Green Shoots and the Sower

There appears to be growing conviction that what we've been witnessing the past eight weeks in the stock market is something more than a bear-market rally. Unfortunately, this is not the beginning of a secular bull market.  Bear market conditions will likely resume.  Buying the S&P 500 at these valuations is very risky given the awful economic fundamentals and considerable work required to repair the damage to the financial and economic system caused by the excesses of the past two decades. The massive monetary and fiscal policy responses to this crisis alone would suggest that this will not be a typical recession and recovery in severity or duration. 

 

Grant's Interest Rate Observer estimates that the government has currently provided combined monetary and fiscal stimulus of approximately 30% of U. S. gross domestic product (GDP) of $14.2 trillion.  This level of stimulus is unprecedented.  For example, monetary and fiscal stimulus applied in The Great Depression period of August 1929 to March 1933 totalled 8% of GDP.  The combined stimulus in the 2001 recession totalled 7% of GDP.  The central issue for the U.S. economic system is that we have too much debt - personal, corporate and governmental.  Total debt to GDP approximates 360%, up dramatically from 230% in the early 1990s.  This debt needs to be paid off through savings, restructured (debt for equity exchanges), destroyed through defaults or otherwise inflated away. This is likely the beginning of a major generational economic adjustment with prudent savings for retirement replacing profligate spending of the massive baby boomer generation.  Consumer spending represents approximately 70% of U.S. GDP and will be adjusting downward toward 63% level as the consumer savings rate rises to 5% to 10%.

 

U.S. economic issues of this size and scope will not be resolved quickly.  Ever since Ben Bernanke, chairman of the Federal Reserve Board, told 60 Minutes in mid-March that he detected "green shoots" of economic recovery, the phrase "green shoots" has become an often used propaganda message.  Desperate for any sign of hope, the political establishment, Wall Street strategists, and media experts have taken to repeating the phrase "green shoots" as a soothing mantra.  The Administration, Congress and the Fed continue to throw manure on these economic "green shoots."  Please do not let this beautiful farming imagery mask the truth. In reality, the U.S. economy has only shown signs that it was deteriorating more slowly.  This passes for improvement and economic "green shoots."  Like life, there are no shortcuts to economic nirvana. There is a lot of hoeing still required to get our economy back on a sustainable growth path.  As Dwight Eisenhower once said  "Farming looks mighty easy when your plow is a pencil and you're a thousand miles from the corn field."  In short, Ben Bernanke is an academic, pencil pushing bureaucrat, not a green thumbed farmer.  Some of Ben's monetary actions and related Federal policy responses will undoubtedly fail to produce the intended results and may also have major unintended consequences.

 

This is reminiscent of the parable of the sower. The parable tells of seeds that were erratically scattered by a sower, some falling on the road and consequently eaten by birds, some falling on rock and consequently unable to take root, and some falling on thorns which choked the seed. According to the parable, it was only the seeds that fell on good soil and were able to germinate, producing a crop thirty, sixty, or even a hundredfold.  Like the sower in the parable, the U. S. government has crudely distributed massive amounts of monetary and fiscal stimulus (seeds). Unfortunately, many financial experts believe that only a limited number of these economic seeds have been targeted to the "good soil" of infrastructure projects or other fertile commercial areas that will ultimately enhance the long term productive capacity of our nation.  The rest of the seed has fallen on road, rock or near thorns.

It's the Consumer Stupid!

Many investors took comfort last week when initial US gross domestic product (GDP) for the first quarter of 2008 was reported at 0.6% compared to consensus of 0.3% and initial unemployment for April came in at 5.0% versus consensus of 5.2%. We believe these initial reports are suspect and subject to negative revisions in the future.  Furthermore, since the consumer represents more than 70% of US GDP as the US consumer goes so goes the US economy. 

As we wrote last fall in "This Ain't My American Dream" about the subprime mess and credit excesses,  "Many of these young Americans will wake up some morning to find that their irresponsibly financed excesses of recent years have left them with no equity in their homes, no liquidity and limited access to credit.  How these young Americans and other citizens in similar situations respond will likely be a key determinant of the future direction of the United States economy and government leadership."

One of the best sources of information on current consumer sentiment is the University of Michigan/Reuter's Consumer Confidence Survey.  The headline of their April press release says it all, but here are some additional stats that paint a more complete picture of the American consumer's psyche.

• Headline "Confidence Sinks to Quarter Century Low"
• The Index of Consumer Sentiment was 62.6 in the April 2008 survey, down from 69.5 in March, and significantly below the 87.1 recorded last April and the recent peak of 96.9 recorded in January of 2007.
• The Index of Consumer Expectations, a closely watched component of the Index of Leading Economic Indicators, was 53.3 in the April 2008 survey, down from 60.1 in March, and well below the 75.9 recorded in April 2007 and the recent peak of 87.6 in January 2007.
• From the January 2007 peak, the Expectations Index has fallen 39%; the Expectations Index fell by 24% prior to the 1990 recession and by 30% prior to the 2001 recession.
• Just three-in-ten consumers plan to spend the tax rebate in 2008, with most consumers preferring to repay debt and add to savings.
• Smaller gains in inflation-adjusted incomes were expected in April than at any time in the past quarter century.
• Consumers expect the unemployment rate to steadily increase during the year ahead, rising to 6.0% by the start of 2009.
• Nearly nine-in-ten consumers thought the economy was already in recession, and three-in-four anticipated that bad financial times would persist for at least another year. This was the worst assessment of overall economic health since the early 1980's.
• Uncertainty about future income and job prospects has had a devastating impact on buying plans, with consumers citing these uncertainties three times as frequently as they did a year ago.

Although the Fed arguably prevented a systemic shock to the financial system with its rescue of Bear Stearns, as it relates to the broader economy the Fed can simply hope to promote a monetary environment conducive to stable prices, employment and growth and hope that the public and economy respond appropriately.  Naturally, we can expect to hear government propaganda statements about the health and resiliency of the US economy with increasing frequency (think reverse psychology, political agendas and legacies), but by no means do Ben Bernanke, Hank Paulson and the Federal Reserve control the direction of US economy.  Rather, the answer to the question of who controls the future direction of the US and global economy is "It's the consumer stupid!" (according to an oft used campaign quote from President Clinton).

This Ain't My American Dream!

The title for this article comes from a line from the song American Dream by Switchfoot.  The song tells a story about a young American who has a wake up call about living excessively.  The song lyrics are an excellent metaphor for the state of the United States financial system and economy brought on by the subprime mortgage mess and credit excesses of the past decade.

When success is equated with excess
The ambition for excess wrecks us
As the top of the mind there becomes a bottom line
Where success is equated with excess

Despite early Federal Reserve assurances that the subprime mortgage troubles would be contained and not cause significant spillover into the financial system and economy, it has occurred.  A comprehensive summary of the subprime crisis mess is available here on Wikipedia. 

As a result of this spillover, the risks of continued market adjustments and adverse economic fallout have increased significantly as past excesses are removed from the housing, credit and equity markets.  The contraction of credit in the subprime and prime mortgage markets has already led to downward pricing pressure in housing in certain real estate markets and the dramatic repricing of mortgage backed securities.  Similar debt deflation may also continue to play out in the debt and equity markets.

Like a puppet on a monetary string
Maybe we've been caught singing
Red white blue and green

But the Federal Reserve does not control the United States economy or its citizens as if they were puppets on a string. At most, the Fed can promote a monetary environment conducive to stable prices, employment and growth and hope that the public responds appropriately. 

The following considerations signal the great difficulty of the subprime financial crisis facing Federal Reserve Chairman Bernanke:

·      The Federal Reserve Chairman’s view of severity of the subprime troubles and its potential impact on the financial system and the economy has deteriorated rapidly.

·       Federal Reserve regulatory framework places considerable emphasis on market discipline. Therefore, the stability of the financial system depends on adequate risk measurement and management by market participants. Recent events raise questions about the adequacy of the risk controls by several market participants. This was particularly evident in financial industries that experienced rapid growth such as non-bank mortgage lenders (several have filed for bankruptcy) and hedge funds (bankruptcy of two Bear Stearns hedge funds and a large capital infusion to one Goldman Sachs hedge fund). In addition to their rapid growth, these industries are characterized by the use of sophisticated financial instruments such as asset securitizations, leverage and derivatives.

·       Note that unlike their bank and mutual fund/investment company brethren, non-bank lenders and hedge funds are lightly regulated.

When success is equated with excess
When you're fighting for the beamer, the lexus
As the heart and soul breathe in the company goals
Where success is equated with excess

We have witnessed an out-of-control credit expansion with company profits of the financial innovators - non-bank lenders and their financiers - taking precedence over the public good.  These financial innovators created new financial products (eg. subprime mortgages and consumer loans, asset backed securities and related securitizations, credit derivatives, interest-only mortgages, negative-amortization mortgages) whose risks were not well understood by consumers and investors.  The long term nature of these instruments makes the estimation of expected profits/losses and their valuation subject to considerable judgment since the economic outcome is contingent on future events.  These valuation difficulties are usually accompanied by enormous incentives to cheat in accounting because employee compensation is tied to reported company profits. Such features may allow profits to be initially reported when the actual underlying transactions will be unprofitable at the end of the day as occurred in the underwriting of subprime mortgages.

This quote from Warren Buffett in Berkshire Hathaway's 2004 annual report appropriately summarizes the situation of the financial innovators.

Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying problems (and occasionally fraud). The real test of a derivatives operation is what it achieves after operating for an extended period in a no-growth mode. You only learn who has been swimming naked when the tide goes out.

With the tide receding, our economic tale arrives at the consumer - the linchpin to the United States economy. 

·       Most American consumers are tapped out after a credit financed spending boom. Many do not know it yet, but their sources of credit have dried up.

·       70% of US GDP is tied to consumer spending. Arguably the boom in real estate and credit resulted in an increase in consumer spending, which has fueled economic growth. Now that the United States real estate and credit markets have cooled off and are contracting, one might reasonably expect a decline in consumer spending and hence a decline in economic growth.

·       According to a Beacon Economics study entitled "Savings and Asset Accumulation Among Americans 25 – 34"

Savings rates in the United States began to drop in early 1980s, from 11 percent of disposable income to 2 percent in 2000. Savings rates dipped into negative territory in 2005 and the first half of 2006. People are literally spending more than they are earning after taxes for the first time since the Great Depression.

·       The net worth of most Americans has declined from 1985 to 2004, particularly among 25 – 34 year olds.  This latter group likely represents a good cohort for the subprime and non-prime mortgage borrowers.

The mean net worth for all American households 25 to 34 increased from $25,000 in 1985 to $26,000 in 2004. However, the median of all households declined from $7,000 in 1985 to $4,000 in 2004. While the median for married households declined from $13,000 in 1985 to $9,000 in 2004.

Many of these young Americans will wake up some morning to find that their irresponsibly financed excesses of recent years have left them with no equity in their homes, no liquidity and limited access to credit.  How these young Americans and other citizens in similar situations respond will likely be a key determinant of the future direction of the United States economy and government leadership. 

I want out of this machine
It doesn't feel like freedom
This ain't my American dream!

Fuel up the helicopter Ben!

(Refers to a 2002 speech in which Bernanke referred to a statement made by famed economist Milton Friedman about using a "helicopter drop" of money into the economy to fight deflation. Bernanke's critics have since referred to him as "Helicopter Ben.") 

Money Really Does Grow on Trees

A Look at WisdomTree Investments

We've all heard the old proverb "Money doesn't grow on trees!" enumerable times in our pre-teen and teenage years. The lesson of this saying is straightforward become a productive member of your family and community, and gain your financial independence through work and service to others. Like many other life lessons, the principle is easy to grasp, but harder to execute, so the lesson is repeated until learned. We then build on this financial wisdom when we grasp the power of compounding, and learn that our money will work for us if we save and invest rather than spend and consume.

It is at this nexus of money, trees and investing that we find WisdomTree Investments, Inc., an emerging exchange-traded fund sponsor. WisdomTree employs the powerful imagery and natural association between money, trees and investing to brand its investment products. Through the use of famous quotes and historical passages on trees, this article takes a look at WisdomTree (Pink Sheets: WSDT) as a business and portfolio investment.

Someone's sitting in the shade today because someone planted a tree a long time ago. – Warren Buffett

WisdomTree is an investment management firm which develops domestic and international proprietary stock indices that serve as the basis for exchange-traded funds (ETFs). The WisdomTree Indices cover all major market capitalizations, both domestically and internationally. In contrast to capitalization-weighted indices, the WisdomTree Indices anchor the initial weights of individual stocks to a measure of fundamental value using other company specific economic factors such as dividends or earnings.

WisdomTree ETFs are differentiated from their competitors based upon their proprietary, fundamentally weighted indexes which introduce a value discipline, or tilt, to index portfolio construction. WisdomTree has a patent pending on the methodology and operation of its indices. WisdomTree believes fundamental values provide a more accurate picture of a company's intrinsic value than its market price alone. In other words, WisdomTree systematically employs Buffett’s security selection mantra "Price is what you pay. Value is what you get."

Recent research from Morgan Stanley "The "Value" of Fundamental Indexing" confirmed this value tilt and found that domestic fundamental indices, such as WisdomTree Indices and the FTSE RAFI US 1000, had high correlations with traditional value indices, such as S&P/Citicorp Value Indices. Additionally, Morgan Stanley researchers looked at risk adjusted returns (Sharpe Ratio) for various indices over 1, 3, 5 and 10 year periods ended 2006. The relevant WisdomTree Large-Cap, Mid-Cap, Small-Cap and Broad Market Cap indices generally had the highest risk adjusted returns in their class of capitalization-weighted, equal-weighted and other indices over the various time periods examined.

The creation of a thousand forests is in one acorn. -  Ralph Waldo Emerson

Acorns appear only on adult trees, and thus are often a symbol of patience and the fruition of long, hard labor. Such is the case with WisdomTree. Its principal sponsors have long labored in the investment field as investor, academic and regulator: Michael Steinhardt, one of the hedge fund industry’s most successful investors, Jeremy Siegel, one of the financial services industry’s most prominent academics from Wharton Business School, and Arthur Levitt, former Securities and Exchange Commission (SEC) Chairman and noted investor advocate.

WisdomTree’s ETF orchard opened for business on June 16, 2006 when it launched the first family of fundamentally weighted indices and ETFs with an initial 20 dividend weighted ETFs. This launch included the first international small cap ETF listed in the U.S. and the first family of ETFs that track indices comprised of high-yielding international equities. The first mover advantage has historically been significant in the ETF industry. For example, State Street Global Advisors (SSgA) introduced streetTRACKS Gold Trust (GLD) prior to Barclays Global Investors launch of iShares COMEX Gold Trust (IAU). GLD currently has total assets of approximately $10.8 billion compared with total assets of approximately $984 million for IAU at the end of March, 2007. WisdomTree International Small Cap Dividend ETF appears to have also garnered this first mover advantage and is now WisdomTree’s largest fund at $475 million as of May 9, 2007.

On October 13, 2006, WisdomTree introduced 10 international sector ETFs. These are the first ETFs to offer pure international sector exposure as existing ETFs are based on a "global" sector model and contain a mix of both international and domestic securities. On February 23, 2007, WisdomTree listed six domestic earnings-weighted ETFs.

They are like a tree planted near streams of water that yields its fruit in season; Its leaves never wither; whatever they do prospers. -   Psalms 1: 3

WisdomTree has been very strategic with its product introductions. It has focused its ETFs in the three largest product areas – Domestic equities (Large-Cap, Mid-Cap and Small-Cap), International, and Sector & Industry. According to Morgan Stanley research, these areas represent 45%, 26% and 12%, respectively, of ETF market share at the end of March, 2007. WisdomTree was not only first to market with a family of fundamentally weighted domestic indices of various capitalizations, but its international ETF product offerings provide great breadth and depth by geography, capitalization and sector.

Of its 36 existing funds, 24 are internationally oriented. While non-US equities account for approximately 55% of the MSCI ACWI (all country world index), most US investors have a substantially lower asset allocation to international equities in the 10% to 20% range. It would seem reasonable to expect US investor’s to increase their international asset allocations over time in an era of increasing globalization, more rapid growth opportunities abroad, and recent outperformance of international markets compared to the US.

Recent research from Morgan Stanley provides some early insights on the effectiveness of WisdomTree’s strategies. US-listed ETF assets grew $11.6 billion for the first quarter of 2007 to $477.1 billion, or at roughly a 10% annual growth rate. Total industry domestic Large-Cap ETF assets declined $1.7 billion to $149.9 billion, or roughly 5% annually, while WisdomTree ETFs in this category grew $241 million to $626 million. Total industry International ETF assets grew $5.2 billion to $126.1 billion, or roughly 17% annually, while WisdomTree category assets grew much more rapidly by adding $994 million to $2.4 billion.

He that planteth a tree is a servant of God, he provideth a kindness for many generations, and faces that he hath not seen shall bless him. -  Henry Van Dyke

While there are obvious economic and personal benefits associated with the innovative undertakings of the WisdomTree sponsors, some of the public statements of the principals also reflect some more altruistic motivations. The following is an excerpt of the April 30, 2007 Barron’s interview with Michael Steinhardt, WisdomTree Chairman and largest shareholder:

Steinhardt says he "was attracted to the idea of an investment product that would be superior in its performance and have at the same time low cost, great liquidity and total transparency." What also made these ETFs appealing is that they offered a good product to average investors, which in his view have not been well-served by mutual funds.

A fool sees not the same tree that a wise man sees. - William Blake, Proverbs of Hell, 1790

The market valuation of WisdomTree was broadly critiqued on limited information in a recent article in Economist on ETFs entitled "Revolution or Pollution?"

However, some worry that growth is getting out of hand, with valuations that recall the dotcom bubble. One ETF provider, WisdomTree, has seen the company’s own share price rise by 80% over the past year, even though it is yet to post a profit.

While WisdomTree has yet to post a profit, history tells us that successful investment advisory firms (Fidelity Investment, Vanguard Group, Fortress Investment, Blackstone Group) have been wonderful businesses to own. The attractiveness of the investment advisory platform reflects the relatively low fixed operating costs and significant operating leverage available with growth in assets under management. The greatest risk to the advisory model besides poor relative performance is runaway employee compensation. Wisdom Tree’s "passive" rather than active investment management platform significantly mitigates this risk. Meanwhile, history has not been as kind to most dotcom businesses.

Furthermore, unlike many dotcom companies whose only assets were intangible ".com" addresses and website hits, WisdomTree has $3.8 billion in assets under management (AUM) as of May 9, 2007 reflective of the tangible value of its intellectual property and its proprietary indices. Notably WisdomTree recently received two ETF industry awards for its innovative indexing methodology.

Do not be afraid to go out on a limb ... That's where the fruit is. -   Anonymous

So let’s inch out on a limb and review a few facts about the company before looking at valuation. Wisdom Tree is a development company and its shares trade on Pink Sheets. While WisdomTree does not currently file its financial statements with the SEC, its financial reports, including audited financial statements for the year ended December 31, 2006, are available at http://www.pinksheets.com/quote/finance.jsp?symbol=WSDT. WisdomTree recently announced that it intends to seek listing of its common stock on the Nasdaq Global Market by the end of 2007. In connection with that listing, the company would file periodic reports with the SEC. WisdomTree has 100.3 million shares outstanding and another 21 million of stock options, warrants, and restricted shares.

WisdomTree is engaged in a highly regulated and transparent industry. WisdomTree filed for and received exemptive relief from the SEC related to various provisions of the Federal securities laws necessary to create and market ETFs. The ETFs are marketed by WisdomTree Trust which is registered as an Investment Company with the SEC pursuant to the Investment Company Act of 1940. Its subsidiary WisdomTree Asset Management, Inc. serves as an investment advisor to the Trust and is a registered investment advisor with the SEC.

As of May 9, 2007, WisdomTree had an equity market capitalization and enterprise value (EV) of $702 million at $7.00 per share and assets under management (AUM) of $3.8 billion. This represents an EV/AUM ratio of 19%. This approximates the EV/AUM ratio (20%) at which AIG Global Investment Group and Atlantic-Pacific Capital, Inc. bought 18.8 million shares (15.9% of Company on a fully diluted basis) at $3 per share on December 22, 2006 when AUM was approximately $1.5 billion.

In addition to these new, sophisticated investors buying in at this EV/AUM level, existing stockholders and directors of WisdomTree also purchased 3,050,000 shares in this offering. WisdomTree closed at $7.80 or EV/AUM ratio of 52% after the AIG announcement. While the share price has languished since then, WisdomTree’s AUM has grown 153%, or $2.3 billion, to $3.8 billion on May 9, 2007 in the 4 ½ months since AIG made its investment.

Like an acorn, WisdomTree has massive potential for growth and ample opportunity to grow into its valuation. The ETF industry is still in its infancy. AUM for the industry has grown from $100 billion at the end of 2002 to $477 billion at the end the first quarter of 2007. ETFs are highly competitive investment alternatives to the $10 trillion mutual fund industry given their enhanced efficiency, transparency and performance reliability. WisdomTree ETFs were intelligently designed and strategically planted, and are being warmly nurtured by their disciplined caretakers for future generations to enjoy. As the business matures over the next decade and longer, holders of the WSDT common shares will find that with WisdomTree "Money Does Grow on Trees."

Full disclosure: Long WSDT in diversified, more risk tolerant client and personal portfolios.

World Series of ETFs

I am writing this piece on my return flight to Chicago from The World Series of Exchange Traded Funds (7th Annual) in Miami, FL on March 26, 2007. Various sources indicated that this is the most popular ETF conference. This was my first time at this conference so I am pleased to report that the popularity of the event is not solely due to the location and creative name (although major league baseball was my first career choice over finance and professional money management). Virtually all of the leading ETF families (Barclays Global Investors and State Street Global) and emerging ETF providers (XShares Advisors) were in attendance as well as several leading industry analysts and commentators. More importantly, the conference provided valuable information about current ETF industry trends and product developments.

We know from academic studies performed by Gary Brinson and his colleagues that asset allocation, rather than security selection, accounts for 90% of the variation in a portfolio's investment returns. We also know from studies by Ibbotson and others on the returns of major asset classes that stocks are the best performing asset over long periods. Most institutions, like the large endowments of Yale and Harvard University, have long adopted these and other academic findings in their investment processes. Unfortunately, a large share of the retail marketplace (individuals, families, etc.) has not. The retail world has adjusted its focus from individual securities to the portfolio level, but these investors have not fully embraced the advantages of strategic asset allocation, passive investment management (indexing) or the consideration of after-tax returns. The ETF industry is an emerging leader in applying academic theory to real world investing and making these institutional best practices available to the retail investors through their products. This article provides information on some of the product and other developments from the conference from the perspective of a potential retail investor.

One of the most significant take aways from this conference was that the ETF industry continues to be at the forefront of innovation in investment management. The industry as a whole is providing investors with valuable tools to manage risk at the asset class and portfolio level. There has been and will continue to be a proliferation of ETF products that capture various risk and return elements of the various asset classes. Optimally, these tools when effectively utilized will allow an investor to increase investment returns while lowering portfolio risk (variability in price). A critical element in chosing between various competing ETFs to achieve investment objectives is an understanding of the ETF structure - index construction and objectives, tax characteristics and liquidity. The following discussion will focus on index construction.

A review of the progression of the various ETF index structures is helpful in understanding these concepts. The initial criteria used to differentiate ETF products was primarily based upon existing index providers (S & P and Russell) and style classifications (Value, Growth and Core), similar to Morningstar's mutual fund classifications. An example of product risk segmentation at this level is large capitalization value ETFs (S & P 500 Value and Russell 1000 Value; indices favor lower price to earnings and price to book value stocks) as compared to various large cap growth ETFs (S & P 500 Growth and Russell 1000 Growth; indices favor faster growing companies with higher price to earnings and price to book value multiples). In addition to the porfolio composition differences at the index provider level (500 stocks versus 1000), each of these style based ETFs tries to capture a different risk-return element of the large capitalization domestic equity asset class based upon valuation metrics (PE and book value multiple).

More recently, the evaluation of risk and return elements of ETF products has progressed to strategic elements (active risk) with the creation of proprietary index weighting methodologies. These propreitary indexing methodologies generally did not exist prior to the introduction of the related ETFs and encompass strategies intended to generate excess returns relative to the market. Most of the more popular indices (S & P 500) used for ETFs are market weighted (index tends to hold more of the higher market cap and higher valued stocks). Proponents of alternative weighting regimes argue that there are better risk-adjusted indexing methodologies than market weighting and cite the 2000 and later bear market in which the higher valued S & P 500 market cap stocks suffered more than the S & P 500 as a whole. Alternatively weighted indices have emerged such as equal weighted ETFs (own 0.2% each of S & P 500 stocks) from Rydex Investments and fundamentally (strategically) weighted ETFs (weighted on fundamental factors like dividends, sales, etc.) from Wisdom Tree Investments, Inc. Since new ETF products are generally aggressively marketed at launch, it is very important to understand index composition to properly assess the level of active risk involved with these products.

An example of this product assessment would be the comparison of a marketed weighted S & P 500 ETF with about 20% of its portfolio in the top 10 names versus 2% for an equal weighted S & P 500 ETF. Although the level of active risk is far from the theoretically highest (single stock risk) by holding only the smallest, most volatile stock among the S & P 500, the equal weighted S & P 500 ETF certainly contemplates security "bets" very different from the market. Clearly, these ETFs should not be considered purely "passive" investments. Fundamentally weighted ETFs take a more pragmatic approach to the introduction of active risk than an arbitrary equal weighting and may have more practical use in an investor's portfolio construction process. This is particularly true if the investor has conviction that the strategic factor(s) (driver of security selection process) underlying the fundamental weighting and portfolio construction are likely to result in excess returns (expectation that active risk will generate higher returns). Wisdom Tree's fundamentally weighted ETFs may be the most appealing product currently available given that their predominant weighting factor is dividends. Dividends have been a significant component of total market returns (dividends plus price appreciation) over long periods of time. Regular quarterly dividends also tend to give managements and boards an additional element of focus and discipline. Wisdom Tree's backtesting of their weighting regime indicates significant outperformance at lower risk (volatility), but, of course, past performance is not necessarily indicative of future results.

A second highlight from the conference was that ETFs are a superior structure for alternative asset classes. This is most visible in commodity ETF products. For example, prior to the introduction of commodity based ETFs an investor seeking exposure to this low correlated asset class (reduces portfolio risk/enhances returns because commodity price movements have historically been mostly independent of stock and bond price movements) would have to pay 1.5% to 2.0% in management fees for access to an "actively" managed commodity pool, futures account or other product. Diversified, "passively" managed exposure to commodities (gold, silver, oil, natural gas, industrial metals, grains) can now be achieved cheaply through ETFs at approximately one-half the fees. As with equity ETFs, an understanding of a commodity ETF's index construction and objectives, tax characteristics and liquidity are critical to the investment decision. The ETF structure is also currently being used for investment in other low correlation asset classes and investment strategies generally not available to retail investors on a cost effective basis, such as currencies and leveraged and short (or inverse) exposures to equities.

A third benefit of the attending the conference was the opportunity to meet with two thoughtful, independent ETF research analysts. I recently subscribed to ETF research coverage provided by AltaVista Independent Research (http://www.etfresearchcenter.com/). I met with the company's president Michael Krause and was pleased to find we share a value orientation and an interest in country demographic trends as an indicator of future economic activity. AltaVista's extensive valuation and performance research on ETFs can be leveraged to manage risk. I also introduced myself to Richard Kang of The Beta Brief (http://www.thebetabrief.com/). Richard is a forward thinking, quantitative analyst on the ETF industry. His bloggings are generally thought provoking and informative and his contrarian views help keep readers alert to potential market risks and opportunities.

In summary, the World Series of ETF conference generally demonstrated that the ETF provider and analyst communtity are providing retail investors with useful, innovative and efficient products along with insightful research and analysis to properly assess these investment products. The ETF fund families together with an emerging independent analyst community are providing retail investors with practical tools and information necessary to adopt investment best practices commonly used by institutional investors - strategic asset allocation, passive investment management (indexing) and consideration of after-tax returns.