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Hedge Fund in a Single Security Makes Bogle See ETFs as Insane

John "Jack" Bogle Sr., founder of Vanguard Group, speaks at the Council of Institutional Investors spring luncheon in Washington D.C. April 11, 2005. Photographer: Ken Cedeno/Bloomberg

The skunk works at IShares’ headquarters in San Francisco is buzzing. Researchers in the development lab pore over data flashing across computer screens while colleagues refill their mugs at the coffee bar and huddle in conference rooms illuminated by translucent blue partitions.

These brainiacs, who create the exchange-traded funds that have made the BlackRock Inc. unit the kingpin of the global ETF market, took a radical departure in November from the index trackers IShares has churned out for a decade. They released a hedge fund in a box.

The IShares Diversified Alternatives Trust ETF packs the complex bets favored by hedge fund managers into one security. There’s no rock star money manager calling the shots; a computer program monitors the fund daily. Anyone with about $50 and a brokerage account can buy a share of an ETF that uses derivatives to bet on swings in stocks, government bonds, currencies and commodities around the world, Bloomberg Markets magazine reports in its July issue.

“There’s going to be a whole rash of these things coming out,” says Michael Latham, head of IShares’ U.S. and Canada operations.

A physicist named Nathan Most invented the ETF more than 20 years ago as a simple mutual fund that trades on bourses like a stock. Fund providers are now unleashing a new breed of “extreme ETFs” that use short selling, leverage and derivatives in a bid to capture a larger share of investor assets.

Double and Triple Returns

The creators range from BlackRock to startups founded by Ivy League professors. And the ETFs come in an array of styles. While “hedge fund replicators” mimic the strategies of exclusive investment pools, other ETFs offer investors easy entree to the volatile world of commodity futures trading. Some “leveraged and inverse” securities even promise to double and triple returns on moves in the Standard & Poor’s 500 Index and other benchmarks.

Assets in more than 260 such funds have soared to $40 billion globally from virtually zero in about four years, according to BlackRock.

Fund providers and registered investment advisers say that if used judiciously, extreme ETFs can help investors curb losses. In the first week of May, the Greek debt crisis triggered the most-volatile swings in U.S. stocks in more than a year. The S&P 500 dived more than 7 percent in five trading days. The ProShares Advisors LLC’s UltraShort S&P 500 ETF, which uses futures contracts and swaps to bet against the index, surged 17 percent during the same period.

‘It’s Insanity’

“If you’re not hedged these days, you’re going to get killed,” says Adam Patti, the chief executive officer of IndexIQ Advisors LLC, a firm in Rye Brook, New York, that copies hedge fund-style investing in ETFs.

John Bogle counters that extreme ETFs may be the next financial concoction to blow up in investors’ faces.

Bogle, the creator of the first index mutual fund in 1975, says these complex securities subvert the discipline of buy-and- hold investing and encourage investors to chase market-beating returns by speculating like day traders. The ProShares UltraShort S&P 500 ETF plunged 9 percent on May 10 after the stock market rallied on news that the European Union set up a bailout fund for indebted nations.

“It’s insanity,” says Bogle, 81, the founder of Vanguard Group Inc. “This is a classic case of Wall Street trying to capitalize on the worst instincts of investors.”

Some investment advisers say hedge fund replicators and their ilk may be twisting the innovative ETF into an overly complex and murky security that is dependent on derivatives.

Reining in Excesses

“I couldn’t possibly justify putting clients’ money into those because they’re brand new, not tested, and I don’t know what’s in them,” says Andrew Mathieson, the founder and managing member of Fairview Capital Investment Management LLC in Greenbrae, California. “It looks like just another way for investors to get plucked.”

Investors can examine the holdings for ETFs managed by IShares and other fund providers online.

“We believe innovation means good ideas coupled with good execution, and we focus on bringing products to market that provide greater access to a range of asset classes or investment strategies in efficient ways,” says Noel Archard, IShares’ head of product development.

Regulators are moving to rein in possible excesses. On March 25, the Securities and Exchange Commission announced it was deferring approval of new ETFs that use derivatives as its staff reviews whether fund managers are stuffing too much leverage and complexity into offerings aimed at retail investors.

Too Risky

And in June 2009, the SEC and the Financial Industry Regulatory Authority Inc. (Finra) issued a joint alert warning investors that returns in leveraged and inverse ETFs could deviate widely from their underlying indexes when held longer than a day.

Finra, the Washington-based organization that polices broker-dealers, has several investigations under way to see if investors are being sold ETFs they may not understand or that may be too risky for their needs, says James Shorris, the agency’s acting chief of enforcement. Shorris is concerned about the role ETFs are playing in what he calls the “retailization” of leverage, derivatives and other hedge fund-style investing techniques.

“Hedge funds are restricted to high-net-worth individuals and institutions for a reason; they are very complicated, and you have to take the risk of losing everything,” Shorris says. “It would surprise us if retail brokers could explain the risks satisfactorily to their customers.”

Garnering Momentum

All this action comes as ETFs continue to explode in popularity and draw investors away from traditional mutual funds. Assets in ETFs worldwide have more than doubled to $1.1 trillion since 2005, and with 833 new funds in the pipeline the market will soar another 20 to 30 percent this year, says Deborah Fuhr, BlackRock’s global head of ETF research.

While mutual funds, with $19.5 trillion in assets, still dwarf ETFs, these upstart securities are garnering momentum: In 2009, ETF providers raked in net sales of $118 billion in the U.S., more than two times the $54 billion collected by index mutual funds, according to Loren Fox, a senior analyst at Strategic Insight Mutual Fund Research and Consulting LLC.

On some days more than 4 out of 10 trades on U.S. stock exchanges involve ETFs, says Tom Lydon, the editor of, an industry website. Following the “flash crash” of U.S. equities on May 6, more than 70 percent of the trades canceled due to excessive declines involved ETFs, according to the SEC and Commodity Futures Trading Commission.

More Exotic Specimens

Some of the biggest names in asset management are jumping into the arena. Legg Mason Inc., Pacific Investment Management Co. and T. Rowe Price Group Inc. are in various stages of unveiling actively managed ETFs that aim to outperform market benchmarks the same way nonindex mutual funds do. And IShares has cracked the $2.7 trillion market for 401(k) retirement plans in the U.S. by selling its ETFs to small and mid-size companies.

“It’s safe to say ETFs aren’t a fad,” Lydon says.

The creators of ETFs are cranking out ever more exotic specimens to bolster the asset management fees they collect from investors. ETFs are cheap: The average plain vanilla one charges investors about 5 cents for every $10 they invest compared with 9 cents for stock index-based mutual funds, according to Morningstar Inc.

IShares and its competitors fetch far more money for complex funds. IShares’ Diversified Alternatives Trust ETF costs 0.95 percent, and the ProShares UltraShort S&P 500 ETF charges 0.91 percent.

Exorbitant Fees

The exotic securities cater to a broad spectrum of investors.

“You can use the exact same product for the most sophisticated institution and for mom-and-pop investors,” says IShares’ Latham, a burly Californian who grew up surfing the Pacific Ocean just 15 miles (24 kilometers) south of his office. “Goldman Sachs is buying the same product as my mom, and for the same price.”

Fund providers are also peddling fancy ETFs to investors who have soured on paying exorbitant fees to hedge funds. Many of these firms blocked clients from withdrawing cash during the credit crash, and about 2,500 out of 9,050 hedge funds in the U.S. shut down in 2008 and 2009, according to data compiled by Hedge Fund Research Inc.

Lack of Liquidity

The IQ Hedge Multi-Strategy Tracker ETF, with fees of 0.75 percent, is a bargain compared with the typical hedge fund that charges 2 percent on assets under management and 20 percent of gains, says IndexIQ’s Patti. Plus, shareholders can bail out of the ETF anytime they choose. The City of New Haven City Employees Retirement Fund invested $8 million in Patti’s strategy.

“The trustees were turned off by the lack of liquidity and transparency in traditional hedge funds,” says Derek Ciampini, a consultant at a unit of Ameriprise Financial Inc. who advised New Haven’s pension board.

In the late 1980s, Most, then head of product development at the American Stock Exchange, set out to boost volume by making mutual funds tradable securities. Most, a polymath who’d worked as an acoustical engineer and commodities trader, faced a problem: A mutual fund would constantly redeem shares as it traded, generating too many taxable transactions. So he retooled the mutual fund to make redemptions with securities instead of cash, limiting capital-gains taxes. That made ETFs cheaper and opened the door to continuous trading.

The First ETF

“That was the key concept of the ETF from which all other features evolved,” Most wrote in a foreword to Exchange Traded Funds by Jim Wiandt and Will McClatchy (Wiley, 2001). Most died in 2004 at the age of 90.

With Most’s help, State Street Corp. in 1993 brought out the first ETF, the SPDR S&P 500 Trust, which was dubbed the Spider. Investors wary of the newfangled instruments mostly shunned them for years.

Then in 2000, Lee Kranefuss, head of the retail products group at Barclays Global Investors in San Francisco, wagered that better product development and marketing would spur a market for ETFs. So with the support of BGI’s then-CEO Patricia Dunn, Kranefuss created IShares at the asset management division of London-based Barclays Plc. And he recruited Latham, an accountant who’d climbed BGI’s management ranks since joining the firm in 1994, to run IShares’ day-to-day operations.

Next Generation

During the next six years, IShares leapfrogged State Street and brought out scores of ETFs that tracked industries, international equities and, eventually, commodities, currencies and bonds. Today, IShares manages more than $516 billion in assets in 430-plus funds and commands 46 percent of the global market, about twice the combined share held by No. 2 State Street and No. 3 Vanguard, according to IShares and Bloomberg data.

Latham took over as head of IShares’ U.S. and Canadian businesses in January 2006 as pressure mounted from investors for exotic ETFs that would hedge market volatility.

“We’d come out of the baby stage where the industry was just trying to break through,” says Latham, tieless in a white Brooks Brothers shirt and chinos at IShares’ 10-story headquarters. “Now, it was moving into the next generation of ETFs.”

In early 2007, Latham turned to Archard, the product development chief, to mint a new line of ETFs with complex strategies that institutions had long used but had been largely inaccessible to Main Street investors. Archard, 40, a chatty Philadelphian fond of plying his colleagues with Dunkin’ Donuts, and his 20-member team occupy two floors at IShares.

Absolute Return

The open office, with its rows of computer screens and desks stacked with books on investing theory, feels like a cross between a trading floor and a university library. That’s fitting given IShares’ provenance. In the late 1960s, economists Eugene Fama, Myron Scholes and William Sharpe tested their theories about market efficiency and risk-return ratios at the firm that eventually became BGI. In 1971, it pioneered the first index strategy by tracking the performance of every equity on the New York Stock Exchange.

Now Archard, who had developed ETFs at Vanguard, and his team have created the first IShares ETF that doesn’t rely on an underlying index. Diversified Alternatives, which trades under the ticker ALT, isn’t designed to produce robust returns associated with hedge funds, according to its prospectus.

Instead, it’s set up to deliver modest gains regardless of how the global economy or the financial markets behave -- what Wall Street professionals call an absolute return. The fund’s paramount goal is to take half the risk of the average equity portfolio by going long and short in broad groups of securities, says the prospectus.

Three Strategies

The ETF blends three strategies that many hedge funds use to insulate their performance from wild swings in the markets. The “momentum/reversal” approach tries to anticipate which way a group of equity indexes, interest rates and commodities are going to move by looking at price history. If a stock index’s recent surge exceeds past performance, the ETF goes long; a slide below historical levels cues a short position. The other two approaches hunt for baskets of securities that are under- or overpriced and exploit changing spreads between groups of fixed-income securities and commodities contracts.

The fund executes all three strategies with futures contracts and currency forward contracts. On May 10, the ETF was bullish on the CAC 40 index of French stocks and the Australian dollar, and it was shorting the euro, Japanese government 10-year bonds and the S&P/TSX 60 index of Canadian equities.

Future ETFs

A computer program, closely monitored by a team of portfolio managers, oversees the fund’s holdings. The ETF, which has a market value of $55 million, has slipped 0.17 percent from its debut on Nov. 16 through May 27, about the same as the HFRX Global Hedge Fund Index.

Latham says this fund is a prelude to future ETFs. In December, BlackRock acquired BGI for $15.2 billion, making the New York-based company the No. 1 global investment firm, with $3.3 trillion in assets. Latham is now working to package BlackRock’s investment strategies in IShares’ ETFs. One area of research: tailoring funds to address specific liabilities for retirees. If inflation were to send a client’s health-care costs higher, for example, the ETF would automatically adjust its bets to produce extra income for a client’s medical bills.

Entrepreneurs are devising their own experimental ETFs. SummerHaven Investment Management LLC, a 14-month-old firm in Stamford, Connecticut, created an index to tame the unpredictable gyrations of commodity derivatives.

One-Room Office

The company, which plans to manage an ETF pegged to its SummerHaven Dynamic Commodity Index this year, hardly seems a hotbed of financial engineering. Its four partners share a one-room office subleased from Basso Capital Management, a hedge fund, with a view of Interstate 95.

SummerHaven’s founders know their way around the arcane world of raw materials investing: K. Geert Rouwenhorst, 50, is a Yale School of Management finance professor who authored a research paper called “Facts and Fantasies About Commodity Futures” in 2004 with Gary Gorton, then a professor at the Wharton School of the University of Pennsylvania. Gorton, now at Yale, is a senior adviser to SummerHaven.

Partner Kurt Nelson, 40, was head of UBS AG’s commodity index business in Stamford until last year.

Startling Results

Rouwenhorst and Gorton showed that from 1959 to 2004, commodities futures didn’t move in sync with stocks yet delivered about the same level of returns. Moreover, the contracts posed less risk for investors than equities, which was startling given the reputation of commodities for volatility.

In a 2007 follow-up paper, the duo, joined by Professor Fumio Hayashi from the University of Tokyo, demonstrated that futures for commodities with low inventories consistently outperformed those with abundant stockpiles.

“These guys brought academic respectability to commodities and showed it’s a real asset class and not just a place for speculators who go broke in pork bellies,” says Jim Rogers, an investor who called the bull market in raw materials in the late 1990s and is chairman of Rogers Holdings in Singapore.

Rouwenhorst, a data hound who studied the commodities-pricing treatises of economists John Maynard Keynes and Nicholas Kaldor, wanted to convert his thesis into an investing strategy. Beginning in the fall of 2009, he and Nelson, along with SummerHaven partner Adam Dunsby, assembled a basket of futures contracts for 27 commodities ranging from platinum to unleaded gasoline to hogs. Then they formulated algorithms to discover which commodities were fetching higher prices for immediate delivery rather than in the future, a pattern called backwardation that signals supplies are dwindling. And they also factored in short-term price momentum.

Nickel and Cotton

The index selects the 14 top contenders every month. In March, the portfolio rotated in nickel and cotton futures and rotated out aluminum and natural gas. And by giving the 14 contracts equal weight, the index decreases the risk of buying just crude or gold.

“When you think about stocks, you think about earnings,” Rouwenhorst says in the precise accent of his native Holland. “So what do you think about with commodity futures? The answer is inventories.”

The SummerHaven index was up 8 percent in the 12 months ended on May 27 compared with an 2 percent increase by the bellwether Goldman Sachs Commodity Index. In December, United States Commodity Fund LLC, an Alameda, California-based company that manages energy ETFs, announced it would distribute a SummerHaven fund.

Next Big Fiasco

Some money managers say investors should avoid extreme ETFs and get back to basics by acquiring undervalued stocks and holding them for the long term.

“We should be dialing this stuff down, but instead we’re going the opposite way,” says Robert Olstein, the chairman and chief investment officer of Olstein Capital Management LP, a mutual fund provider in Purchase, New York. “When all these funds come unglued, this is going to be the next big fiasco on the Street.”

Many investment professionals are telling their clients it may be riskier not to use these new ETFs. The S&P 500 fell 2.7 percent annually in the decade ended on Dec. 31, 2009. Investors, especially baby boomers on the cusp of retirement, have to consider the prospect of depending on income from their portfolios in a bear market.

“Most people want simple solutions, but buy-and-hold investing only works in a bull market,” says Louis Stanasolovich, CEO of Legend Financial Advisors Inc. in Pittsburgh. “Investors can be more nimble now; the tools are out there.”

Future of Investing

Investors are warming to this brave new world. In April 2009, Frank Transue, a Chicago-area civil engineer, agreed to let his investment adviser plow hundreds of thousands of dollars from his 401(k) plan into many ETFs, including one for oil futures and another that shorts Treasury bonds.

“It took some convincing because I’m a conservative investor,” Transue, 68, says. “Now, I’m looking at moving a large portion of my portfolio into ETFs.”

The true test for exotic new funds will come when they demonstrate they can reap profits consistently in a volatile, post-crash world. Then, shareholders will see whether these newfangled ETFs are the future of investing or just another financial experiment gone awry.

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