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Exchange traded
funds (ETFs) have been around for almost 20 years but small boutique firms
are finding new ways to slice them up and repackage them for investors who
are taking an active approach to their investment funds, not simply buying
and holding them. Richard Kang, CIO and director of research for New
York-based Emerging Global Advisors, specializes in ETFs and says liquidity
and more choices are responsible for record amounts of cash flowing into
ETFs. In this Energy Report exclusive, Richard talks about his funds and some
reasons niche ETFs are changing the investment landscape.
The Energy Report: Richard, your
firm offers a number of ETFs as investment vehicles. Your ETFs are branded
under the brand name EGShares. Please tell us about your philosophy for
going the emerging-markets ETF route.
Richard Kang: Clearly, the
emerging markets theme is very hot right now, especially for those investors
who have traditionally focused on the U.S. and developed world. Many
investment vehicles focused on developed markets offer little yield. Returns
are as volatile as they could be anywhere; for example, the S&P 500 has
gone down 50% twice in the last 10 years—once when the dot.com bubble
burst and the other because of the global financial crisis in 2008. All
markets are related to one another. Whether you go to Japan or Europe, what's
the benefit? So for many reasons emerging markets are hot. The problem with
emerging markets is the practicality of investing—they're often
non-transparent and illiquid. You can't short them even if you want to.
Sometimes they're hard to access, like India for example, and they're
expensive to access when you consider trading costs, fund fees and other
considerations. For these reasons and others, ETFs have become the weapon of
choice.
TER: Please explain the term "weapon of
choice" in that context.
RK: Investors seeking higher returns would
like to have some kind of active component in emerging or frontier markets
but they believe that this category is relatively inefficient, as opposed to
U.S. equity markets, which are relatively efficient. Thousands of analysts
study Coca-Cola or General Motors, so those prices are pretty much where they
should be. There are far fewer analysts in emerging markets but investors
want to access those markets and think there's a great opportunity to churn
out some added return by taking an active management approach. But stock
picking is difficult for maybe 90% of investors who don't spend time in India
or China. That's where an ETF makes sense. It's an underlying passive
strategy with an index, but it's also a tool to actively manage one's risk exposure.
India versus China, energy versus industrials or utilities—those are
active decisions. For many investors, an ETF is their weapon of choice for
that—plus the pragmatic aspects of ETFs that deal with the issues of
cost, diversification, liquidity, transparency, shorting, etc. mentioned
earlier.
TER: Why not an emerging markets mutual fund?
RK: A mutual fund company would tell you:
"Please don't trade our fund because it hurts us. Administratively, it
adds costs to us and to you, the investor." Not just that but the
regulators have said the same thing. The market timing of mutual funds was a
scandal several years back. In any case, everybody's saying "Don't do
it. You should buy and hold the mutual fund," and rightly so in both
cases. An ETF provider, like us, says: "Please trade these. They're
supposed to be traded; that's why we build them and place them on the New
York Stock Exchange." Investors around the world go to the NYSE for one
reason only—liquidity. If I go to a billionaire in Dubai and say,
"I can build this fund for you on the Dubai Exchange," they'll say,
"Please don't do that. We have U.S. dollars and we need the liquidity of
the New York Stock Exchange." That's why investors go there. Further,
with more volatile asset categories like emerging market equities, many
investors would rather shorten their holding period. That's the reason ETFs
are traded, not simply just bought and held.
TER: Of particular interest to us are your
energy and mining ETFs: EG Shares Dow Jones Emerging
Markets Energy Titans Index Fund (NYSE:EEO)) and EG Shares Dow Jones Emerging
Markets Metals & Mining Index Fund (NYSE:EMT). Why did you choose passive ETFs versus
actively managed ETFs?
RK: The ETF industry, which started in the
early 1990s, was built out of underlying index or passive strategies. Today,
I would say close to 99.99% of ETF assets around the world employ passive
strategies. I'd be surprised if it was even 0.01% in active strategies, in
terms of total global ETF assets. Then, we look at the very large funds. They
are the most vanilla of passive strategies like the SPDR S&P 500 ETF (NYSE:SPY), which tracks the S&P 500. For us, a
passive strategy was pretty much a no brainer. We were coming out of the
worst financial crisis since The Great Depression when we launched these
funds. If we were going to put a product out there, it had better be
something that we believe is palatable to most investors. Investors want the
liquidity they can't find in emerging markets. We knew we had to provide that
with a portfolio of, let's say, 30 stocks. A concern was that if we tried for
a more diversified portfolio of 100 energy or mining stocks maybe those in
the bottom quarter or even half might not be that liquid. The 2008 financial
crisis was one of liquidity as much as anything else was, so we needed to ensure
that we were pretty basic in what we did.
TER: Your first ETFs
focused on specific sectors within emerging markets versus a range of
sectors. What specific sectors are you focusing on now?
RK: When we first launched our company, we
started with the energy fund and the metals and mining fund. We felt the
commodity play was strong coming out of the bottoms of March 2009; but we
were not certain how strong the recovery was going to be. Clearly, the
recovery wasn't that strong; therefore, it has taken a while for oil and
other commodity prices to come back.
Our latest fund focuses on emerging market consumers, another sector
that we're big on. In September 2010, we launched our EG Shares Dow Jones Emerging
Markets Financials Titans Fund (NYSE:EFN). So, we have various sectors that we're
bullish on; but to diversify our product lineup, we also moved to more
thematic funds focused on country-specific infrastructure (specifically
infrastructure funds focused on China, Brazil and India, respectively). We
also have a small-cap India fund, EG Shares INDXX India Small Cap
Index Fund (NYSE:SCIN), which focuses on India consumers. But we are still
very keen on the idea of a sector approach to emerging markets—not just
a country approach.
TER: How often are the Dow Jones indexes
updated, in terms of holdings?
RK: For the Dow Jones indexes and the sector
funds that track them, the names are rebalanced once a year in June. But we
rebalance the weights quarterly. Now those rules aren't necessarily
firm. Some rules are imposed on top of them; for example, a company could be
reclassified to a new sector based on how its revenues are derived, as an
emerging market from developed market or a list of other possibilities.
TER: Most of the companies that your energy ETF
is tracking are large oil companies with some gas exposure. You don't have
any control over what you're investing in, per se. How do you determine how
you set up these ETFs?
RK: Good question, and there are several
answers. First, we are not the active investor. We provide the ETF as a tool
for active investors. That's a very important concept with the ETF space. You
won't find any ETF provider saying they're bullish on the S&P 500 or we
have a short view on oil or long view on gold. It's not what we do; we
provide the tool so investors can make that call.
In the case of this energy fund, it's clear. We find these companies
in emerging markets, not developed markets. When we consider the index from
Dow Jones, it's Dow Jones' index but we have to be mindful that there are
certain portfolio management rules that regulators impose for diversification
or tax purposes. So we might have to work with them to bend the index
construction rules a bit; for example, let's say we built an oil fund and it
was 80% Russia. Frankly, it wouldn't be easy to justify because investors
would say, "I should just buy a Russia fund." And that has happened
before. In Canada at one point Nortel was two-thirds of the index. People
said, "I think we should cap this index," and that's exactly what
they did. That's a very good example of what many index providers do for
ETFs. They say we have to cap certain things so you don't have too much
weight in a particular sub-industry or country.
TER: Are you saying that forming these indexes
with Dow Jones is a collaborative approach?
RK: Not in the past but today, especially with
more niche indices, it is. In essence, it prebuilt these indexes; they are
kind of off the shelf. There is always this push and pull between the index
provider and the ETF provider. At the end of the day, the ETF provider is
going to build a fund that tracks this index; but, frankly, its success is
dependent on the ability to justify the fund. You can always sell the fund if
it makes sense in portfolio management terms.
If it's too overweighted in a particular country or subsector,
investors are going to think that's not good. Let's say, for example, we came
out with a consumer fund that consisted of a bunch of emerging market car
companies. As much as that may be the case based on the rules, it would not
be very diversified. You want something else to
diversify the fund—not just durables. So when you talk with an index
provider, you have to have that discussion beforehand. Afterward, you cannot
change the index so simply. It's very hard to tell investors, "Oh, we're
going to change the rules."
TER: What about the allocations between large
companies and highly prospective small companies? How do you ensure some of
those small companies with significant growth prospects get in the indexes?
RK: That's a very good question. For us, our
sector fund has an underlying index of 30 names regardless if it's the
energy, financials or metals fund. Why do we do that? Because we want to make
sure we're providing investors access to the most liquid names. They are, by
definition, the largest names but large often means more liquidity. If I said
I'm building a gadget fund that contained Apple, RIM and Nokia, there would
be no fear of buying or selling shares. If I really wanted to dump these
names, or dump this ETF, it wouldn't be a problem because there's going to be
liquidity to sell these. Now, let's say I built a speculative gadget fund
with unknown providers in Taiwan or Korea. You might not be able to get out
of that fund because if you're selling, others may also be selling out of
these relatively smaller names. That's a real problem. We have the top 30
names by size and assured liquidity so, if investors needed to, they could
get out.
TER: How is Dow Jones determining that?
RK: It's pretty standard regardless of the
index provider. Any index provider looks at not only market cap or free
float-adjusted market cap to see what's available based on size, but there
are also various metrics used to determine the availability of shares if you
have to buy or sell. For example, average daily trading volume is a very
basic one. You can look at the previous 30 days or previous 3 months and say,
on average, how many shares were trading at that point in time or on a
particular day?
TER: Why do you believe in investing in
emerging markets by sector versus taking a country-by-country approach?
RK: We don't have analysts picking one stock
over the other. We don't make those calls, but others do. We believe, for
example, many who make a call in the emerging markets will have a bearish or
bullish view on India versus China. But others have more of a sector view.
Most investment banks or research houses are divided by sectors, like airline
analysts or retail analysts. I don't think you will find a Canada analyst or
a Mexico analyst as easily.
Let's look at the Russian market. Many investors think Russia is all
about oil, but that's not necessarily the case. If you're buying a Russia
fund, you're buying less than 50% oil. You're also buying metals, consumers
and industrials. You're buying other things but you're also putting all your
eggs in one basket in terms of Vladimir Putin and the political risk in
Russia. So, if you're in Russia due to your willingness to accept
energy-related risk, perhaps you might be interested in our emerging markets
energy fund. It's heavily exposed to Russia. As of September 30, 2010, it was
roughly 29% Russia; but it also has names from China, Thailand, India,
Brazil, South Africa and others to make it a little more diversified than if
it were all in Russia.
TER: Most of the large holdings in this fund
are in the so-called BRIC countries: Brazil, Russia, India and China. You
just talked about Russia and Russian oil titan OAO LUKOIL Oil Company (OTCPK:LUKOF) is a large holding. What are some others?
RK: Let me first state that the most common
method used in indexing many sector funds is based on market capitalization.
In other words, the larger the company, the greater proportional weight
you'll have in the index the fund is tracking. It's just the nature of the
beast. As of today, the BRIC nations have the larger companies. You won't
find the larger emerging market names coming out of Poland or Indonesia;
they're coming from these four nations.
One is Reliance Industries Limited (BSE:RIL; LSE:RIGD), which is a very big position in our fund
and a gigantic play in India. India is where you're going to find a lot of
future growth, so much growth the country has high inflation and it's been
ratcheting up interest rates there despite having a hot stock market during
this recent period of monetary tightening. The investment thesis is that the
Indian consumer and public sector will need massive amounts of energy for
infrastructure and consumerism. It's the same story in Brazil. Petrobras (NYSE:PBR) was associated with the largest IPO in
history this year due to the fact that investors understand there's this big
deepwater oil find off the coast of Brazil that Petrobras needs to access.
The theme is very common. Huge multinationals like Exxon Mobil Corp. (NYSE:XOM) and Chevron Corporation (NYSE:CVX) are going to the emerging markets to get
hard-to-access oil. It can't all be in safe countries, such as Canada with
its oil sands. That's why the emerging market energy fund is significantly
focused on oil in emerging markets because they have the supply, and the
demand is kind of a no-brainer.
Another one of our holdings is China's China National Offshore Oil Corp.
(HK:883), also called CNOOC, which trades in Hong
Kong—a very liquid market. Gazprom
(LSE:OGZD; Fkft:GAZ; RTS/MICEX:GAZP; OTC:OGZPY),
PetroChina Company Ltd. (NYSE:PTR; HK:857)—these are all huge names; we're
talking Exxon kind of names. What's important to understand is that you can
get out as long as the portfolio manager of the ETF is able to sell the
underlying shares. That means each one of the underlying positions in the
fund must be super liquid. That's the reason that we have 30 names.
TER: The EG Shares Dow Jones Emerging Markets
Energy ETF has averaged just under 20% since it launched in May 2009. Year to
date it's at 14.1%. Are those kinds of returns enough to keep your investors
happy?
RK: That question is very appropriate for
mutual fund investors because they buy and hold. But only some ETF investors
buy and hold because they like the cheap cost of ETFs. Some are very short
term because they like the liquidity and the ease of trading. And nobody is
telling them not to trade ETFs.
For those ETF investors who are long-term oriented, I'm hoping that
they're ok with those returns. It's been a tough market. Oil hasn't gone up
to $100 a barrel, which I think many would've
guessed after such a bad recession. What concerns us most is the short-term
investor; have they been able to pick up those strong bull markets and avoid
any strong corrections? Have we done our job in terms of tracking the
underlying index? I think that's how we best keep our investors happy.
TER: During your time as a blogger under the
banner Beta Brief in 2008, you talked about ETFs being the next wave.
What's next for ETFs and those sorts of beta instruments? Please give us some
parting thoughts on where you see the market heading.
RK: The ETF industry is growing. It's been
around since the early 1990s, but so much of the money in the industry is
concentrated in very vanilla names that are liquid—very cheap but also
very well understood. One exception is the SPDR Gold Trust (ETF) (NYSE:GLD), which is universally known but not a
typical stock index as it tracks gold bullion prices.
I think the evolution of the ETF industry will continue with greater
understanding that some of these markets are relatively exotic but that the
liquidity is still there. As long as I can buy or sell the underlying
positions easily, we're all good in terms of liquidity.
Now the question is: What other markets are investors going to be
looking for in the future? I think they're going to look for greater returns
out of a frontier market. They'll look at how they can replicate something
like a hedge fund; and they'll start looking at these new, actively managed
ETFs that try to mimic a mutual fund. Can those be as liquid as the vanilla
strategies out there in the indexing space? I think this is the future
evolution of the ETF space and we'll see if that causes investors to dump
their mutual funds in even greater amounts than they have in past years. If
they move over to the ETF space, will they then want to move a little bit
beyond indexing to something that is more like a mutual fund, which is a
little bit of active management? I'm guessing that might be the case but we
haven't seen it yet. We'll see.
Richard Kang has served as Emerging Global Advisors' CIO and director of research since September
2008. He began his career in 1995 at Guardian Timing Services, a
Toronto-based hedge fund. In 2001, Richard was hired to build and manage the
investment management subsidiary for Affinity Financial Group, a private
wealth management firm. In late 2002, Richard cofounded Meridian Global
Investors, an investment counseling firm managing globally diversified
portfolios that include both traditional and alternative asset classes
primarily through the use of passive instruments. By the summer of 2003,
Richard was retained by a Toronto-based startup fund of hedge funds, Quadrexx
Asset Management, for two years to oversee its operations as CIO. Richard
consulted for various asset allocators as well as fund managers in the areas
of hedge funds and ETFs at the end of 2006. From fall 2007 to fall 2008, he
helped start up and was the first CIO of ETFx Indexes LLC, a boutique index
provider focused on alternative investments.
A frequent speaker on a broad array of topics ranging from instrument
types (ETFs, hedge funds and derivatives), portfolio management, as well as
risk measurement/management, Richard has been quoted in a number of
publications including The Wall Street
Journal, Reuters, Investor's Business Daily, SmartMoney, CBS
MarketWatch and BusinessWeek. In addition to business television appearances
and writing articles for various industry publications and journals, Richard
has served as a chairman, moderator, panelist and advisory board member at
numerous industry conferences in the U.S., Canada and Europe, as well as more
recently in the Mideast and Far East Asian regions. Richard C. Kang is a
registered representative of ALPS Distributors, Inc.
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