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April 13, 2007

Key Component of ETF Lineup Still Missing
by Tyler Mordy

Recent action in the exchange-traded fund industry shows no sign of any slowing in its breathtaking growth path. There have been over 70 new US listings year-to-date, with worldwide assets continuing to explode in the first quarter of 2007 (US ETF assets are up 34.4% over the same period last year, according to the Investment Company Institute).

The objective for ETF providers remains clear: cover every component of the investable universe - long or short. One fund company has even filed to track a sector involved with "dermatology and wound care", not to mention an ETF focused on firms operating in the state of Missouri.

As the industry matures and financial markets go through rising and falling phases, markets will ultimately decide which ETFs are successful and which are not. Consistent with developments so far, assets will tend to gravitate towards the more "core" components of portfolios. As more options become available in these sectors, the individual investor is the clear winner. Elsewhere, it is definitely "buyer beware".

While ETF providers scramble to cover every nook and cranny of the market, one asset class is glaringly absent from the lineup: international fixed income. Bonds issued in foreign currency should be staples of well-diversified portfolios.A vast amount of financial literature supports this view, highlighting their importance in reducing risk and improving overall longer term returns. During inclement investment market periods - when you need diversification the most - bonds play a particularly vital role in managing risk and safeguarding capital - (certainly so in countries with a proclivity for declining currencies).

Benefits of Bond ETFs. Bond ETFs are a breakthrough in the fixed income portion of the portfolio construction process. Trading on exchanges similar to their equity brethren, they carry all the same benefits - ease of purchase, high liquidity, tax efficiency and one-stop diversification. Government, corporate and high-yield fixed income ETFs are all available (only domestic-oriented, for now).

They can also be purchased at a far lower cost than their mutual fund counterparts. In fact, actively managed bond funds have substantially higher fees, coupled with a dismal track record of generating alpha over the long run.

(See February/March issue of ETFocus for performance benchmark comparisons). With low real yields and lofty valuations in many asset classes, lower returns are quite probable over the next several years. In this type of environment, maintaining low expenses will be crucial.

Another principle advantage of bond ETFs is maintenance of a constant credit quality and duration profile. Without having to directly purchase bonds and roll them over at maturity each time, preserving durations in the fixed income component of active strategies becomes much more convenient with ETFs. Pricing transparency, historically only available at the institutional level, has been a further advantage for individual investors.

What about International? ETF providers have not ventured into the international fixed income arena, despite the success of ETF offerings in domestic bond markets. Although overseas exchanges list a small handful of fixed income ETFs, access is often restricted to high net worth individuals or institutional investors with the capital to negotiate lower transaction costs. Additional fees imposed by foreign exchanges also represent a substantial burden on individual investors.

Barclays' iShares suite of fixed income ETFs have been enormously popular. The broad-based fixed income ETF tracking the Lehman Brothers U.S. Aggregate Index (AMEX:AGG) has accumulated assets of over USD $5.5 billion since its inception in September 2003. ETF manufacturers, like State Street Global Advisors and Vanguard, have noticed. Both recently announced intentions to launch bond ETFs competing directly with the domestic lineup offered by Barclays.

So where are the foreign bond ETF offerings?

Case for Foreign Bonds. Higher returns and risk reduction are the primary rationales for investing in foreign bonds. But diversification benefits are only experienced when correlations are sufficiently low, as measured against other portfolio holdings.

In recent years, many asset classes with traditionally low correlations have seen a much higher correlation with the general stock market. This heightened correlation is emblematic of latter phases in lengthy bull market cycles (as exhibited in the financial market boom witnessed over the last few years). The implications are quite serious, as this decreases their utility as risk-reducing portfolio diversifiers and may lead to a false sense of actual diversification.

Fortunately, many segments of the foreign bond market have retained their low correlation status. In fact, international fixed income is currently one of the few remaining assets with low correlation statistics, even as measured from multiple currency domiciles.

With the US economy on recession watch and many financial markets looking stretched, current market conditions are characterized by growing risks and unfavourable valuations. Incorporating low or negatively correlated conservative assets with reasonable return prospects is now appropriate - foreign fixed income can certainly fill part of that role.

Emerging Asian Bonds Attractive. Asian bonds are an excellent example of a foreign fixed income market with low correlation qualities, in addition to higher yields, attractive value and sufficient liquidity. Improving credit quality, significantly undervalued currencies and positive structural economic reforms in the emerging Asian region bode well for future returns. Importantly, regional Asian bonds exhibit negative correlations to many markets including their own stock market and the more developed G7 bond markets. Consider the Hong Kong listed ABF Pan Asia Bond ETF (HKSE:2821), a basket of Asian currency denominated bonds issued by both government and quasi-government organizations in developing Asia. This ETF carries a mere 16 basis point expense ratio.

Unfortunately, an investment such as the ABF Bond ETF is not easily available to Canadian or US retail investors since it is only accessible on international exchanges. Crosslisting (i.e. securities with listings on multiple exchanges) these types of investment is becoming more common and would be a solution towards foreign bond access.

Investors vs. Wall Street - Perennial Mismatch. New product launches are often accompanied by the most inopportune timing, spurred on by investor demand after the asset class has experienced a strong run up. Many mutual fund providers learned this the hard way when, during the last innings of the dot-com boom, several tech-focused funds were launched just as the market was cresting. True to form, the same phenomenon will be repeated with some new offerings in the ETF industry.

But Wall Street will always have a different product to peddle. Fortunately, informed investors can be selective, only utilizing the vehicles which fit into their risk and return objectives. The same holds true for ETFs. Choosing the right ones is critical, but the primary focus should always be on the discipline of portfolio construction - holding the right assets in the most efficient vehicle.

Fixed income has never been a glamorous component of investor portfolios - and certainly not exciting enough for many on the Street. But the hallmarks of capital preservation, safety and diversification make bonds a critical constituent in successful portfolio management.

Tyler Mordy
Hahn Investment Stewards & Company Inc.

Hahn Investment Stewards & Company Inc.
Global Fund Management & Investment Counsel
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Phone: (888)-957-0602 e-mail: information@hahninvest.com

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