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Hungry Alpha Seekers Chomp Up ETFs

Sharp money managers love market volatility.

While some investors get squeamish by daily, 200-point rises and drops in the market, alpha-seeking managers are using exchange-traded funds' long and short capabilities to garner hedge-fund like returns on any given day.

And now, increasing numbers of sophisticated investors are flocking to these types of funds, particularly exchange-traded notes, with 57 new ETNs launched in the first half of the year, according to State Street Global Advisors' "2008 Mid-Year Exchange Traded Fund Report."

The overall number of ETFs issued in the first half of the year, 131, was sharply lower compared to last year, the report said, but when combined with the spike in ETNs, the number of exchange-traded products is very close to last year.

"Despite a sharp decline for U.S. equities in the first half of 2008, investors continued to increase their appetite for ETFs, which is a testament to the increasingly vital role ETFs play in a growing number of portfolios and strategies," said Tom Anderson, head of strategy and research for State Street's Intermediary Business Group. "ETFs are helping to level the playing field by improving access to segments of the market that were once beyond the reach of most investors."

Weak markets have caused a decline in industry assets, but the broadening range of ETF asset classes available-such as bonds, inverse, leveraged, emerging market, international and commodity ETFs-have helped investors diversify away from U.S. equities, the report said.

"Mutual fund advisors are using ETFs because they make sense and they are a lower-cost product," said Ed Lopez, director of ETF strategies for Rydex Investments. "ETF awareness is definitely growing."

A buy-and-hold strategy makes sense if you're logical and patient, but staying true to that logic can be difficult, especially when you're faced with a six-month decline, Lopez said. There are many prudent things investors can do to protect their portfolios.

"If you're looking to dabble in the financial sector but you don't want to commit 100% of your capital, you can consider a leveraged product for your portfolio," he said.

Inverse strategies allow investors to go long on a short product, without having to actually short anything, he said.

Inverse ETFs saw an incredible 112% increase in assets during the first half of 2008, according to the State Street report. Currency ETFs experienced a 62% increase in assets, commodity ETFs grew by 34% and fixed-income ETFs grew by 27%.

Bonds have always been a great way to diversify an equity portfolio and protect against inflation, Anderson said, but their high cost and low liquidity have prevented them from taking a larger role-until recently. Currently, bonds make up about 8% of total ETF assets, he said.

"Bonds have a lot of embedded costs," said Matt Tucker, principal and head of U.S. fixed income investment solutions for Barclays Global Investors. "It costs between 100 and 300 basis points to trade municipal bonds. With a bond ETF, it's a wrapped product that's easier to manage and cheaper."

Many Benefits

Bond ETFs are more liquid, transparent, cost effective and tax efficient than regular bonds, and they can be traded throughout the day, Tucker said.

Actively managed ETFs, which received considerable attention, speculation and media coverage earlier this year, finally debuted in March, just as the markets began to show serious problems.

That bad luck and poor timing has led to disappointing results for a well-intentioned product.

Five active ETFs have come to market since March, with combined assets of just $65 million, the State Street report said.

"More troublesome is the extremely low trading volumes in these ETFs, just over 2,000 shares average daily share volume," State Street said. The marketplace seems to be sitting on the sidelines, taking a "wait and see" attitude.

"We're still at the beginning of their cycle," Anderson said. "There's still definitely a place for active ETFs."

Sector ETFs, which break apart a broad index into its component parts-like financials, energy, utilities, materials, etc.-have garnered considerable interest lately as individual sectors have performed in sharp contrast to the rest of the index.

In the S&P 500 GICS Sector Indexes, financials were the worst-performing sector (with a total return of -29.73%), but saw assets increase by 57% in the first half of the year. The energy sector was the best performing, with a total return of 8.88%, but saw ETF assets increase by only 1.83% and the number of shares drop by almost 11%.

"Energy had been one of our strongest sectors, but it has seen negative flows recently," Lopez said. "In May and June, energy prices were taking off, but a lot of people were talking about a bubble. People were betting the energy prices bubble might pop and were taking profits off the table."

As people become more comfortable with ETFs, they will seek out more products that are uncorrelated with U.S. equities. Smart money will always find the performing assets.

"A large body of academic work suggests that asset returns have some degree of predictability," said Peng Chen, president of Ibbotson Associates, a wholly owned subsidiary of Morningstar "We can't control the gyrations of the market, but we can create portfolios that are diversified and tax efficient to help investors achieve more stable performance and keep more of the returns."

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