From the April 2013 issue of Research Magazine • Subscribe!

April 1, 2013

Enthused About Innovation

Guggenheim Partners has a rich history of serving institutional investors and ultra-high-net-worth individuals. And the firm, whose formula for success was defined by Meyer Guggenheim and his sons, has found a business model that works. It’s also pushed the New York City-based firm into one of the most innovative parts of the financial landscape: ETPs.

William H. Belden, III is a managing director and head of product development at Guggenheim Investments. Mr. Belden has direct oversight for mutual funds, closed end funds, exchange-traded funds, variable annuities and product strategy. Prior to his current role, he was responsible for the overall operations of Guggenheim Investments ETF business line, which included product development, distribution and marketing activities.

Mr. Belden earned his MBA from the University of Chicago’s Booth School of Business and has a B.S. in finance from Miami University. He is series 7, 24 and 63 registered. Here are excerpts from his conversation with Research magazine. 

The Guggenheim S&P 500 Equal Weight ETF (RSP) celebrates its 10-year anniversary in April 2013. Do you think equal weighted portfolios have gotten the recognition they deserve?

Launched in 2003, RSP was Guggenheim Investments’ first ETF as well as the first alternatively weighted ETF—a milestone in the industry. As you mentioned, the fund will celebrate its 10th anniversary later this year, which is a tremendous milestone specific to Guggenheim Investments. 

Alternative weighting methodologies, such as equal weighting, have garnered significant attention during the past several years, however we still do not feel that equally weighted portfolios have received the recognition they deserve. Cap weighting is the more traditional and commonly used investment methodology, while equal weighting takes some explanation to understand its many benefits, including outperformance and diversification potential. As it relates to diversification, equal weighting has the ability to provide broad exposure across market segments and sectors, which may reduce concentration risk and result in a more balanced portfolio. Furthermore, a systematic quarterly rebalance serves the purpose of reallocating from index constituents that have appreciated the most, and have potentially become over-valued, to those that have decreased in value, and are potentially undervalued. 

Those investors who have taken the time to educate themselves on the potential benefits of equally weighted strategies may have realized significant outperformance over the traditional cap-weighted approach. For example, over the past five years, RSP has offered more than 1,400 basis points of outperformance when compared to SPY, while exposing the investor to only slightly higher levels of volatility with 5-year annualized volatility levels of 23% and 19% respectively. 

It is important to note that equal weighting will not outperform during all market cycles. Historically, this weighting methodology has lagged during periods of mega-cap outperformance. However, it should be considered as part of the core equity holdings discussion alongside the market-cap weighted products.

Emerging markets still have higher economic growth rates compared to developed markets and many of these countries even have less debt. What kind of opportunities do you see?

Emerging market ETFs represented the fastest growing ETF segment in January of 2013 with $5 billion in net inflows.  We see exciting opportunities in a number of emerging market locales including Latin America and China. Taking a top down approach, what happens in the U.S. affects emerging markets. Per the U.S. Department of Commerce, and despite the slight contraction in Q4 2012, the U.S. economy has been expanding since Q3 2009. This drives export demand and presents growth opportunities for emerging markets. As China continues to import materials to fuel its export machine, emerging nations rich in natural resources, such as Chile and Peru, tend to benefit. 

Chile and Peru fall into a somewhat grey area with many index providers. Both have developed just enough to be included as emerging nations with some providers, thus giving them a very small percentage allocation within the index. As an alternative, the benchmark index for the Guggenheim Frontier ETF (FRN), is maintained by BNY Mellon, and includes Chile and Peru. As such, both receive larger allocations within that index. FRN is a simple way to get exposure to this region without having to assume significant single country risk.

The Guggenheim China Real Estate ETF (TAO) gained 58.73% and was a top performing ETF in 2012. How important is China to the global economy?

China has been, and continues to be, incredibly important to the global economy. It is the largest exporting nation in the world, the most populous, and the largest foreign holder of U.S. government debt. For the U.S. and European nations, the historical difficulties that manufacturers have had in entering China have put them at a competitive disadvantage. For China, a downgrade in the U.S. credit rating could devalue their Treasury holdings. 

As you mentioned, TAO has been performing well and is currently the only China real estate ETF in the market. Over its five year history, it has outperformed during periods of strong markets in China and conversely underperformed during more challenging periods. For broader exposure to the Chinese equity markets, we offer investors the Guggenheim China Small Cap ETF (HAO) and the Guggenheim China All-Cap ETF (YAO). 

In addition to equity based ETFs, several products have launched in the past year providing access to the Dim Sum bond market including the Guggenheim China Yuan Bond ETF (RMB). The Dim Sum bond market is comprised of renminbi denominated bonds issued in Hong Kong. The availability of these products signals the continued liberalization efforts by China to open portions of its markets to outside investment. 

The BulletShares ETFs take a unique approach to bond fund investing. What’s their strategy?

Fixed income ETFs have become an important access point to bonds for many investors. And similar to their equity counterparts, fixed income ETFs offer a low-cost, fully transparent alternative to bond mutual funds as well as individual bonds. Until recently, strategies such as setting up a bond ladder, or targeting a specific point on the yield curve, have been difficult to replicate through ETFs. 

Guggenheim created BulletShares ETFs as a way to offer investors solutions to these problems. BulletShares ETFs are structured to track an index comprised of bonds, as well as to mature in a targeted year. Unlike traditional ETFs, which have a perpetual life, defined-maturity ETFs have a specified maturity date established when the ETF is launched. When the fund reaches that maturity date, the fund’s final net asset value (NAV) is returned to the current shareholders. This pre-defined maturity date allows investors to create portfolios that can do the following:

  • Ladder a portfolio
  • Fill maturity gaps in an existing portfolio
  • Obtain targeted yield-curve exposure/manage interest rate exposure
  • Manage future cash flow needs

These benefits are in addition to the low-cost, fully transparent, tax efficient, and tradable structure provided by ETFs in general. The Guggenheim BulletShares suite is comprised of eight investment grade corporate bond ETFs and six high yield ETFs with maturities spanning 2013 to 2020.

As of this interview, three BulletShares products (BSCB, BSCC, BCJC) have reached successful maturity, demonstrating that defined maturity ETFs can be a powerful and effective way to manage to specific investment goals. As proof of their usefulness to investors, the BulletShares lineup has enjoyed explosive growth of over 127% for the twelve months ended 02/15/2013, with now over $2 billion in assets.

Stock market volatility last year hit pre-financial crisis lows. How should financial advisors be preparing their clients for higher volatility ahead?

If financial advisors expect volatility to be higher in 2013 than it was in 2012, and they are seeking to limit the amount of volatility in their clients’ portfolios, I would encourage them to consider dividend paying equity ETFs—both domestic and international. These ETFs consist of lower risk equities offering yields at a time when the “hunt for yield” continues to be at the forefront of many investment strategies.

Advisors may also do well by looking toward more defensively positioned stocks or ETFs consisting of similar constituents. These are stocks that tend to have low relative valuations, conservative accounting, dividend payments, as well as a history of relative outperformance during bear markets. 

The Guggenheim Defensive Equity ETF (DEF) may help a diversified portfolio better weather market volatility while still remaining positioned for upside opportunities. DEF is designed to provide exposure to “defensive” companies—those that have historically had superior risk/return profiles in down markets. As of the most recent quarter end, the defensive sectors of utilities, consumer staples, and health care comprised approximately 53% of the fund. An allocation to these sectors may help limit a portfolio’s downside risk.

Where do you think are the best income opportunities for dividend investors?

The Fed’s unprecedented participation in the market has continued to hold Treasury and agency securities at very high valuations. If and when the Fed reduces its participation in the market, valuations on many fixed income investments could fall. For those investors seeking income, equity income ETFs offer competitive yields and the opportunity for capital appreciation while being less sensitive to interest rate movements. 

There is a positive correlation between equity prices and the 10-year Treasury yield when it is below 4%. As of Feb. 20, 2013, we are just above 2% on the 10-Year Treasury. This could make the case for a continued focus on the equity income space as there are a number of products available to investors. Equity income ETFs use a wide-variety of screening techniques when picking the underlying constituents. Potential investors should review the holdings to make sure they align with their investment objectives.

The Guggenheim Multi-Asset Income ETF (CVY), which invests in dividend paying stocks, ADRs, MLPs and REITs, has been popular in the past year for this very reason. CVY offers a combination of attractive income with a current SEC Yield of 5.39%, and solid growth potential. Dividend-paying ADRs and MLPs deliver income—while equity exposure increases the potential for long-term price appreciation. 

ETF growth has been explosive during the past decade. Do you believe this growth is distorting financial markets?

No. The growth in ETF assets has certainly been explosive. With that growth have come questions regarding the effects that ETFs may have on market stability. We view these opinions as mostly unwarranted. Since its inception, the ETF structure has provided investors with a reliable source of liquidity and price discovery. Investors have rewarded the convenience and flexibility of that structure by continuing to invest in ETFs as a larger and larger portion of their overall portfolios.

To provide transparency to ETF investors, and without exception, ETF issuers are required to publicly post holdings of all ETFs on a daily basis. Investors are also able to estimate, on an intraday basis, the fair value of any ETF using the intraday net asset value (iNAV) capability in most trading screens. These mechanisms help provide greater depth and liquidity, and thus better price discovery, for the financial markets. These features should be interpreted as positives for the overall health of the financial system.

The first U.S. listed ETF was launched 20 years ago. What kind of future do you see for ETFs?

There are a number of areas in which I see future growth prospects for ETFs. There has been substantial growth in the number of registered investment advisors constructing portfolios consisting exclusively of ETFs. The focus for these firms has shifted from picking individual stocks and bonds to creating alpha through the use of a portfolio of ETFs. Assets in this space surpassed $50 billion in 2012 and have a very steep growth trajectory heading into 2013. 

Although only 18% of total U.S. ETF assets, the share of flows into fixed income ETFs continues to rise. Net flows into fixed income ETFs in 2012 topped $50 billion with taxable bond products accounting for $45 billion. This category alone has grown to $225 billion in assets, from $53 billion just four years ago. I see continued opportunities for product innovation and growth in the fixed income space. 

I also see room for growth in the alternative weighting space. Guggenheim currently has a suite of equally weighted ETFs as well as a suite of “pure style” ETFs, products benchmarked to indices with mandates targeting only the most growth-oriented or the most value-oriented stocks. These are both alternatives to the more commonly used market cap weighted indices. I see both equally weighted and pure style products as broader solutions to, and part of, the continued search for “better beta”—finding methods of indexing that produce superior risk-adjusted returns over the long run. 

As a next phase of ETF growth, or possibly as an extension of the “better beta” category, I see outcome oriented strategies as a natural transition point. These can be defined as ETFs offering the investor a specific solution-based outcome, or experience, as compared to the traditional index tracking or alternatively weighted products. Examples of outcome oriented strategies are low volatility ETFs and target-maturity ETFs such as the Guggenheim BulletShares suite mentioned previously. Low volatility ETFs seek to manage volatility by either allocating to equities with historically low realized volatility or by shifting between equity index exposure and cash. BulletShares offer investors a solution to cash flow needs while also allowing them to target specific maturities in the corporate and high yield bond spaces.

It is clear that the ETF industry has developed to a point where strategies, such as the two mentioned above, are possible. I expect innovation of this type to expand quickly, particularly in the fixed income space, as overall growth and focus on the ETF industry continues to increase. L

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