing in that market, it makes me nervous.

Credit Quality

Index-weighting methodology isn’t the only obvious problem with bond indexes. The other big fat elephant we dance around is credit ratings.

As far as I know, all the major bond indexes use official bond ratings from S&P, Moody’s and Fitch Ratings to determine which bonds are “investment grade” and which are “high yield.”

Didn’t we learn anything from the financial crisis? Can we really trust the ratings agencies to do their job?

Here I think there is a relatively easy solution. Why not use credit default swap rates to determine credit quality rather than the “official” bond ratings? We could define the split between “investment-grade” and “high-yield” debt based on the cost of insuring against default for the next five years. Let the market make the determination, in real time, rather than the troubled credit ratings agencies operating with a lag.

Now don’t get me wrong―Mr. Commodities wasn’t all doom and gloom. In fact, his talk was both informative and highly entertaining. But Rogers doesn’t sugarcoat things―he’s very matter-of-fact about his concerns and projections for the future. And most of them don’t bode well for the U.S.

I’ll be posting an interview with Jim Rogers on the site in the coming week, but for now, I just wanted to offer some highlights from his speech at ETF Securities' mini-conference and the Q&A that followed.

1. The 21^st century belongs to China

According to Rogers, the 19^th century was the era of the British Empire and the 20^th century was the U.S.’ heyday. But the 21^st century is China’s (though the rest of Asia is definitely going to get a boost too).

The reasons for this are many, but some points brought up by Rogers include the following:

1. The Chinese want to live like we do;
2. They are more eager to work;
3. They are better at saving;
4. There are 1.5 billion Chinese citizens (and 3 billion people in all of Asia), and we owe them money. They are, according to Rogers, “among the best capitalists in the world.”

There will be some setbacks, of course, Rogers says, but these are opportunities. “If you see setbacks in China, you should pick up the phone and get more involved,” he advised, before adding his favorite refrain, “The best advice of any kind that I can give you is to teach your children and grandchildren Chinese.”

China’s path to world domination started with Deng Xiaoping’s capitalist programs in 1978, and there hasn’t been any looking back since. Rogers views China’s dominance as nigh-on unstoppable except for one little thing: its water problem. There are parts of the country that are running out of water, and when the water disappears, Rogers points out, so does civilization. However, the country is acting aggressively to combat the problem, and he doesn’t view it as that much of a threat.

2a. Jim Rogers is not a Ben Bernanke fan

Yep, it’s a fact. No “Team Bernanke” shirts for Jim Rogers (who said to scattered applause during the Q&A session that if he was in charge of the U.S. economy he would “abolish the Fed and resign.”).

Rogers is appalled by the government’s actions—Bernanke’s in particular. The U.S. government’s strategy calls for the debasement of the dollar, he says, calling it a “horrible policy.” While he concedes it can work in the short term, it NEVER works in the mid- or long term.

“He’s going to run those printing presses until we run out of trees, because that’s the only thing he knows,” Rogers said of Bernanke.

Add that on top of the country’s rapidly growing astronomical debt, and Rogers believes you’ve got a recipe for disaster.

2b. The U.S. dollar is screwed

Consider this a corollary to point 2a. Its status as a reserve currency is teetering on a precipice, in Rogers’ opinion, and he’s not alone. In fact, so many people are selling dollars right now that he’s sitting tight, waiting for a possible—and ultimately unsustainable—rally in order to exit the market. Of course, if it fails to rally and just drops again …

“I’ll just have to panic and sell like everyone else,” Rogers said.

3. Commodities, commodities, commodities

OK, as mentioned before, there are 3 billion people in Asia, most of whom are aspiring to play the home version of the American Dream game show. And let’s face it: American society is largely about consumption. We like stuff―we buy it, we wear it, we eat it, we flaunt it, we sometimes even bedazzle it (yeah, Google that). So that’s a lot more consumption on the global level. Rogers notes that while consumption is expected to increase exponentially, not a lot of capacity has been added in the last few decades for a lot of commodities. Meaning, not a lot of new refineries have been built, and not a lot of new resources have been discovered or excavated for a variety of commodities.

In terms of oil, Rogers cites the fact that Saudi Arabia has not seen any new oil discoveries but has consistently said for the past two decades that its reserves are at 260 billion barrels (in which time it has sold 60 billion barrels). He also points out that farmers are a rapidly disappearing species. So to sum up―that’s a lot more people competing for diminishing resources (including the all-important energy and food). Basic supply and demand theory pretty much takes it from there.

“Commodities are the second-largest asset class in the world,” Rogers noted. And they are “the best anchor” for your portfolio, he adds.

Rogers says the typical life span of a commodities bull market is 18-20 years. We’re currently in year 11 right now. Yeah, it could end tomorrow, but that whole supply and demand imperative could also extend this bull beyond its typical time frame.

During the Q&A session, though, the conversation took a darker turn. One questioner asked if the increased competition for resources might lead to war, and Rogers allowed it was a possibility, though he hoped it would not come to that. He pointed out that when a rising power clashes with an established power, the result is usually war, and said that research consistently shows that resource shortages lead to war. So, sure, commodities shortages might start World War III, but if you invest in the commodities themselves, you might at least be in decent financial shape when the shelling stops—and I’m not being flippant at all. War drives up the costs of commodities.

4. U.S. government bonds are the next big bubble

Well, would you lend money to us? Rogers says short-term bonds are probably OK, but he advises getting out of anything with a longer maturity. He calls it “inconceivable” that anyone would lend money to the U.S. for 30 years at the going rate, and notes that the U.S. was a creditor nation as recently as 1987.

“Now the U.S. is the largest debtor nation in the history of the world,” he said.

And for bond portfolio managers, he had some very pointed advice: “Get a new job.”

5. Protect yourself

The underlying theme of Rogers’ entire speech was that the world is changing, and here are some things you should know if you want to come out the better for it (and for your family members, clients, etc., to also come out the better for it) financially. Based on Rogers’ observations, it seems recognizing that change is a key step, but so is adapting to it (see advice regarding learning Mandarin, for example). And in Rogers’ eyes, commodities are a good way to achieve this protection. No investment is certain of course, but right now, he thinks commodities look pretty darn good.

Best Comment Of The Night

Addressing one audience member’s question, Rogers asked if the young man were an MBA. The questioner admitted to holding an MBA and was promptly told he should swap his MBA for an agriculture degree from Texas A&M.

“You should become a farmer,” Rogers said.

That’s an old line for Rogers, but he added a new wrinkle. If you’re not going to become a farmer, you should open the first Lamborghini dealership in Iowa. Because with farmers closing in on extinction just as the world needs more food, that’s probably what they’ll be driving in a few years.

The first of the two long/short quant ETPs is the Elements S&P CTI exchange-traded note (NYSEArca: LSC). I wrote about LSC for our subscription-only monthly publication ETFR, so if you are a subscriber, you can see the story here.

LSC is a long/short commodity-linked note monitoring six different groups of assets: energy, industrial metals, precious metals, livestock, grains and softs. Because the note only alters its positions once a month, investors can occasionally find themselves on the wrong side of the trade for up to a period of around three weeks. For example, last month the note had a 10.5 percent short position in precious metals, much to investors’ chagrin.

LSC has since dropped its short position in precious metals, but it does have a 35 percent short position in cocoa, livestock and grains. While that might be a sensible position, I worry that we may be entering a commodity bull market where investors may chase everything and anything in the futures markets for a while.

I also worry that, after the vigorous recent rally in gold, that metal may be due for a small pullback. In other words, it is likely that investors could find nearly half their portfolio invested on the wrong side of the trade.

Sophisticated Strategy

For all the potential volatility however, a long/short commodity strategy is one that makes sense long term. It’s unclear how long emerging markets consumption will continue to grow at a breakneck pace, and the underlying economic conditions in the West are hardly growth-oriented right now. If you are a commodities investor, ignore those who tell you to dump all your money into raw materials, and instead choose a sophisticated strategy. That’s what LSC is here for.

The second ETP I want to focus on is the ProShares Credit Suisse 130/30 exchange-traded fund (NYSEArca: CSM). Many of the same arguments for LSC apply to CSM, but they are a little different.

CSM is a 130/30 fund, meaning it is 30 percent short and 130 percent long. It invests in S&P 500 companies and alters its positions monthly. (See story here.)

Since it was launched in August, CSM has beaten the S&P handily. At last count, it is up 8.25 percent vs. 7 percent for the S&P during the same time frame, and the performance disparity looks even better for the fund in the past month.

Where these types of funds tend to get stuck, however, is during a time when technical indicators take a back seat to the news flow (there’s no quant fund I’ve heard of yet that accurately predicts news events). Unfortunately for CSM, such a time is ahead of us, with third-quarter earnings.

Right now, CSM is short firms such as Tiffany & Co., KB Home and Nicor—all of which have relatively tame earnings expectations and may well beat analysts’ forecasts. If that is the case, then CSM’s performance relative to long-only S&P funds such as SPDR S&P 500 (NYSEArca: SPY) could look less impressive at the end of this month.

If third-quarter earnings disappoint across the board (and this is what I think will be the case), there could be a fairly big sell-off in stocks. Because CSM is a long-biased fund, it will fall in price along with everything else.

A round of selling in equities would present a great time to take a position in a long/short quant fund such as CSM. In 2010, equities are still likely to rise on a net basis as the economy recovers, except that this time there are likely to be some significant price adjustments (particularly among financials).

That is where CSM’s model works best, since it can capture the capital outflows in some companies, while it still gains from an overall market uptrend.

Investors shunned most quantitative models for most of 2009; next year they will likely come back to outperform us with a vengeance.

This was the chart that grabbed me from the latest S&P GSCI report, which comes out quarterly covering the commodities markets:

This chart shows in stark, stark detail the craziness that is being a commodities investor. It looks at the total return of a fully collateralized position in a particular futures market (dark blue bar) vs. that same return minus the spot return (light blue bar). If the bars are the same length (as it nearly is in live cattle), that means that the spot return—the actual price of cows on the hoof—was completely flat, and the only return investors had (negative, in the case of Bessie) was from the combination of roll yield (the cost or benefit of contango or backwardation in the futures contracts), and the minimal interest earned on a notional collateral position. If the bars are unequal (like lead, for instance), the difference between the two represents gains in spot price. In the case of lead, the 120 percent year-to-date windfall has been almost entirely due to spot prices.

But the way I like to look at this chart is to think of it as the cost (or benefit) of being a futures investor, regardless of spot prices. That’s what those light blue bars represent. So in the case of crude oil, playing crude through futures costs you almost 60 percent. Spot crude has essentially doubled this year, moving from the low $30s per barrel to a recent holding pattern around $70.

Futures investors missed out on that entire run, thanks to having to roll their positions each month.

But the biggest goat by far here has to be natural gas. While in “what if” terms crude oil investors got robbed, the reality is they’ve essentially stayed even, maybe even up a few percent, depending on when you got in.

Natural gas investors have had absolutely the worst of all worlds. Not only has the spot price just been slaughtered this year—from around $6/MMBTU at the beginning of the year to around $3 now—the contango in the natural gas market has been crippling, meaning not only were you an idiot for being in natural gas, you were even more of an idiot for being in natural gas futures.

Don’t take that the wrong way—the market doesn’t mince words. Every trade has a hero and a goat. Maybe you were a genius because you were short natural gas futures.

What’s the relevance to ETF investors? Well, for the first time in history, there’s a very real chance you could have participated in this craziness directly with your Aunt Mildred’s retirement account or your daughter’s college fund. Every one of the commodities I’ve mentioned has a futures-based ETF available (you can even invest in live cattle if you’ve got access to London, with the ETF Securities Live Cattle ETF (London: CATL).

That run in lead could be had with the iPath Lead ETN (NYSEArca: LD), and we all know the big players in oil and gas (NYSEArca: USO and NYSEArca: UNG, respectively).

But there’s a deeper lesson under the hood in natural gas. I can tell you stories about how it’s classically seasonal, and how people make a killing trading it. I can even spin you a yarn about how it’s the cleanest of the fossil fuels, and how its eventual scarcity will make longs rich. But the futures market trumps all.

I can’t possibly say it better than S&P’s GSCI team did in this month’s report:

“Natural gas is probably the best demonstration of the ‘no free lunch’ law in commodity indexing, as evidenced by the S&P GSCI Natural Gas Index which commenced at 100 in January of 1994, ended September at 2.63. Over the same period, the natural gas future has increased about 125%. While 2008 served as a strong reminder ‘to know what you own,’ 2009 has reminded investors ‘to know how to be properly exposed to commodities.’”

100 to 2.63 in 15 years. Now that’s podracing.

A decade ago, the task of most mainstream financial advisers was relatively simple. They formed relationships with clients, developed a straightforward wealth-building plan, invested their clients’ money in a portfolio of mutual funds and tried to make sure that their clients didn’t do anything stupid while the market did the work.

To me, that last piece was always the most valuable. Having someone or something in between you and your money is often a good idea. A good adviser can dissuade you from acting on impulse, either rushing to buy the “next big thing” or rushing to sell something that has under-performed. In both cases, it usually saves you money in the long run.

For most advisers, however, the task of actually managing money was secondary. The best portfolios are almost always boring, and a decade ago, boring meant a simple split between U.S. equities and U.S. bonds, perhaps with some international equities thrown in. Some advisers would tilt their portfolios toward small caps or value, and a few on the bleeding edge would sprinkle in emerging market exposure.

Advisers who wanted to try to beat the market bought actively managed mutual funds. By and large, they used relatively simple metrics like trailing performance and manager tenure to pick one fund over another.

Those days are over. ETFs have changed the game, in two important ways.

First, they have broadened the universe of asset classes that an adviser can consider. An adviser today must do more than just choose between U.S. stocks, foreign stocks and U.S. bonds. They have to decide whether to weight emerging markets in line with their share of global market cap (11 percent) or their share of global GDP (24 percent). They have to choose whether to add international bonds to a portfolio or stick with the U.S. fixed-income market. They have to decide if commodities and currencies have a role in investor portfolios, and whether TIPS make more sense than Treasuries.

These decisions were possible in the good old days too, of course, but they were more difficult to execute, and often concealed behind the boardroom door of an active mutual fund manager.

Trickier Role

ETFs have opened up a hundred targeted areas of the market to advisers, all one trade away, all cheap. This has made the adviser’s job a hundred times more complicated as a result.

(I feel this pressure myself. I’m considering adding international fixed income as a new asset class to my streamlined 13.65 basis point ETF portfolio. It would be the first major change to that portfolio since I designed it in 2007. More on this in a future blog.)

The second change is even more fundamental. With ETFs, the burden of generating returns has shifted away from mutual fund managers and squarely onto the shoulders of the individual adviser.

Whether they use all ETFs or a sprinkling of ETFs, mutual funds and single stocks, the best advisers now embrace the idea that the fundamental driver of returns is a portfolio’s asset allocation policy. The chief goal of the underlying instruments in the portfolio is thus to provide exposure to an asset class or theme that the adviser wants to tap into, not to try to beat an underlying benchmark by a percentage or two.

I suspect that over the next few years, we’ll see the average fee charged by mutual funds decline as their services become less valuable, and they are forced to compete head-on with the one-two punch of good advisers with efficient ETFs at their disposal. Meanwhile, the average fee charged by financial advisers may go up, or at least stay stable, as their services become more valuable.

For investors, this means that the choice of adviser is becoming increasingly important. As I’ve said before, your cousin Charlie is no longer good enough.

There are some excellent financial advisers who will choose to outsource their portfolio management using model portfolios, and focus on client services; that’s legitimate, as long as the model portfolios they use are thoughtfully designed and carefully implemented.

But it doesn’t change the fact that the adviser’s role in generating portfolio returns is growing. And that means the value that you ascribe to picking the right advisers should increase as well.

We covered the story here.

The move wasn't that surprising. After all, when the CFTC revoked DB's position limits back in August, it was really just a matter of time before the two funds either got a makeover or shut down entirely.

But DB's restructuring plans are more than just a new coat of lipstick. The revisions, slated to take effect between Oct. 19 and 31, will significantly change the commodities exposure these funds can give investors.

DBA and DBC, currently worth $2.2 billion and $3.3 billion, respectively, are two of the most popular commodities ETFs. With their high concentrations in just a few key contracts, the funds are ideal for gaining exposure to the Big Guns of the commodity markets.

DBA, for example, tracks the world's staple crops—corn, wheat and soybeans—as well as everyone's favorite additive, sugar. DBC, on the other hand, tracks two staple crops (corn and wheat), two crucial energy sources (WTI crude and heating oil), the most widely used industrial metal (aluminum) and a universally beloved safe haven, gold.

Basically, the old versions of DBA and DBC cover only the A-List commodities, the ones with the highest liquidity and rock-solid, diversified demand pictures.

New-vintage DBA and DBC, however, will incorporate commodities with a little more volatility and a little less liquidity into their composition. DBA will halve its four core agricultural positions to make room for coffee, cocoa and livestock futures, while energy-heavy DBC will drop its current 35 percent weighting in WTI crude to just 12.4 percent, adding in contracts for gasoline, Brent crude and natural gas. (See the full weightings here.)

It's not like DB is dipping into something as illiquid as lumber or uranium here. And by diversifying the portfolio, they lessen the impact of a massive swing in one of the bigger commodity contracts.

But adding in these new markets also has the potential to pump more volatility into the mix, and potentially very different returns. We've all been paying attention to what's going on in natural gas lately, right? And what about livestock? It’s been on a straight path downward for more than two years now.

Even the impact on something like Brent crude will be interesting: Brent is a popular European contract, but it's by no means as widely traded as WTI crude. (By my count, this is the first time a major commodity ETF has invested in a non-U.S. energy contract. The first, but probably not the last.)

In short: DBA and DBC won't look much like themselves anymore. They’ll look more like the more diversified commodity ETFs that are already on the market, such as the iPath Dow Jones-UBS Commodity Index Total Return ETN (NYSEArca: DJP) and iShares S&P GSCI Commodity Indexed Trust (NYSEArca: GSG).

Of course, from the fund's perspective, any weighting overhaul is better than liquidation, and as the CFTC crackdown continues, I'm sure we'll see many more funds try similar alchemy in the future.

But the change is not without consequences. Investors are losing a degree of choice in the commodities market, forfeiting the option of investing only in the biggest of big commodities. And by making a foray into more narrow contracts, DBA and DBC may be potentially exposing investors to added volatility—or at least a very different pattern of returns—as well.

MarketWatch columnist Chuck Jaffe highlights the new AdvisorShares Dent Tactical ETF (NYSEArca: DENT) as his "stupid investment of the week." Jaffe reviews portfolio manager Harry Dent's track record and finds it lacking.

Read the full column here.

The chart below shows the Counterparty Risk Index (CRI) history since the beginning of 2008. The index is an unweighted average of the credit default swap spreads of 14 major financial institutions. The left-hand scale gives the cost (in basis points) of insuring against default for a five-year term.

The three big spikes on the chart mark the near-failure of Bear Stearns (in March 2008), the Lehman default (September 2008) and renewed concerns over bank safety at the market’s nadir in March 2009.

If crises appeared at six-monthly intervals since last spring, this time we appear to have broken out of the cycle.

What about the individual banks that make up the index? Here is a chart, courtesy of CMA Datavision, of the CDS spreads of the U.S. bank members of the index, plus Barclays and Deutsche Bank, the leading players in the U.S. exchange-traded note market.

Citigroup now ranks as the riskiest U.S. bank, and JP Morgan as the least risky, though it’s fair to say that the CDS spreads have converged significantly and there is far less difference between individual names than there was a year ago.

For the record, here are the levels from earlier today, ranked from least to most expensive to insure against default: JP Morgan (72bp), Barclays (76bp), Deutsche Bank (82bp), Goldman Sachs (107bp), Bank of America (120bp), Merrill Lynch (137bp), Morgan Stanley (140bp) and Citigroup (200bp).

(The fact that the Merrill Lynch CDS trades at a slight premium to that of Bank of America, its owner, is interesting.  This reflects speculation that the broker may yet be spun off from the parent bank, in which case the CDS would follow the reference entity, Dave Klein of Credit Derivatives Research told me.)

The levels should matter to exchange-traded product investors: All of these banks except Citigroup underwrite exchange-traded notes.

Is the worst now over? As Gillian Tett noted in a column in last week’s Financial Times, the concentration of overall (gross) risk in the credit derivatives market amongst the leading banks has actually risen since the AIG bailout of last September, and regulators are still finding it difficult to assess whether banks are handling their net risk exposures sensibly.

And, in what sounds like the ultimate reinsurance spiral, banks have become net sellers of protection on sovereign debt; hardly reassuring if one remembers that the banks are themselves propped up by the governments concerned. Lloyd’s, anyone?

So, while the reduction in overall default risk so far this year will come as a reassurance to investors, these are charts that are worth keeping an eye on.

Some people never fail to surprise you.

John Prestbo, editor of Dow Jones Indexes and the original founder of the Journal of Indexes, presents investors with a novel sector rotation strategy today in a new column on MarketWatch. Arguing that the current economic recovery could be muted, he suggests that one way for investors to potentially beat the market is to buy equal portions of each sector of the market and rebalance at the beginning of the year.

You can read John Prestbo's full column here.

Investors are increasingly favoring bonds over stocks, according to a new article from Sam Mamudi in the Wall Street Journal. The old adage that long-term investors should pile into equities is fading from view.

In addition, Mamudi says, many investors now want to incorporate alternative assets such as commodities into their portfolios.

"The whole 60-40 idea is almost like Betamax videotapes; it's now passe," says Andrew Silverberg, co-manager of Alger Balanced Fund, in the article. "It gained popularity while we were still in a bull market ... [Asset allocation should be] more dynamic."

Read the full article here.

Matt points out that as a closed-end fund, CAF currently trades at a premium. In addition, the Shanghai-listed Chinese A-shares that the fund invests in also trade at a premium, compared with equivalent shares listed abroad. Add it together and CAF ends up being 18 percent more expensive than a basket of similar Chinese company shares listed in Hong Kong or New York.

In other words, you are paying nearly a fifth extra for the hope that other international investors will, over time, attempt to flock to Shanghai. (Read the whole story here.)

For Matt, that’s too high a price for what seems like an outright gamble. There are few who would disagree.

The A-share premium ultimately works like initial repayments in a Ponzi scheme. If China opens up its domestic exchange to international investors, that premium will likely collapse.

But that might not happen for a long, long time. And in the meantime, the premium depends on what price investors in the domestic markets are willing to pay each other. As such, that’s the way I think you have to judge any investment in CAF.

I don’t think it’s very useful to use a year-to-date, or even 12-month, time horizon for CAF. This was a period of dynamic readjustment in global equity prices, where markets were more or less insularly focused.

Instead, mark the time horizon for the fund back five years, and compare the results with other China-related ETFs. When you do that, you can see that CAF easily beats competing ETFs such as GXC and FXI in terms of percentage-point gains.

Indeed, up until the beginning of the market fallout in late 2007, CAF was more than three times ahead of these two.

This was a period when China was implementing all sorts of new foreign-investor-based programs; there was also plenty of cheap money to channel into them. That hasn’t been the case this year.

Of China’s various qualified foreign institutional investor (QFII) quotas, only one bank (UBS) was at its $800 million maximum investment limit earlier this year (it has recently been expanded to $1.2 billion). The rest have around $400 million or less invested in the mainland through the program.

Placing a bet on CAF then is not just placing a bet on China; it’s placing a bet that foreign institutions will throw more cash China’s way. Judging from all the various trading notes I’ve seen recently citing emerging markets as the big profit area going forward, I think that’s a plausible scenario.

As banks become better capitalized again, and if China decides to keep most of its domestic market closed to foreign investors (extremely likely), there will be all sorts of creative ways in which firms try to get in the back door. That, in turn, will mean mainland equity prices begin to skyrocket.

So if you think loose global monetary policy will end up channeling much of today’s greenbacks eastward, CAF could well present a viable investment opportunity right now.

Details are in the works for the launch of the first aluminum-backed exchange-traded fund, the Wall Street Journal reported Monday.

Though Glencore International, the world's biggest commodity trader, and Credit Suisse Group are still looking for both an ETF provider and regulatory approval, the new ETF is said to reflect growing interest in physically backed commodity products in the face of looming stricter U.S. regulation in the futures markets.

Abundant supplies of aluminum following a drop in demand associated with the economic downturn is also encouraging the creation of the ETF as a way to help soak up some of that supply and keep prices firm.

Recently, the price of aluminum on the London Metal Exchange has soared, trading some 50 percent higher than the seven-year lows it hit earlier this year, and though some analysts see further growth ahead, the massive inventory overhang could pose a threat to those gains. In fact, LME aluminum stocks are at record-high levels in warehouses across the globe, and that aluminum will eventually need to be absorbed by buyers.

It's not clear where the ETF will be listed, but some sources suggest it might happen on the Swiss and German exchanges.

Metals-backed ETFs have significant influence in their underlying markets, the Globe and Mail said Monday. Glencore is a large holder and trader of aluminum, and it has partnered with Credit Suisse before.

You can read the full Wall Street Journal story here.

You can read the full Globe and Mail story here.

You can read a HardAssetsInvestors.com in-depth feature on the aluminum market here.

Your recent blog presents the same tired argument: Growth and value show high correlations to one another. Therefore, why bother using them in a portfolio?

I’ll tell you why: Because they work.

People who argue differently have their heads stuck in the ivory tower, too worried about “correlation quotients” to think about what actually matters to investors, which is returns.

Let’s take a simple case. Since the market bottomed on March 9, the rolling three-month correlation between the iShares Russell 3000 Growth ETF (NYSEArca: IWZ) and the iShares Russell 3000 Value ETF (NYSEArca: IWW) has been well over 0.90. To academics, the two are essentially identical.

But in the real world, there’s been a huge difference: IWV has outperformed IWW by more than 7 percent, in a period of just 6 six months. It has also beaten the broad market iShares Russell 3000 ETF (NYSE Arca: IWV) by 3 percent.

Now consider a different stretch: from Sept. 15, 2008 (the day Lehman Brothers went bankrupt) through March 9, 2009. The correlation between IWW and IWV over that stretch was again consistently above 0.90, but on a performance basis, IWW outperformed IWV by 10 percent.

What happened is obvious: After Lehman’s bankruptcy, the market started punishing risk. Not surprisingly, growth stocks (which have stronger fundamentals than value stocks) outperformed. When the market bottomed, investors started to reward risk again, and value gained.

An investor who timed that transition perfectly … who bought growth on Sept. 15 and switched into value on March 9 … is now 8 percent ahead of an investor who just bought the market and held on.

I’m not saying it was easy (or even possible) to call that transition perfectly. But even if you missed it by a week or a month, you still did well.

Not everyone has the inclination or temperament to tweak the risk focus in their portfolios on a real-time basis. I don’t. But I know some investors and advisers that do, including some who have been doing it successfully of late. For them, growth and value (like large-caps and small-caps) are useful.

A quick search of the ETF database will show you something quite telling—71 ETFs are dedicated to a slice of the market self-defined as either “growth” or “value.” That’s nearly 10 percent of the U.S. ETF market.

But honestly, why?

First, there’s a definitional issue. Russell (just to pick one index provider) defines their growth and value universe based on two characteristics: price-to-book and “projected growth” based on IBES (Institutional Brokers’ Estimate System) consensus estimates. This very distinction makes the indexer in me cringe. By taking the market and slicing it into buckets, and then picking one, investors are fundamentally picking stocks, and I still believe that rarely makes sense.

Let’s take a look under the hood at one family of growth and value: the iShares Russell 3000 series.

This brutal chart looks at the Russell 3000 ETF, IWW, and compares it with the growth and value ETFs, IWZ and IWW, respectively. It’s a pretty compelling story for value investors, and indeed, it’s been a bad 10 years to be chasing earnings estimates—the value investor has made over 30 percent. The growth investor has lost nearly 40 percent, and was down over 50 percent earlier this year. Self-proclaimed value investors will undoubtedly say “duh” at this and note that the whole point of investing is to buy cheap and sell expensive, and that’s just what a value index is designed to do—select the cheaper stocks from a pool.

The problem, of course, is that Warren Buffett doesn’t run the index. The determination of what goes into which buckets is only made once a year in June (in the case of Russell), and stocks ping-pong between the two buckets based on where they happened to be trading at reconstitution. The top performers list for both the growth and value indexes over the past calendar year includes AIG, Citi and Martha Stewart. The decision to sell in one index and buy in the other was simply formulaic, and the timing entirely planned.

In short, it replaces the fallacy of picking the winner based on research, or a hunch, with picking the winner based on the calendar.

Further, there’s increasing evidence that the distinction between growth and value is far less relevant than it has been in years past. Consider the same chart over the last year:

In this time period, the growth investor has ruled the day, losing just about 6 percent vs. the value investor’s 14.25 percent decline.

But perhaps more important for investors focused on actual portfolio construction instead of just stock picking, there’s evidence that the growth and value buckets could just as well be a random distribution.

This chart plots the correlation between IWZ and IWW since inception, looking at rolling 30-day periods and daily returns.

Back during the end of the dot-com run-up and through the dismal 2001 period, there was a real difference between growth and value. It was possible to make the case that the two buckets had distinct performance characteristics: that splitting the universe based on IBES rank and price-to-book ratios created distinct portfolios where one zigged while the other zagged. Alas, what I see when I look at this chart is that the two buckets are now essentially identical, with correlations predictably in the 90s since the middle of the decade.

ETFs give us access to virtually every asset class in the world, from fine-grained equity sectors and themes to international bonds and currency. That the ETF industry has focused so much energy on the dinosaurs of growth and value seems unfortunate.

Standard & Poor's will consider creating a commodity futures index that excludes commodities listed in the United States, according to a new report in the Financial Times. Michael McGlone, head of the S&P GSCI, says the firm has been flooded with requests from clients concerned about the impact of the expected regulatory crackdown on commodity investors by the Commodity Futures Trading Commission.

The CFTC is widely expected to enact new rules this fall that would severely limit the size of positions that investors can take in the commodity futures market.

Many have predicted that such a crackdown would only serve to move commodity investors overseas, and the announcement by S&P is the latest sign that such a migration may in fact take place.

The S&P GSCI is the world's most popular commodity index. Approximately $60 billion is currently benchmarked against the index.

Read the full story here.

United States Commodity Funds LLC has launched a new exchange-traded fund designed to provide short exposure to the crude oil market.

The United States Short Oil Fund (NYSEArca: DNO) aims to capture the inverse of the daily return of the front-month West Texas Intermediate crude oil futures contract, as traded on the New York Mercantile Exchange.

On a one-day basis, the fund should mirror the returns of the popular United States Crude Oil Fund (NYSEArca: USO). Over longer time frames, the returns may diverge due to compounding. (For more on the impact of compounding on returns, check here or here.)

DNO will charge 0.60% in annual expenses.

Unlike most leveraged and inverse products, DNO will not use swaps to achieve its exposure. Instead, it will take short positions in the actual underlying futures contracts.

DNO will compete directly with the PowerShares DB Crude Oil Short ETN (NYSEArca: SZO), a short oil exchange-traded note with $27 million in assets under management.

SZO differs from DNO in two ways. First, it tracks a slightly different index: DNO exclusively focuses on the front-month futures contract, while SZO sometimes owns out-month contracts instead. More importantly, while DNO compounds its returns on a daily basis, SZO compounds them on a monthly basis.

The difference between monthly and daily compounding may seem like a technicality, but for long-term holders, the differences can be dramatic.

There are also two products that provide leveraged inverse exposure to the crude oil market: the PowerShares DB Crude Oil Double Short ETN (NYSEArca: DTO), which compounds returns monthly, and the ProShares UltraShort DJ-UBS Crude Oil ETF (NYSEArca: SCO), which compounds returns daily.

The prospectus for DTO is available here.

Do our well-used Greek letters help us make sense of the investment landscape, or do they actually hamper us in managing money? As James Montier, formerly of Societe Generale’s asset allocation team, now with Boston-based fund manager GMO, pointed out in an article published in 2007, as soon as you use the terms “alpha” and “beta,” you are invoking the spirit of the capital asset pricing model.

And, unfortunately, CAPM doesn’t actually work in practice.

Why not? Apart from some questionable assumptions about frictionless trading and investors having identical goals, the key problem with CAPM is that it assumes that stock returns are normally distributed. In other words, the theory requires that stock prices follow a random walk, with the price movement in one period entirely independent from that in all previous periods, and having no bearing on the future, either. This “Brownian motion” assumption produces the famous bell curve of statistics when one measures the percentage gains and losses over many time intervals.

However, while the bell curve accurately maps many phenomena in nature—people’s heights and weights, for example—many studies have now shown that it is inaccurate when describing financial market movements. Stock prices, which reflect the collective mood of millions of people, move according to far wilder trajectories, and there is plenty of evidence that markets have “memory”—which shows up in the serial correlation of returns. Even volatility tends to occur in “clusters.”

By viewing the world through the lenses of “alpha” and “beta,” you are automatically assuming a linear relationship between risk and return, with risk measured only according to a bell curve framework. Take away the framework, and the terms have no real meaning at all. So why do we persist with them? Part of the reason for the continuing popularity of the Greek letters is that we use them as a kind of shorthand—beta for passive, systematic, indexed; and alpha for active, more subjective, discretionary. And, of course, in the fund management world, while beta has meant (relatively) low fees, the claim of being able to source “alpha” has been the road to riches for fund providers.

But, just as it’s possible (and indeed, statistically likely) for the self-proclaimed alpha-seeker to deliver below-market performance, it’s just as likely that well-thought-out, entirely model-driven systematic approaches can generate superior returns over time.

At this week’s Terrapinn ETF conference in London, Chris Sutton of Watson Wyatt predicted a change in trend in the investment management industry, away from the artificial separation of alpha and beta and towards a more holistic approach. Sutton also argued that the ETF world needs to move from a period of product proliferation to one of increased innovation in index design.

I agree wholeheartedly with this, and would like to see a great deal more systematic strategies offered to investors in ETF format. As ever, the challenge will be to make these investment approaches understandable and transparent, without losing their competitive edge. But there are surely great opportunities out there for those who can hit the correct fund design. Isn’t it time to send at least two of our friendly “Greeks” back to the language classroom?

You can read the whole story here.

I’ve long been a big proponent of investing in so-called Asian frontier countries. As Cris points out, “These smaller countries complement China and India. They should benefit from the rise of their larger neighbors and the region as a whole, while offering exposure to different themes and sectors.”

In fact, when I talked to Franklin Templeton’s outgoing emerging market fund manager Mark Mobius earlier this year, he was in the process of putting more of his own personal money into these miniature high-growth markets (you can read that story here, but you’ll need to have access to Index Publications’ subscription-only monthly ETFR publication).

Cris highlights Vietnam as a location rich in the potential for returns. I think he’s right. After tumbling around 70 percent in value early last year, the market has staged a bit of a recovery so far this year, and stocks look attractive there now.

The Market Vectors Vietnam (NYSEArca: VNM) exchange-traded fund, which was launched only last month, is already up 12 percent. That’s the kind of dynamic place Vietnam is, with huge swings and wild statistics. What do you expect when half the population is under 25?

Indeed, one of the things that makes Vietnam so appealing right now is that it was only recently that the country took a dive. In emerging markets investing, you often find that a giant correction after a bubble brings with it all sorts of useful policy and financial innovations that, ultimately, lead to more stability and continued growth. This was the case with Thailand after 1997.

With that in mind, I found it unfortunate that Cris spent so much time discussing Malaysia and so little on Thailand. Thailand has gone through something of ruckus lately, with a militant left-wing government seizing power from a democratically elected right-wing one.

While it’s not exactly desirable to have a forced government in place, the country’s new prime minister, Abhisit Vejjajiva, is an impressive leader. Educated at Oxford University in England, Vejjajiva is a calmly spoken, economically sharp policymaker with a heavy international focus.

Unemployment in Thailand is now falling and gross domestic product growth is on course to climb again slightly. Property prices are rising, too, particularly in the south of the country and in Bangkok, its capital.

With the iShares MSCI Thailand Index Fund (NYSEArca: THD) up 76 percent year-to-date, just 16 percent below its 18-month-ago price of $50 a share, there’s good reason to believe that this ETF has found the support it needs to continue to outperform traditional emerging market benchmarks.

It’s often been said that Asian frontier markets are something of a 2010 story. With such impressive strength in large emerging markets this year, I think we are on course to hit that forecast.

We’ve covered the debut of the Dent Tactical ETF (NYSEArca: DENT) closely on IndexUniverse.com. We wrote about the launch here, and ran an in-depth interview with Harry Dent, one of the fund’s portfolio managers, here.

The idea is simple: Two well-known market forecasters, Harry Dent Jr. and Rodney Johnson, will actively manage a portfolio by “identifying, through proprietary economic and demographic analysis, the overall trend of the U.S. and global economies and how consumer spending patterns may change based on this analysis.”

That sounds like a fairly normal active strategy. What makes DENT interesting is that the two managers will implement their strategy using ETFs. DENT, in other words, is an ETF-of-ETFs.

That’s interesting because it solves one of the major headaches of creating an actively managed ETF: front-running. It’s difficult to front-run trades in liquid ETFs, provided you know how to trade those ETFs appropriately. DENT is a nice solution.

That’s doesn’t mean I’m a huge fan. For starters, DENT is much too expensive. With an expense ratio of 1.56 percent, DENT is the highest-priced ETF ever, far surpassing the Market Vectors – Vietnam ETF (NYSEArca: VNM), with its 0.99 percent expense ratio.

Then, again, that may not be the right comparison. I actually don’t think that DENT is competing with other ETFs. It’s in a whole different market.

For most investors and financial advisers, ETFs are building blocks. They are designed to offer focused exposure to specific markets and asset classes. Investors use them to create portfolios based on their own personal views of the market. The task of generating alpha lies with the end investor (or their adviser).

DENT doesn’t fit into that model. The managers of DENT have complete discretion. They can go to 100 percent cash if they want. As a result, there’s no way to fit the product into a traditional asset allocation strategy. You have no idea what DENT will hold tomorrow.

DENT is actually competing with traditional active mutual funds. Or, perhaps, in a more interesting twist, it’s competing directly with financial advisers. Viewed from those perspectives, the 1.56 percent expense ratio is at least a little more reasonable.

The average actively managed equity mutual fund charges 1.13 percent, according to Morningstar. As an ETF, DENT should be more tax efficient than traditional mutual funds, perhaps making up the gap.

The more interesting comparison is with a financial advisor. DENT is effectively taking over the portfolio management task from the financial adviser. The fund charges 0.95 percent for that service (the remainder of the 1.56 percent is made up of underlying fund fees and “other” expenses).

Is 0.95 percent ridiculous for asset allocation management? No, but it’s not cheap either. There are plenty of excellent ETF-focused financial advisers charging fees closer to 0.75 percent or 0.50 percent.

Like everything, the proof will be in the pudding. If DENT can deliver great returns for a number of years, investors may embrace it. But I bet most will take a wait-and-see attitude, and watch how the returns roll in. If the fund were a bit cheaper, more would make the jump. But with a premium price, you’re going to want to see proof of premium performance before you buy in.

ShariahShares FTSE USA Fund and the ShariahShares FTSE Developed ex-U.S. Fund will invest in foreign and domestic companies that meet the stringent requirements of Sharia law.

ShariaShares FTSE USA Fund will track the FTSE Sharia USA Index, which comprises 241 mid- and large-cap U.S.-traded shares.

ShariaShares FTSE Developed ex-U.S. Fund will track the FTSE Sharia Developed ex-U.S. Index, a market-cap weighted index which comprises stocks from 25 of the 48 countries in the FTSE GEIS Index Series.

The exchange-traded funds will be permitted to invest 80 percent of their assets in underlying securities, and 20 percent in futures and options contracts

In keeping with Sharia law, the funds will not be allowed to invest in non-Islamic banks, finance, insurance, alcohol, entertainment, or tobacco companies. Moreover, the funds cannot purchase shares in food producers of non-halal or pork products, or weapons manufacturers.

In order to meet the investment criteria of the funds, companies will also have to show debt, cash and interest-bearing items less than 30 percent of total assets, and accounts receivable less than 50 percent of total assets. In addition, they must meet specific revenue and dividend guidelines.

The fund’s advisor is California-based Florentez Capital Management.

Sharia-screened ETFs are popular in Europe. These would be the first in the U.S.

-- This report was filed by IndexUniverse.com's senior reporter Daniel Harrison.

[Correction: An earlier version of this article suggested that the new ShariahShares would be the first Shariah ETFs in the U.S.  The Javelin ETF (NYSE Arca: JVS) launched in June of this year and provides exposure to the global ex-U.S. markets.]

ShariahShares FTSE USA Fund and the ShariahShares FTSE Developed ex-U.S. Fund will invest in foreign and domestic companies that meet the stringent requirements of Sharia law.

ShariahShares FTSE USA Fund will track the FTSE Shariah USA Index, which comprises 241 mid- and large-cap U.S.-traded shares.

ShariahShares FTSE Developed ex-U.S. Fund will track the FTSE Shariah Developed ex-U.S. Index, a market-cap weighted index which comprises stocks from 25 of the 48 countries in the FTSE GEIS Index Series.

The exchange-traded funds will be permitted to invest 80 percent of their assets in underlying securities, and 20 percent in futures and options contracts

In keeping with Sharia law, the funds will not be allowed to invest in non-Islamic banks, finance, insurance, alcohol, entertainment, or tobacco companies. Moreover, the funds cannot purchase shares in food producers of non-halal or pork products, or weapons manufacturers.

In order to meet the investment criteria of the funds, companies will also have to show debt, cash and interest-bearing items less than 30 percent of total assets, and accounts receivable less than 50 percent of total assets. In addition, they must meet specific revenue and dividend guidelines.

The fund’s advisor is California-based Florentez Capital Management.

Sharia-screened ETFs are popular in Europe.

-- This report was filed by IndexUniverse.com's senior reporter Daniel Harrison.

Exchange-traded fund provider Global X Funds filed a prospectus on Sept. 10 with the Securities and Exchange Commission to launch six new ETFs, which will track different sectors of the Chinese economy.

The funds are: Global X Consumer, Global X China Energy, Global X China Financials, Global X China Industrials, Global X China Materials and Global X China Technology.

The funds will be 80 percent invested in American Depositary Receipts and Global Depositary Receipts, and 20 percent invested in swaps and options contracts.

The funds will employ strategies to replicate to 95 percent accuracy the performance of the underlying FTSE-created sector-specific indexes they follow after fees and expenses, and will issue creation units in blocks of 50,000 shares. Global X did not mention what management fee would be charged for investing in the funds.

The new ETFs are a breakthrough for the industry, since for the first time investors will be able to gain access to specific sectors of the Chinese economy, according to market watchers.

“What’s unique about these funds is that they will enable investors to specifically invest in specific Chinese sectors, as opposed to choosing a broader emerging market or China ETF that’s heavily invested in a range of sectors,” wrote Tom Lydon of Global Trends Investments in a recent note.

Global X Funds also filed to register seven additional funds, which aim to track foreign markets that are currently hard to access for U.S. investors. The funds are: Global X Denmark, Global X Emerging Africa, Global X Finland, Global X Norway, Global X Pakistan, Global X Poland and Global X United Arab Emirates. (You can read the filing here.)

The Danish, Finnish and Norwegian funds follow the recently-launched Global X FTSE Nordic 30 (NYSEArca: GXF), a fund which is heavily-weighted in Swedish equities (46 percent). Since its launch on Aug. 20, shares in GXF have leaped 11.9 percent in value.

The provider’s other ETF, Global X InterBolsa FTSE Columbia (NYSEArca: GXG), is also doing well since its debut in February, up 86.5 percent.

-- This report was filed by IndexUniverse.com's senior reporter Daniel Harrison.

Skepticism definitely plays into the mix when considering this new exchange-traded fund (NYSE Arca: DENT).

Ron Rowland has written a recent Seeking Alpha column in which he projects that the ETF will make his April 2010 ETF Deathwatch list. He makes some very interesting and valid points. (You can also see related IU.com stories on DENT's costs and a recent Q&A with Dent about his investment strategies here and here.)

My concern I share with Rowland is with the fund's expense ratio – 1.56 percent before the waiver, and 1.5 percent after.

That’s A LOT of basis points, and it seems to undermine the very foundation of what an ETF is supposed to be all about. According to the Investment Company Institute, the average expense for equity mutual funds in 2008 was 0.99 percent.

That study however, excluded funds of funds, which would be more comparable with DENT.

But there are a bunch of ETFs of ETFs out there following index strategies, and they don’t come close to the costs of DENT.

PowerShares charges 79 basis points, with no waiver, for its funds of funds based on indexes from New Frontier Advisors. Meanwhile, the ones offered by iShares all charge 35 basis points or less, after a 14-basis-point waiver.

Granted, these are still index-based funds, and they are primarily invested in other “in-house” ETFs, but it’s hard not to flinch when you compare those prices with DENT’s.

A key appeal of ETFs has always been that they are cheaper than actively managed mutual funds and many – if not most – index mutual funds.

But until recently, almost all of the funds have managed to keep their expense ratios below 1 percent, which I consider a pretty important barrier. Off the top of my head, the MacroShares are the only ones I can think of that have definitively burst through the 1 percent ceiling, and they are not structured like traditional ETFs.

Basically, DENT isn’t even in the same ballpark as your average ETF in terms of expenses. And I can’t help but wonder if it’s setting a bad precedent—opening the floodgates, as it were—especially with regards to actively managed funds.

To date, actively managed ETFs from PowerShares and Grail Advisors have kept costs at 80 basis points or below. But the AdvisorShares fund nearly doubles that.

So the launch of DENT raises a bunch of questions.

The key one for the fund itself is: Will investors be interested?

But also: Will it outperform? Will it have sufficient liquidity?

And most importantly for ETFs: Will it set the trend for future fees?

• AdvisorShares debuts with DENT
• SSgA launches preferred stock ETF
• EGA rolls out emerging markets financials fund

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NEW LISTINGS

SSgA Launches Preferred Stock ETF

Sept. 17 saw the launch of the SPDR Wells Fargo Preferred Stock ETF (NYSE Arca: PSK), which tracks an index of 160 nonconvertible preferred stocks. The fund charges an expense ratio of 0.45 percent. It is the third preferred stock ETF to hit the market, with competitors fielded by the iShares and PowerShares families of ETFs.

EGA Launches Emerging Market Financials ETF

Emerging Global Advisors LLC rolled out another of its emerging markets sector exchange-traded funds on Sept. 16. The Emerging Global Shares Dow Jones Emerging Markets Financials Titans Fund (NYSE Arca: EFN) tracks an index of 30 financial companies drawn from 10 different emerging markets. The new fund charges 85 basis points.

AdvisorShares’ DENT Lists

The AdvisorShares ETF family made its debut with the launch of the AdvisorShares Dent Tactical ETF (NYSE Arca: DENT) on Sept. 16. The fund is based on the research and quantitative management style of money manager Harry Dent. The actively managed fund is essentially an ETF of ETFs and comes with a management fee of 1.56 percent.

[Bloomberg] PowerShares Files For Build America Bonds ETF

Bloomberg News covered a recent filing from Invesco PowerShares for an ETF that will hold Build America Bonds, which are municipal bonds that are part of the federal stimulus program. The Build American Bond Portfolio will track an index from Merrill Lynch.

Van Eck Filing Covers Junior Gold Miners

Van Eck filed earlier this year for an ETF tracking “junior” – or small- to mid-cap – gold and silver mining companies. The proposed fund would join the firm’s existing gold miners ETF – the Market Vectors Gold Miners ETF (NYSE Arca: GDX) – which targets large-cap gold mining stocks. That fund has accumulated nearly $4.5 billion in assets. No existing ETF covers small- and mid-cap precious metals miners.

UNG Slated To Reopen This Month

The managers of the U.S. Natural Gas Fund (NYSE Arca: UNG) announced last week that they would likely begin accepting new creation units for the fund on Sept. 28. Creations had been halted in July after the CFTC was slow to approve an expansion of UNG’s allowed number of creation units; when approval finally did come, the fund’s managers still kept it closed out of concerns related to possible increased regulation.

ETFs Filed—By Fund Company

There are currently 518 ETFs in our list of prospectuses filed at the SEC.

You can click on any fund and link directly to the prospectus.