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ETFR
exchange-traded funds report
www.indexuniverse.com/ETFR
Issue No. 78
May 2007
And That’s
The Way it Is
By Jim Wiandt
Let me say first that I am a big fan of
Tom Lauricella and Diya Gullapalli of The
Wall Street Journal. I think there are few
financial journalists out there really working
for investors’ interests. The financial
media is a sordid, incestuous landscape,
where big reporters are regularly
snatched up by fund companies to
become well-paid PR agents, and gritty
reporting is softened by fancy dinners
and golf outings. A reporter pointing out
scandalous behavior and really lobbying
for the interests of average investors is a
breath of fresh air. Often, that’s just what
Tom and Diya do.
But (and you knew there was a “but”
coming), these two have just plain gotten
it wrong this time. In a March 17
post mortem of the February 26-27 market
collapse, Tom and Diya came out
with a coauthored article, Fast-Money
Crowd Embraces ETFs.
UPDATES
Adding Risk for
Individual Investors
The article examined the performance of
emerging markets ETFs in the wake of
the collapse of the Chinese market. In
particular, it focused on the iShares FTSE
Xinhua 25 ETF (NYSE: FXI), a popular
fund tracking 25 large-cap Chinese companies
listed on the Hong Kong Stock
Exchange. The gist was that the very
structure of ETFs failed: US investors sold
ETFs like FXI at prices lower than the
underlying stocks ever traded. In short,
the article claimed, “fast money” took
advantage of individual investors.
Here’s the central fact of the article,
directly quoted:
One ETF managed by Barclays Global
Investors that tracks the Chinese stock
market closed the US day on Feb. 27 down
9.9% even though the index it was tracking
had fallen just 2.1% during Chinese trading
hours. That index fell another 3.1%
5
IN THIS ISSUE
ETFR's publisher, Jim Wiandt, discusses
the affect of recent market turmoil on FXI.
Cover
HealthShares, the slim health centric ETFs
that began trading on the NYSE earlier
this year, have become some of the most
active ETFs in the market recently,
attracting volume and assets.
Cover
The fundamental twist continues as FTSE
RAFI indexes become the basis for a line
of mutual funds by Charles Schwab; ETFs
tracking the same indexes were licensed
to PowerShares last year.
Page 3
Looking for a dash of pure technical
analysis to complete your portfolio?
PowerShares teamed up with Dorsey
Wright to design an ETF using a form of
technical analysis called relative strength.
Page 6
ETFR’s Q1 performance derby includes
the top 20 winning and losing ETFs.
Pages 8
ETFR’s monthly database includes all USlisted
ETFs. For European and international
ETFs, please see the electronic version
of ETFR or go to www.indexuniverse.com.
Page 12
HealthShares gain market appeal
After being excoriated in some corners
of the media for their reed thin, healthcentric
ETFs, seven HealthShares topped
the 10 best performing ETF list at close
of business on April 5, according to the
Wall Street Journal. (The three other
ETFs were also in the healthcare sector.)
While one day of stellar performance
does not a successful track
record make, it does suggest that this
ETF family can add alpha to a portfolio.
In the days following this headturning
performance, one or two
HealthShares remained among the
WSJ’s top ten ETFs.
The biotech space is heating up
and becoming more active since the
recent FDA’s Dandreon decision.
“There were more than 11 IPOs last
year in the biotech space, and liquidity
is trying to find a sector home,”
says Nat Wasserstein, president of
XShares Advisors. “Emerging markets
have been disappointing, blue chips
are flat at best, and real estate is dropping
like a stone.”
Wasserstein goes on to argue that
the hardest part of investing in
biotech is choosing individual stocks—
which is exactly why ETFs are so
appealing. While all health sector ETFs
diversify single stock risk,
HealthShares’ ETFs are slim tools that
allow investors to isolate a specific
healthcare subsector and can
serve strategies long or short.
3

ETFR
4 Natural gas ETF
in the works
Victoria Bay Asset Management, the
folks that brought the $900 million US
Oil Fund (AMEX: USO) to market, has
filed papers with the SEC for an ETF tied
to the price of natural gas. The US
Natural Gas will, like other commodity
ETFs, buy natural gas futures contracts
on the New York Mercantile Exchange
and roll them one month to the next,
while investing collateral cash in
Treasuries. Victoria Bay’s isn’t the first
natural gas ETF in development.
Barclays Global Investors is also planning
such a fund.
Claymore adds three
quirky and four style ETFs
In early April, Claymore Securities
added seven ETFs to its ever-expanding
lineup. As usual with this ETF provider,
three of the products are quirky, four
are domestic style boxes.
The style ETFs include: BIR Leaders
Mid-Cap Value (AMEX: BMV); BIR
Leaders Small-Cap Core (AMEX: BES),
Q1 Expert Portfolios
Amidst much market turmoil, the major
indexes were either flat or down slightly
as the first quarter closed. The Dow
was down 0.9%, while the S&P 500
and the Nasdaq Composite gained
0.2% and 0.3% respectively. (For a
fuller picture of first quarter performance,
see March Madness, this issue
page 7.)
The best performing
portfolio
for March was
Saddle River, up
1.98%, and the
best performer for
the quarter was
UPDATES
Great Companies Large-Cap Growth
(AMEX: XGC), and Zacks Mid-Cap Core
(AMEX: CZA).
The remaining three ETFs are:
• BIR Leaders 50 (AMEX: BST), which
tracks the BIR Leaders 50 Index. It
holds 50 common stocks and ADRs
listed on US exchanges and covered
by Best Independent Research,
LLC, a consortium of the following
five independent research companies:
Ativo Research, Channel Trend
Inc, Columbine Capital Services,
Ford Equity Research, and Thomas
White International.
• Ocean Tomo Growth 6
PMMA Momentum, up 3.34%.
Newcomer Saddle River Capital
Management rebalanced its portfolio,
as scheduled March 1, and now holds
RSP at 17.5%, IWR at 15%, IWM at
10%, EFA at 40%, EEM at 10% and
XLB at 7.5%.
All the portfolios invested $1 million
January 1, 2007 in no more than
ten ETFs.
Advisor
Ret (%)
Ret (%) Ret (%)
Q1
March
2006 2005
XTF 80 Growth 1.59 2.63 17.96 8.80
PMAA Momentum 1.94 3.34 19.71 9.90
Saddle River 1.98 2.05 16.78 13.16
S&P 500 1.00 0.30 15.80 4.84
Russell 2000 0.63 1.95 18.40 4.59
EAFE 2.90 4.05 26.30 13.34
1 the next day in China.
You can see what Tom and Diya are
driving at: If the underlying Chinese
stocks only dropped 5.2% over two days,
how could US investors sell with prices
down 9.9%?
The argument is wrong in many ways,
and this is one case where a picture is
definitely worth a thousand words. The
chart on page nine shows the performance
of three iterations of the FTSE
Xinhua 25 Index trading across three different
markets:
• The underlying index, trading in
China
• FXC, the UK-based ETF tied to the
index
• FXI, the US ETF
Where to begin?
The easiest place is with the assertion that
the Chinese market “fell another 3.1%
the next day.” Indeed: The underlying
index closed down 3.1% the next day in
China. But as you can see in the chart on
page nine, the market opened down 6%
from the previous close, or just 1.77% off
of the close of the US market (a full 4
hours and 45 minutes earlier). If you look
at that chart, the trend lines are almost
comically perfect: a seamless, connectthe-dots
painting of shifting investor sentiment.
It looks to me like, well, stock
market trading in action.
The article drove me crazy because I’d
spent a long time over two days with
Tom and Diya in the days before the article
was published patiently explaining
some of their misunderstandings of how
ETFs work. And after all of that, they
ended up posting something that really
warrants a retraction. If you’re going to
compare today’s US-listed ETF close with
something, try tomorrow’s live opening
of the Chinese index. It seemed to be a
case of the story writing itself, with the
facts being lined up behind that initial
idea, instead of the other way around.
The Facts
• On February 27, funds like FXI (and,
indeed, much of the market) went into a
downward spiral. Here’s that quote
again: “One ETF managed by Barclays
Global Investors that tracks the Chinese
stock market closed the US day on Feb.
27 down 9.9% even though the index it
was tracking had fallen just 2.1% during
Chinese trading hours. That index fell
another 3.1% the next day in China.”
• That first line is meaningless. The
market crash (and everyone knows international
markets have increasingly
moved in lockstep) did not start to happen
until early afternoon in the US, hours
after the Asian markets had closed.
• The second line is a fumble at best, and
a ham-handed hand at making the data fit
the story at worst. Focusing on the close of
Chinese trading the next day, rather than
the open, is simply a fundamental mistake.
Quick quiz: “How do free markets
work?” Answer: “They price in the relevant
information.” If someone sees what
they think is an inefficiency on the sell
side, they BUY BUY BUY. It happens every
day in every market in various degrees.
Only in the wake of a market sell-off and
settling is anything clear.
Effectively, the sellers of FXI were
caught that day in the same place as intraday
sellers of DIA, SPY or any one of a
thousand individual stocks: the markets hit
bottom around 3pm EST, and if you sold
then, you lost out. The US equity markets
recovered some territory 9
ETFR • May 2007 5

ETFR
5 between 3pm and 4pm that day,
and that recovery continued when the
Chinese market opened four-and-a-half
hours later. You can see that clearly in the
trend line of recovery in the chart below.
The great irony here is that there is far
more defined, gameable risk in a traditional
mutual fund that prices its net asset
value once a day. Say an ordinary
investor sends in money to his fund company
to purchase shares of the AA Active
China Fund at the close of the Chinese
market. He gets those shares priced at
the NAV. The next day, the US market
trades up 3%. A hedge fund manager
can practically be certain that the Chinese
market will follow the US market up when
it opens four-plus hours later. But because
the fund’s price is based on the previous
day’s close in China, he can still buy
shares at yesterday’s NAV. Essentially, for
a fund that does not “fair value price”
(and most of them don’t), the odds are
very strong that hedge fund managers
and other “fast money” can swoop in
and steal that return from the rest of the
funds shareholders. That, like expenses,
is something knowable; the live direction
of trading is not. I’ll take my chances in a
volatile market to bet on the losing team
after the game is over any day.
As a result, a long-only investor in a traditional
mutual fund is much more likely to
get damaged by hedge fund trading
around volatility than an ETF investor.
The only ETF investors who were damaged
in February were those who panicked and
bailed out intraday
on February 27.
Traditional fund
investors, on the
other hand, could
(and probably did)
get hit by a bunch of
shares being bought
on the cheap based
on stale pricing
(assuming no fair
value pricing is in
effect). To add insult
to injury, traditional
mutual fund shareholders
will have to
pay capital gains on
all the fund activity
caused by buys and
sells based on this
late-trading strategy.
Pct Change (%)
2.00%
0.00%
-2.00%
-4.00%
-6.00%
-8.00%
-10.00%
-12.00%
The Malaysia Example
Tom and Diya’s argument, while wrong,
is not new. The poster child for “failed
ETF pricing” is the iShares MSCI Malaysia
ETF (AMEX: EWM). In 1997, during the
Asian financial crisis, the Malaysian markets
shut down to international investors.
Malaysia’s politicians, furious at currency
speculators like George Soros, also halted
trading in the Malaysian ringgit.
For US investors, EWM quickly became
the only game in town. If you had bigtime
Malaysian exposure, EWM was the
only way to hedge it. Effectively, the ETF
became the price discovery mechanism
not only for the Malaysian market, but also
for the Malaysian currency.
As might be expected, the ETF traded
at wild premiums and discounts to the
closed-off Malaysian markets, with discounts
reaching 20-30%. But while people
decried these differences, the ETF was
actually doing its job: it was pricing the
market as accurately as possible, given
investor sentiment at the time.
FTSE China
Trading Feb 27 - Feb 28
16:15
21:00
0:30
3:30
7:30
11:30
15:30
19:30
23:30
3:00
6:30
10:30
13:30
Trading Hours (EST)
Conclusion
It seems to me that the only case Tom
and Diya could even try to make about
trading on February 27 is that ETFs trading
outside the live market for the underlying
stocks may have more volatility, due
to thinner overall trading. But what’s the
suggestion there? Shut down after-hours
trading? Don’t allow live trading on foreign
markets in the US? It’s lunacy, especially
when the obvious alternative (openend
funds) has more knowable downside
to investors. ETFs are only a reflection of
the markets they represent.
In effect, you end up blaming the
market for its own volatility. The ETF
structure didn’t fail, as Tom and Diya
seem to suggest. In fact, the opposite is
true: ETFs reflected prevailing market
sentiment at that time. There happened
to have been more sellers than buyers. If
you had the guts to take the other side of
that trade, instead of selling in panic, you
made money. That’s how the market
works. That’s arbitrage. That’s capitalism.
The truth is that ETFs have brought
MORE liquidity, MORE transparency and
MORE stability to the markets. You can
short ETFs, even in a precipitously falling
market (unlike ordinary equities). And if
a ton of short volume comes in, the ETF
shares theoretically have to be created to
cover those loans, necessitating the purchase
of the underlying and actually flattening
the downward volatility.
In short: good intentions, bad execution.
The great irony is that, like the general
tone of current affairs, the authors
have really turned reality on its head to
make the very strength of ETFs into their
weakness. They’re simply barking up the
wrong tree. Take on ETFs for being too
narrow? Sure. Do some exchange-traded
products have ill-considered structures
and active-like costs? Absolutely. Those
criticisms you can level. But don’t take on
the free markets.
FTSE China Local
Market
FXC China ETF London
FXI China ETF US
China
Market: 21:00pm – 3:00am
London
Market: 3:00am – 11:30am
US
Market: 9:30am – 16:15pm
ETFR • May 2007 9