Tuckwell: Avoid Smart Indexes, Stay Simple


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[This interview previously appeared on HardAssetsInvestor.com and is republished here with permission.]

Graham Tuckwell, founder and chairman of ETF Securities, was a driving force in listing the world's first physical gold ETF in 2003 on the Australian Stock Exchange, followed in 2005 by the world's first oil ETF. And today of course, commodity-related funds make up a growing portion of the $1.5 trillion ETF industry. Tuckwell's U.K.-based ETF Securities now offers more than 200 exchange-traded products that offer access to equities, currencies and commodities. HAI Managing Editor Drew Voros recently spoke with Tuckwell about the ETF industry as a whole and the strategies that guide his company's products.

Hard Assets Investor: As a pioneer in the ETF industry, could you give me some of your impressions on how the ETF industry has developed?

Graham Tuckwell: It certainly has exceeded everybody's expectations. In some ways not surprisingly, but when you start from a zero base, it's hard to be confident and say, "This is going to open the commodity markets to all and be nearly a $200 billion market in just over a half-dozen years." In some sense we're not surprised, but we're very pleasantly surprised that it's actually achieved what many of us thought could well be possible.

HAI: Are you surprised at the breadth of the products? Or did you think that if one works, they're all going to work?

Tuckwell: When I started looking at this, I was only looking at the gold products. To be honest, I didn't actually know what an ETF was. They didn't really exist in Australia where I started the product, but I soon learned about it pretty quickly. But the ETF industry was somewhat in its infancy, particularly in Australia and Europe, although it had been around a few years in the U.S. I quickly latched onto the concept that it wasn't just gold; it could be a whole lot of other commodities. But clearly that required different technology. And I really wasn't aware of how the indices worked for tracking commodity prices, priced off futures markets.

That's why when we came out with the oil ETFs, which was our first-ever commodity product outside of gold, we in fact had our own formula built into the prospectus rather than tracking an index. We built that product from first principles based on the assumption that it had to actually match the position a futures trader would take in the market, because if it didn't, it could be arbitraged against us by the futures market.

As it turns out, of course, the formula that we invented matches what is now used in commodity indexes. Because back when we did the first oil product, there were only composite commodity indexes; there was no such thing as an individual commodity index. Therefore, I didn't look too deeply into how these commodity indexes were built.

So it was only when I approached the Dow Jones-AIG Index people to create an individual commodity index for the first time that we realized that the way they built them was exactly the way that we had already built our oil product.

HAI: What was the initial reasoning behind the first gold ETF in 2003?

Tuckwell: I was on the investment committee of the Australian Gold Council. I'd been asked to attend a few of those meetings. And at one of those, the Australian Stock Exchange had come along and said, "Look, a couple of banks have approached us wanting to do options on gold. But in order to list the options, we need to have some form of the underlying listed in order to price them.

And I said, "Well, that's a good idea; you should list gold on the [Australia] Stock Exchange." They said, "Yes, but the problem is we only list companies on the Stock Exchange, because that's what it's for:stocks." I thought, "Surely, we can come up with some sort of mechanism." I said, "Well, we should do it. Maybe we should invent something to do it." And everybody thought, "That's really a good idea."

And I said, "Well, who's going to pay for it?" And then that's when everybody sat on their hands. And I said, "I think it's a good idea; I'll pay for it. But if I pay for it, I'm going to own it." So that's what happened and we managed to get it done. That structure has now stood the test of time. But the interesting thing was, when I went to get it listed, I said to the Australian Gold Council, "I'd like your support in this." And they said, "Well, Mr. Tuckwell, we're not too sure you're worthy of our support. We are the Australian Gold Council; perhaps we should only give it to a big investment bank, not a small guy like you."

I thought, well, I don't like that. So I promptly went and talked to the World Gold Council and they said, "Yeah, that's a fantastic idea; we'd love to support you." And that's actually why the World Gold Council appeared in the prospectus and not the Australian Gold Council.

HAI: And of course later the World Gold Council co-opted your idea for the SPDR Gold Trust (NYSE Arca:GLD).

Tuckwell: Well, to be fair, one of the members of the World Gold Council, Pierre Lassonde, had thought of the concept and talked to the World Gold Council about doing some sort of gold product. That was still in its relatively early stages when I was doing mine. He subsequently became chairman of the World Gold Council. Had I known how big the GLD ETF was going to be [$73.5 billion in AUM] right at the beginning, I would have moved the whole family straight to the U.S. and spent all of my money building GLD and got that out first.

HAI: What are some of the biggest disappointments in the development of the ETF industry, in your perspective?

Tuckwell: There has been a lot of negative publicity about ETFs coming from various sources, particularly last year. I thought that was complete overkill. I sort of totally expected a criticism coming from active managers because ETFs are going to gradually eat their lunch. There will always be a place for active managers, but instead of ETFs being, say, 20 percent of the market, and active managers being 80, it should be the other way around. Managers should be paid for asset allocation, not so much for stock picking. But there's always a place for really good stock pickers, as we know.

I think it's fair enough for regulators to look at the ETF industry, because it's going to grow and grow and grow. And the larger it grows, of course, the more understanding regulators should have of it. But I think there's nothing particular I've seen that's inherently wrong in ETFs. They are a recent invention because they generally depend on computers to price them intraday, unlike mutual funds, which are priced at the end of each day. I believe that for the most part, people would never have invented mutual funds in their current form had they had computers.

It's more a case of who's selling them, and education. They should be correctly labeled and only marketed to those people who really understand them. You want an open market; you don't want to regulate markets out of existence.

We have to make sure that intermediaries are actually educated themselves on selling to their clients. Because most products, as we know, are sold, they're not bought. So the problem I see is not so much with the ETF providers as such; it's with the knowledge of the intermediaries and making sure they understand them.

HAI:A lot of people talk about alpha-generating commodity products. Is that an oxymoron?

Tuckwell: Yes, I think it is when referring to attempts to optimize roll strategies. There are a lot of people who have been around the commodities markets for many, many years that are well aware of how to trade out along the curve and do things in different ways. We in fact have two types of products:The normal ones, that we call the classic products, which are the short end of the curve; and we've got a whole suite of products that prices six months out.

And what we've found is simply by just doing that, going six months out, it's actually outperforming most of these so-called smart indexes, which is interesting in itself. In other words, smart indexes look to be good on paper, but in practice, they don't deliver much more than what one can obtain just by going further out on the curve and sticking to some simple rules.

In other words, just by avoiding the contango by going further out is all that is needed, if that's where the markets happen to be. And of course in certain markets, the front end of the curve product will perform best.

HAI: Clearly precious metals have worked as a commodity for exchange-traded products. Are there some major commodities, let's say for instance, agricultural products, that just don't work as well?

Tuckwell: I think you're right. Over a long period of time, some of the agricultural products tend to behave as an inherent contango in the market. But the fact is, if prices are going up faster than the contango is eating away at them, then you can still get a good return.

HAI:Despite gold's correction, we're not seeing much in the way of outflows from gold funds. Why do you think that is?

Tuckwell: Perhaps the investors in our products and precious metals ETPs are there for a specific reason and not trying to speculate on price so much; they're trying to have it as part of a balanced portfolio. So what we tend to see is if prices run quite high, they will often sell, so we get redemptions. And then when prices pull back, that's when we get the creations. And you would say, "Well, that's a very logical thing to do; gee, we've actually got logical investors." Whereas what you find in many stock markets is when it rises like crazy, that's when all the buying comes in; you know:"When the bellhop is buying, you've got to exit." We see more logical behavior in our products.

HAI:What kind of innovation do you think there's room for in the industry?

Tuckwell: The next big step has to be a far broader usage of ETFs. They should be available to a much wider audience. For example, wider adoption of ETFs in the 401(k) market in the U.S. is a logical one. The audiences that have bought into ETFs have been somewhat narrow. But I think there is still a great deal of the investment community that doesn't necessarily know about ETFs very much at all. And that's certainly the case in some of the global markets. If you look at some of the markets in Asia, they've hardly got any ETF industry, if at all. That will definitely flow through. But I think you've still got significant gaps in the markets, even in the most developed market.

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