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May 26, 2006

This Week's Financial Innovations
by David Shvartsman

There's been some interesting news lately of innovations in the financial markets. A number of new and previously unseen products were released onto the markets over the course of the past year, and during the week the just ended.

The rise of exchange traded funds, coinciding with the accelerating popularity of commodities, has brought about the creation of several new ETFs based on assets once relegated to the futures exchange. Market particpants can now take positions in gold, silver or oil as though they were buying a stock, but that is not all. Soon it may be possible for some intrepid souls to speculate in an asset class new to financial exchanges: residential homes.

Flipping houses, bacon

Just one of the week's recently launched products, the Chicago Mercantile Exchange housing futures began trading May 22. The CME housing contracts are based on ten different city markets and a composite housing index. So far the market has been slow to take off; a total of 52 contracts traded the first day. A Globeandmail.com story reported that not only are some skeptical about the market's ability to catch on, but that it can claim to accurately represent something so diverse as residential housing. Chicago real estate mogul Sam Zell offers his take:

"Houses are not the same," said Sam Zell, chairman of Chicago-based Equity Office Properties Trust and Equity Residential, the biggest U.S. apartment owner.

"It's very hard to come up with a kind of trading instrument that would truly reflect the risk and the reward when in fact the basic asset is not the same."

Despite pessimism from some observers, the CME and its partners are hoping that the contracts, based on the repeat sales analysis of the S&P/Case-Shiller Home Price Indices, will prove to be a reliable gauge of home price activity and a useful hedging instrument for property owners, builders and investors.

Leveraged ETFs

Reuters reported on Wednesday that ProFunds Advisor won approval to introduce 12 new ETFs, some of which will employ leverage. From Reuters:

The new funds, which would be known as ProShares, seek to offer double the daily performance of a market index, or double the inverse, or opposite, daily move of an index. Four of the 12 will not use leverage but seek to offer the inverse daily move of an index.

The ProShares funds will use borrowing, futures contracts and various other methods to create the desired leverage. While some mutual funds have used leverage for several years (some of the Rydex funds come to mind), industry insiders mentioned in Reuter's story say leveraged ETFs are an entirely new product. Apparently these ETFs have been long in the coming, with Index Funds Advisor's Jing Sun reporting on their development back in 2002.

A Gold Miner's ETF

Also new on the ETF front is the Market Vectors-Gold Miner's ETF (symbol:GDX), which began trading earlier this week. While previous gold-related entrants to the ETF market focused on tracking the metal, the new Gold Miner's ETF will actually follow an AMEX index of gold mining stocks. The AMEX Gold Miners Index (^GDM) and its components can be seen at Yahoo! Finance. The Gold Miner's ETF was brought out by Van Eck Global, who introduced America's first gold-mining stock mutual fund in 1968.

More to come?

All this and we have yet to mention the expanding horizons being explored by the financial exchanges in their round of merger mania. Should Euronext accept a merger bid from the New York Stock Exchange, it will create the first transatlantic share market and give the NYSE entry into the European derivatives market (via Euronext-owned Liffe).

Meanwhile, the Swiss Exchange is looking to guard its independance but has teamed up with Deutsche Boerse in a venture that will expand their joint offerings of securitized derivatives. According to a recent report in the Financial Times, the suite of offerings grows ever more complex but this does not hinder demand.

Led by banks in Germany, Switzerland and Italy, investors have been confronted by a bewildering range of structured products. While some, such as warrants, are familiar, others, such as highly complex synthetics with exotic trademarks, are harder to grasp.

But whatever their characteristics, demand is booming, whether from retail investors seeking guaranteed returns along with some downside capital protection, or institutions looking for more arcane products. The number of monthly new listings on the SWX alone doubled from 700 in the autumn to more than 1,400 in March.

That's all for this installment. Have a great week, everyone.

David Shvartsman
Finance Trends Matter

Copyright © 2005-2008 David Shvartsman

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