Better Commodity and Emerging Market ETFs - the ISE's Indexing Strategy

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Mark Abssy submits:

Mark Abssy is the Index & ETF Manager for the International Securities Exchange. In this capacity, Mark is responsible for all phases in the development of innovative tradable products from concept to commercial launch.

Prior to joining ISE, Mark has held various product management positions at Morgan Stanley Investment Management, Fidelity Investments and Loomis Sayles & Company LP and has worked on the institutional client side, managing short-term investments for Genzyme Corporation. Mr. Abssy is a member of the CFA Institute and the New York Society of Security Analysts. He received a BSBA in finance and international business from Northeastern University in Boston, Massachusetts.

Mark recently sat down with Seeking Alpha's Jonathan Liss to discuss the ISE's unique approach to indexing, offering much insight into the 10 (and counting) ETFs currently based on ISE indexes.


Seeking Alpha (( SA )): Thanks so much for taking the time to speak with us Mark. When and why did the ISE get into the indexing business? What has your experience been so far? At what point did you begin designing indexes with ETFs in mind?

Mark Abssy (( MA )): We started developing indexes in 2005. At that time, our focus was on developing indexes that we would use as the underlying for the derivatives contracts, options specifically. In 2007, we realized the opportunity available to us in the ETF space and have been enjoying what I like to call "modest success" in the space with approximately $1.2 billion of ETF assets tied to our indexes.

SA: How does the decision process work in terms of which indexes you have decided to create? Is it just about gaps in what's available to investors, or is it more about focusing on areas you feel you have real expertise and an ability to add value for investors?

MA: Product design ideas can come from any number of places. While we look to fill gaps in investors' portfolios, we do so by looking to fill gaps in ETF issuers' product lines - after all, an idea without a product is still "just" an idea.

The expertise question is interesting. I wouldn't necessarily say that we are experts in every single sector or area in which we produce indexes. I equate "expert" with being a seasoned industry analyst with his finger on the pulse of the industry in question with earnings targets, broad industry forecasts and thoughts and opinions on each company's management team. We can certainly speak to the fundamentals of an industry, but we're not a research shop in the classic sense. Where we look to add value is in devising the right methodology for the index and selecting components that will achieve the desired exposure.

SA: What was it about standard cap-weighted indexes that you feel offered investors an unsatisfying investing experience?

MA: Most of the industries/strategies covered by our indexes have companies with a wide range of market capitalization. We feel that allowing the larger cap companies to dominate deprives investors of participating in the growth opportunities provided by smaller companies. Further, it is often the smaller companies that provide true pure play exposure to an industry, particularly an emerging one.

SA: Have you found the heavier weighting of smaller cap companies within many of your indexes has led to underperformance vs. comparable cap-weighted sector indexes in down markets, as is frequently the case with small caps during market sell-offs? Would you say weighting or component selection have ultimately had more of a beneficial effect on ISE index performance?

MA: We use various weighting schemes as a tool to level the playing field in terms of providing exposure. We do want to give larger, more established companies a higher allocation but not so much that they end up drowning out the smaller names. I haven't run the attribution modeling, but I would say that from a performance perspective, component selection provides more impact to returns than the allocation methodology.

As to your question about small cap impact in down and up markets, this classic observation doesn't really play out in most of our indexes. The indexes tend to focus on narrow segments of the economy so any cap biases tend to be overshadowed by the overall health of the sector in question.

SA: Let's discuss some of your indexes that have been tied to specific ETFs. Probably the most popular of these is the ISE-Revere Natural Gas™ Index ((FUM)) which is currently tied to 3 ETFs: [[FCG]] from First Trust (which currently has more than $650 million in assets) and the leveraged and inverse leveraged [[FCGL]] and [[FCGS]] from Direxion. Why has FCG outperformed natural gas futures ETFs like UNG and GAZ so significantly? It seems the outperformance would be significant even with the contango issue removed from UNG's and GAZ's long-term performance.

MA: Outperformance of FUM over natural gas spot prices has to do with the idea that natural resource companies are inherently leveraged to the underlying natural resource they produce, extract or mine. I like to think about it in terms of what components go into valuing something. In commodity spot markets, prices are determined almost entirely on the current supply/demand curve. Equity valuation is much more complex, but my point here is that much of a company's valuation is derived from future expectations. As the price of a commodity rises, there is a kind of future earnings compounding effect that builds itself into the stock's current price.

We've seen this over time with natural gas stocks but there have been other recent examples, like last year when copper prices spiked. Copper spot prices jumped 10.24% from August 31 to the end of October 2010 and the ISE Global Copper™ Index rose 33.53% in that same time frame. What's interesting is that copper prices had been rising since May of 2010 and the index was rising too, but in lockstep with spot prices. It was only when copper spot prices hit a certain level that valuations on the companies in the index really took off.

SA: Your natural gas index is interesting for a few reasons, notably the fact that it's equally-weighted and the fact you're using a 'value-investing' bias in the screening process. Are these strategies you feel investors should be applying to all index selection? If not, why for natural gas specifically?

MA: Except in times of mania, every investor is a value investor (except maybe dedicated momentum investors). Because we had identified more than enough names in the space to maintain an index, we decided that including these screens would be additive to the process. Investors realize diversified exposure to the natural gas space and are doing so with a value bias. Not a bad combination.

With regards to applying this same selection and weighting methodology to all indexes, we develop index methodologies to custom fit the space we are in. What works for natural gas may not work for copper, which in turn won't work for wind energy, etc.

SA: Another interesting fund you built the index for is the First Trust ISE Chindia™ Index ETF ( FNI ). Where'd you come up with the idea to pair China and India? Are there advantages to populating the Chindia index solely with Chinese and Indian companies that trade in the U.S.? Are there sectors you wish were more or less heavily weighted?

MA: The rationale behind this one is really quite straightforward because I think the demographics of this trade speak for themselves. While we wanted to get exposure to these markets, the data we needed was difficult to obtain, and the markets even more difficult for issuers to access. If we were looking to create a more traditional benchmark then we would have used locally traded shares, even though the index would not have been readily investible for investment managers outside China and/or India.

In terms of sector exposure, the methodology guide naturally allocates names to those sectors dominating the space as defined by market cap and liquidity. Despite the role of market capitalization in component selection, final weighting is determined by equal weighted tiers. Again, we are looking to provide exposure to the theme, not trying to anticipate the next breakout sector.

SA: Going back to the launch of the First Trust ISE Water Index™ ETF ( FIW ) in May of 2007, the fund has crushed the three similar ETFs currently trading in the U.S. ([[CGW]], [[PHO]], [[PIO]]). This is a great lesson on the importance of choosing the right indexes when building your portfolio. What about the composition of this fund has made it such a great performer? Do you think investors can expect reversion to the mean here?

MA: Of the three funds you mentioned, the only apples to apples comparison I would make is FIW against PowerShares Water Resources Portfolio ETF ( PHO ) as the indexes for both funds are constrained to U.S.-listed names only. In looking at the long-term returns, FIW dominates PHO.

I honestly can't point specifically to the "one thing" that the ISE Water™ Index ((HHO)) has or does that provides a clear explanation for this [outperformance]. The underlying index for PHO is an equal weight index that rebalances quarterly while HHO utilizes a tiered weighting methodology that rebalances semi-annually. HHO's minimum market cap is $100 million ($50 million less than the other index) but the liquidity requirements (shares traded) are ten times as high (1 million as compared to 100,000). My guess is that a combination of differences in weighting methodology and timing of rebalance cycles play into the outperformance. Of course, FIW's lower expense ratio helps as well.

Mean reversion? I like to think that our index is the mean. Hopefully, investors will come to the conclusion that the way to get these returns is to invest in FIW, not hope that FIW is going to undergo some type of mean reversion.

See also Crouching Tigers, Hidden ETFs: AIA vs. ASEA on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: FIW , FNI , MA , PHO , SA

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