IndexUniverse is reporting the offering of a new frontier markets ETF on the Nasdaq: the PowerShares MENA Frontier Countries Portfolio (PMNA). The PMNA will track the Nasdaq OMX Middle East North Africa Index, which includes the countries of Bahrain, Egypt, Jordan, Kuwait, Lebanon, Morocco, Nigeria, Oman, Qatar, and the United Arab Emirates. Claymore recently offered the Claymore/BNY Mellon Frontier Markets ETF (FRN) on the Amex, which is more global given that in also includes countries in Asia, Europe, and Latin America, along with the Middle East and Africa. As a result of its focus, the PMNA is a little more concentrated in oil-rich countries. In a recent post we discussed the new Gulf States index launched by S&P, called the GCC 40, covering 40 stocks from the Gulf Cooperation Council. Of interest is that this index covers some of the same region as as the PMNA, but is focused more on financial companies, and less on crude oil and industrial companies.

The PMNA ETF may be of interest to those investors looking to participate in the growth of the oil-rich gulf states that are themselves in the process of reinvesting capital. Furthermore, some analysts have recently discussed how Africa could be one of the next regions for growth. If this is the case, then Northern Africa would be a good place to start investment in this continent.

Also, for those who are interested, there is a distinction between emerging and frontier markets. The term emerging market was first introduced by the World Bank and is often used to describe a country with an economy that is in the process of rapid industrialization, and one that usually finds itself between developing and developed status. The term frontier market is often used to describe equity markets of smaller and less accessible countries of the developing world, yet still investable. Frontier markets are essentially "pre-emerging" markets that are expected to be classified as emerging markets once capital and liquidity increase. Frontier markets could have a high level of development, but still be too small to be considered emerging (for instance, the Baltic States, such as Estonia and Lithuania). They could also be countries where investment restrictions have started to loosen, allowing companies to be investable (such as countries in the Gulf States), or be countries with lower levels of development than similar regional emerging markets (such as Vietnam and Pakistan). As to be expected, frontier markets in general may offer higher return and longer-term growth, but will also carry more risk.

As recently reported at Bloomberg, hedge funds have produced their worst first-half performance since 1990, when the firm Hedge Fund Research began tracking returns of the hedge fund industry. Hedge funds are down collectively 0.75% year to date. Lower equity returns, the impact of volatility, and the inability to borrow cheaply due to the credit crunch all appear to be affecting performance.

The impact of less leverage has been discussed for a while now, and the fallout of lower equity returns is evident to all investors. What has not been discussed as much is how increased volatility is apparently affecting some funds. This is ironic given that many funds and traders thrive on volatility, or at least need some type of market movement. Now, many managers are finding that they cannot cope with the changing nature of the markets.

As a result of the poor performance of the market, and in particular hedge funds that are often expected to protect against losses, investors appear less willing to stick around for the long-haul, and instead are looking for more immediate returns. Given the current challenges for hedge fund managers, large established funds with both proven strategies and proven managers are doing well. On the other hand, small funds are seeing lower returns, redemptions, and in some cases are closing up shop (see previous post).

In addition to hedge fund veterans, such as John Paulson and Philip Falcone, whose funds have returned 26% and 42% year to date, respectively, some quantitative funds using computer modeling for investment decision making are also up this year. New funds, with managers spinning off from existing larger, more credible funds are also seeing inflows of capital as investors look for managers and strategies that generate confidence and offer more reliability. No doubt struggling funds will continue to look for ways to generate alpha and keep nervous investors, and their capital, from heading for the exits. The trend of hedge funds scooping up talent, just as Wall Street is cutting back on salaries and bonuses, is likely to continue (see previous post).

As recently reported at IndexUniverse.com, Standard & Poor's launched the S&P GCC 40, covering 40 stocks from the Gulf Cooperation Council markets, a trade bloc formed by the Persian Gulf states of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates. The narrow-based index will contain large and liquid stocks that are participating in the current growth in the Persian Gulf. Of note is how Saudi Arabia, a largest market of the six, is excluded since it is not considered investable, or accessible to foreign investors. Stocks included in the index must have a market caps of $400 million or more and average daily volume over three months of at least $1 million. Three countries have the lion's share of the weighting, with the UAE at nearly 35% weighting, Kuwait at around 30%, and Qatar will a little over 29%. Financial companies also hold over 60% of the index weighting. Not surprisingly, the index was up 10.82% from January-May of this year, along with being up 39.22% for the last 12 months.

The index may prove to be popular as investors look for ways to diversity their international exposure away from the BRIC countries, while also participating in the growth spurred by higher crude oil prices, available capital, and increased investment in the region. Furthermore, crude oil and industrial companies do not dominate the index, allowing investors to limit their exposure to this volatile commodity directly, yet still benefit from its recent increases.

The WSJ is reporting on a survey of 96,000 investors, brokers, and analysts conducted by the CFA Institute. The survey found that many of its members want a new regulatory body to oversee rating firms, along with a different set of ratings for structured products, such as for mortgage-backed securities and CDOs. Amazing, the CFA survey found that 11% of the 1,940 respondents globally said they had seen a ratings firm change a rating as a result of pressure or influence from an outside party, such as a bond underwriter.

Around 47% of respondents said regulators should force ratings firms to use different symbols for structured-finance products that differ from ordinary corporate debt, while 42% said they should not. Even with current problems, the number voting for change is significant, given that changing from the AAA scale would be costly and may initially add even more confusion at a time when the credit market is already in a tenuous state. The article mentions how "The SEC proposed a new rule in June that would give ratings firms the choice between using new symbols for structured products or publishing more research about the products' risks. "Given the level of confusion, we felt there should be a more overt requirement" to use different symbols, said Mr. Schacht." I guess we don't need more information about the risk, just a different symbol system. I find it interesting how we cannot have both. I realize that is not exactly what is being said, but it is telling nonetheless. While ranking from 1-10, or something similar would be clearer when distinguishing the move from say, A to Baa, does it really help one understand the risk any better?

There is an interesting article from Bloomberg that discusses how TIPS (Treasury Inflation Protected Securities) are not living up to their goal of protecting against inflation. The principal for TIPS increase with increases in the CPI, yet many bond holders do not feel that the CPI is properly tracking inflation, in particular the large price increases in gasoline and soft commodities, such as corn. Even as prices have increased over the last 18 months, yields on TIPS relative to Treasuries have essentially stayed the same.

As an alternative, some investors are using swaptions, which when purchased give the buyer the right to purchase a swap. Swaptions are essentially options on interest-rate swaps. Inflation swaps allow one party to pay a fixed rate in exchange for the inflation rate. Lately, swaptions have been better at gaining value when the expectations of future inflation increase, even if the CPI is not keeping up. As an example, in April and May one-year inflation swaptions returned about 0.3%, compared with a 2% loss by TIPS of all maturities. Nonetheless, even while reacting to inflation better, some investors still prefer TIPS since they are backed by the government, unlike derivatives that depend on the credit quality of the issuing firm.

As a former Missouri native growing up in the suburbs of the St. Louis area, I had come to think of Anheuser-Busch and the Clydesdale's as part of my identity, even before I was old enough to drink. Along with McDonnell-Douglas (now gone and replaced by Boeing), AB was part of the fabric of St. Louis. Just about every person you knew either worked for Mac or AB, or at least had a family member or friend who did. When McDonnell-Douglas was finally taken over by Boeing, it felt like the city was losing its security blanket, even though most of the employees and operations stayed. Now that Anheuser-Busch may fall victim to a takeover attempt by InBev, it feels more like potentially losing a friend.

Of course, this friend was the one that hung out with the cool kids, and only the best cliques. To get a job at Busch, well, you seem to have to know someone, someone deep in the clique. Yet, we all tried. I mean how great would it be to work for a beer company, especially one as dominate as AB? As they say, people drink in good times and bad, so job security was a given. Plus, they owned (or did own) the baseball Cardinals, another St. Louis tradition. And of course, they made really cool commercials. All was good.

But then the city got punched in the gut with news that InBev was making a play for Bud. InBev? Who the heck is InBev? Coors, sure. We have all heard of Coors, but they were no threat. Miller? Sure. They were big competitors, but let's be real. We did not really worry about Miller. The great taste - less filling commercials were amusing, but again, not to worry. We had Bud Light. And then a little thing happened while everyone slept. Smaller beer companies started becoming larger ones, and before you knew it, once mighty AB was a target. Instead of being the one acquiring, AB became the acquired - maybe.

So there it is. As AB's stock languished in the high $40's and low $50's, InBev offered $65 a share ($46.4 billion total), and mouths in St. Louis and across the country collectively gaped open. As expected, Bud rejected the offer, and went on the offensive. As a starting point, the company began running countless commercials of the CEO August Busch IV talking about company heritage. Notably, the commercials also included other spots with father and former CEO August Busch III, who did not always agree with his son's stewardship. InBev quickly replied by running an advertisement discussing what it would not change, including the headquarters in St. Louis, the U.S. breweries, Grant's Farm, and of course, the Clydesdale's. In addition to commercials, AB has begun crafting a $1 billion cost cutting plan that they hope will bring value back to the shares. In other words, we don't need your $65 a share bid. We can do it ourselves.

The cost cutting plan will include cutting 10% of the workforce over two years through attrition, cuts in benefits, price hikes for its top beer brands, and the repurchase of $7 billion in shares. This is all good, unless of course you are a big beer drinker, or an employee seeing your benefits reduced. Yet, while possibility too little, too late, does this really help AB? If InBev does acquire AB, wouldn't you expect InBev to do exactly the same thing? It would seem that such a move by AB does not really strengthen their case with existing shareholders, as far as maintaining control, but actually makes it more likely that InBev will proceed with their takeover attempt. AB may be doing nothing more than speeding up the process for InBev, both from a cost-cutting perspective, and also from a takeover perspective. AB may simply be forcing their hand, causing them to raise their bid, or go hostile, beyond just threats to remove the board.

While seemingly late, and possibly counterproductive to halting a deal, AB may have no other choice than pursue the approach it is taking. AB currently does not have a poison pill in place, but does have the means of adopting one. Nonetheless, given their recent talk of increasing shareholder value internally, it is difficult to see them putting one in place. The other much talked about option of buying out the remaining half of Mexican brewer Groupo Modelo also seems unlikely given that all six families that control the remaining 50% would have to sign off on the deal.

If the deal does go through, it is unclear at what price. Some analysts are predicting that InBev may have to go as high as $73 per share to close the deal, while others are predicting that even if the InBev offer goes as high as $80 a share, AB would still say no. Of course, if $73 per share could make the deal happen, there is no guarantee that InBev could come up with the financing. InBev has written to AB stating that it has the necessary financing in place for the $65 per share deal, yet if the deal goes higher, or becomes hostile, it is unclear if banks will want to step out on a limb in the current credit environment. InBev also recently announced that it plans a stock sale to fund the AB bid (see Jackson Business Journal article), but did not disclose how much capital they hope to raise, causing some concern regarding their ability to obtain enough money from the credit markets to get the deal done.

So what is an investor or trader to do? If the deal does get done, it is likely to be at a higher price, possibility in the $70s. Given the closing price of $61.67 on July 3rd, that gives around a 5.4% return for a price of $65, a 13.5% return for a offer of $70 a share, and a return of 21.6% for a deal going out at $75 per share. If InBev were to pull a Microsoft and simply walk away instead of going hostile, the price will surely fall back near the before-take-over value (near $48 per share), representing around a 22.2% decrease in price, unless of course you assume that investors believe the internal turn-around story advertised by AB and reward the company with a higher valuation. Given how Yahoo! fell, even with the Google news, this is unlikely. Yet, if investors do believe the story, the downside of taking a position may not be as painful. Nonetheless, any position now, given either optimistic or pessimistic scenarios, should produce a roughly one-to-one risk-reward relationship.

For those who trade options, buying calls may be a safer, and a potentially more profitable move. Currently, the December $60 calls are going for about $5, essentially eliminating gain at a $65 per share takeover, but allowing you to double your money if the offer rises to $70 per share. Of course, traders will need faith that the offer will be increased. If expecting a $70 per share price, another investment might be the December $65 strike calls, which are going for about $2. At $70 you are getting over $5 for your $2 investment, and of course limiting your downside. To help pay your premium, traders could also sell December $50 strike puts, currently going for about $1.30, or December $45 strike puts, going for about $0.70, depending on whether you believe the turn-around story by AB, and how much you think the price might fall if the deal does not go through. September calls are a little cheaper, and give a slightly better reward if you think any deal will either be done or fall apart quickly. But this is only one trade, and probably not the best. Things may change tomorrow. There are countless possibilities.

As for me, I will probably have a hard time pulling the trigger. No only is the risk-reward outside my comfort zone, with too many possibilities, there is also added danger since this would be an emotional trade. As any trader knows, once emotions sets into your trading, you are dead. Furthermore, I would probably be rooting against myself. It would kind of like be betting on the Tigers over my beloved Cardinals in the 2006 World Series, simply because all year the Tigers appeared to be the better team. What is the point? I both lose and win no matter what happens. It's a wash. I guess I could buy some puts, but again, I would be trading with emotion, and not my head.

It is worth noting that I have closely followed and commented on the Microsoft-Yahoo! talks for the last six months, arguing that Jerry Yang should just look out for shareholder interest and get the deal done. Now as I find myself hoping AB can stay a St. Louis tradition, calls of hypocrisy are understandable. Yet, this one is slightly different, at least to me - AB has leading brands in its markets, and seems to have some idea how to create shareholder value. But, their are similarities too. Without a deal, shareholders will certainly have to wait and hope that management can delivery the same value for them, something that I am still not convinced Yahoo! could do by themselves. I believe that AB can. If they don't, AB has no one to blame but themselves. In general, the founders or the family members of founders will need to realize that they are vulnerable. This is not just their company, it is the shareholder's company. If they cannot bring value, then the shareholders will find someone who can. If you sit on your hands long enough, competitors and/or shareholders may take your company away from you. Just ask Steve Jobs. He ended-up getting control of his company back. AB may not be as fortunate.

Are you interested in generating returns that consistently on-average beat the S&P 500, have a low correlation with other assets, and have low volatility of returns? Looking to get into the commodity markets, but worried that crude oil, natural gas, coal, and the soft food commodities have gotten ahead of themselves? No need to worry. We have the prefect investment for you - wood. No kidding, wood. And when I say investment, I mean investment. Waiting around for trees to grow is not for active day traders.

As reported by IndexUniverse, it turns out that timber investments have outperformed stocks, bonds, and commodities over the long run. In fact, the NCREIF Timberland Index, which is the standard benchmark for this asset class, increased 18.4% last year, versus a 5.5% rise for the S&P 500. Over time, the Timberland Index has beat all the major asset classes, except small-cap stocks. From 1992-2006, returns for timber were 12.2%. During the same time, large cap stocks returned 10.6%, small cap stocks returned 15.4%, international equities returned 8.2%, and corporate bonds returned 8.0%. When you consider volatility using the Sharpe Ratio, timber has the highest risk-adjusted returns, even beating small cap stocks (the Sharpe ratio for small cap stock was 0.63%, while reaching 0.84% for timber). Since 1987, the timber index has had only one down year in 2001 (-5.25%). During the same time frame, the S&P 500 has been down four times (as low as -22.10%).

Timber as an asset class also has a very low correlation to other asset classes given that its primary driver (biological growth) is not as affected by sub-prime woes, dot-com meltdowns, or the next Enron. The trees just keep growing. Also, with timber there is always the threat of physical damage (who among us has not seen a California wildfire on TV recently). Yet for a diversified portfolio, physical losses usually only decrease returns by 0.1% annually, on average.

What are the downsides? First, timber has been attracting more attention lately, so some investors have been paying up for assets. There is a lot of institutional and private money chasing a limited number of trees, at least those open to harvest and investment. Some investors are now even looking overseas. As with any investment, overpaying can certainly lower returns. Second, trees are not liquid investments given that much of their return requires patience. When you look at the profits from trees, about 61% comes from biological growth, with 33% from the price of timber, and 6% from land appreciation. Selling at the right time, and waiting for the trees to get big enough to command top dollar, are key. Patience truly is a virtue for timber investors.

So where to invest? George Nichols, who authored the original IndexUniverse article, does a great job outlining the pros and cons of current "timber" investments in an article located here. I put quotes around the word timber because, as Nichols points out, many proclaimed timber investments are not what they seem. Two popular timber ETFs are the Claymore/Clear Global Timber Index ETF (CUT) and the iShares S&P Global Timber & Forestry Index Fund ETF (WOOD). If anything, they have easy to remember tickers. The problem with these ETFs is that they do not provide investors with direct access to the timber asset class - which has all the return, correlation, and volatility benefits mentioned earlier. Each is broadly focused on forestry/paper stocks, such as International Paper (IP). Instead of investing in an asset class, investors end up investing in a sector, one of which ironically may suffer with higher raw material timber costs. According to Nichols, WOOD appears to be a little better than CUT for correlation to timber, primarily due to its REIT exposure (more below). Nonetheless, it is also still not perfect, or really that good as a timber pure-play.

An alternative to ETFs are timber REITs. Nichols mentions three in his article: Plum Creek Timber (PCL), Rayonier (RYN), and Potlatch (PCH). Plum Creek has 8 million acres of forests, making it the country's largest non-government owner of timberland. Unfortunately, like the ETFs, the REITs are also not pure-play timber companies since each has manufacturing operations, giving significant exposure to sawmills and paper mills. Of the three mentioned, Plum Creek Timber has the highest timber exposure (71%), yet still suffers a low correlation to timber. Nonetheless, it is expected that correlations will increase in the future as firms continue to divest manufacturing assets, giving the funds a higher pure-play timber focus. Potlatch recently announced that it was spinning-off its pulp-based businesses.

So what to do? Nichols believes that in theory timber is an attractive asset class that should be considered as part of a portfolio. Unfortunately, in practice, getting some timber in your portfolio is more easily said than done. Of the group, PCL is the most attractive, even if not a perfect proxy for timber. Waiting for more divestment of manufacturing operations from each of the REITs may be necessary to fully see the benefits that timber investment offers. Who ever thought wood could be this profitable, and for that matter, so difficult to buy?

(Note: For those interested in more details beyond this summary, please refer to both articles written by Nichols. Each is well written and researched, providing both the pros and cons to timber investment, along with data to support his conclusions.)

Recently, there have been some interesting financial products being released and/or discussed (see previous posts, here and here). Now IndexUniverse.com is discussing the development of a no-load, open-ended mutual fund that is based on hedge fund replication techniques. The fund offered by IndexIQ, called the IQ Alpha Hedge Strategy Fund, replicates hedge funds returns by purchasing various combinations of individual securities and ETFs, ETNs, and ETVs. The fund does not come cheap since investors in the replication fund will need to pay both the management fees from the replication fund, along with the operating expenses of the underlying securities and exchanged traded products that are used for replication. As of June 4, 2008, the index was comprised of 13 ETFs, ETNs, and ETVs representing exchanged-listed securities, fixed income, currencies, commodities, and real estate assets. This will bring the total expenses of the fund to 1.64% for investor class shares, slightly below the 2% expense ratios often required by traditional hedge funds. The advantage is that unlike traditional hedge funds, replication strategies can save the investors the 20% fee on profits that is also typical for hedge funds.

The IQ Alpha Hedge Index uses algorithms to create six strategies that seek to replicate the risk-adjusted returns of six different hedge fund indexes, including Long/Short Equity (currently -16.67%), Equity Market Neutral (13.33%), Fixed Income Arbitrage (3.33%), Global Macro (33.33%), Emerging Markets (33.33%), and Event Driven (33.33%). Then, optimization techniques and leverage are used to generated alpha by adjusting the weights among these six hedge fund strategies. In addition to adjusting for return, adjustments are also made to provide lower volatility relative to the S&P 500, with a correlation to the S&P 500 that is similar to the correlation between typical hedge funds and the index. The fund, which has been offered for only a short time, currently has an alpha of 7.72%, beta of 0.48%, and correlation of 0.58 versus the S&P 500. More details about the fund can be found in their fund summary sheet. It is also worth mentioning that a number of researchers, investors, and hedge fund managers do not necessarily believe that replication funds are as fantastic as often advertised. A somewhat dated, albeit still interesting and different perspective can be found in a post at the Hedge Fund blog.

There is an article at Spiegel Online that discusses an interesting turn of events in the Persian Gulf, and another consequence of high crude oil prices. Oil rich countries are turning to coal to fuel existing and new coal-fired electricity power plants. Why would oil rich countries do this? Simple economics. Coal is currently cheaper per BTU, making it more cost effective for oil producing countries to export their crude oil, rather than use it for domestic electricity generation. As mentioned in the article, the cost of producing a megawatt hour of electricity using coal is only about 42% of the cost of producing electricity using natural gas, and only about 22% of the cost of using crude oil, based on current prices. Of course, coal is also currently more polluting than natural gas, and even crude oil. Even when using a modern anthracite-fired power plant, emission from coal are 750 grams of CO2 per kilowatt hour of electricity produced. This CO2 level is 100% more than a gas-fired power plant, and nearly 50% more than an oil-fired power plant. Yet, while affecting air quality, many of the Gulf States are classified as developing countries, meaning that they have no obligation to reduce their CO2 emissions under the Kyoto Protocol. Coal stocks took a beating yesterday, but if crude oil and natural gas prices continue to rise, more countries, especially those outside the Kyoto Protocol, will no doubt continue to increase their use of coal.

As reported at the People's Daily in China, futures trading volume is up 148% in the first half of 2008 as trading in farm products rose. Volume was up 36% at the Shanghai Futures Exchange, where gold, copper, and zinc trade. At the Zhengzhou Commodity Exchange, where wheat, cotton, and sugar are traded, volume was up 450%. The Dalian Commodity Exchange, which trades corn and soybeans, saw trading volume increase 381%. Compared with other developed world exchanges, the Chinese futures markets are still weaker, but futures trading in pork, steel, crude oil, silver, and lead are expected to be traded on the various Chinese futures exchanges in the near future, and volume in existing products is expected to continue to increase as well.

Farmers in Iowa and other regions across the U.S. are deciding if they plan to replant after recent flooding wiped-out entire crops. Not unexpected, prices for the soft agricultural commodities reacted to the news of the flooding with higher prices as traders began worrying about whether supply would be anywhere close to current demand levels. Fortunately, many farmers now take out crop insurance, allowing them to recover at least some of their initial investment (covering up to around 85% of average recent production). Since the floods of 1993, the number of acres of USDA-insured land has more than doubled. This leaves many farmers with a dilemma - take the insurance, or replant. If farmers take the insurance, supply will be down and prices are sure to stay high into the fall, and could potentially go higher. If farmers decide to replant, the potential exists for getting closer to a normal supply-demand balance, and preventing further prices increases.

As reported at the WSJ, the high price of soybeans, currently near $16.23 a bushel for July contracts (see additional WSJ story), is turning out to be too tempting for some farmers. As corn prices rose last year, many farmers switched from planting soybeans to planting corn. Even with the corn crop damage, recent USDA reports showed that farmers had planted 87.3 million acres of corn, compared to the original forecast of 86.0 million. The extra 1.3 million acres of supply caused the price of corn to sell off some this week. Of course, this also means that less soybeans had been planted. A farmers strike in Argentina, a major global supplier, has also put upward pressure on soybean prices. Ironically, the current high prices may actually be the catalysts needed to cause some farmers to forgo crop insurance and take the risk of replanting. For some farmers, even if the soybean yields are below 50% of normal levels, and soybean prices approach $10 a bushel, they can still make enough profit that it is worth taking the risk. But there are risk. In addition to the risk of new weather issues, crops planted this late are also at risk of being damaged from an early frost. Furthermore, corn planted after June 25th, and soybeans after July 10th, receive less coverage from insurers.

So what is an investor to do? Outside of investing directly in soybeans, where the risk of weather and other factors affecting supply and prices levels will still be volatile and somewhat unpredictable, another potential area for investment could be the fertilizer companies. Given the late planting, and issues with land and weather, farmers will no doubt be looking for ways to increase yields. This should help companies such as Potash (POT), Agrium (ARU), and Mosaic (MOS), each of which continues to have the ability to raise fertilizer prices. In addition to fertilizer, farmers will also need to purchase new seed. Companies that could benefit include Monsanto (MON), Dupont (DD), and Syngenta (SYT). If farmers are enticed by the high prices to replant soybeans, each of these companies should benefit. Furthermore, returns from this new round of planting will not be as sensitive to commodity price if there were to be any future crop damaging issues, such as additional harsh weather. Profits from the sale of fertilizer and seed will for the most part have already been made. One caveat to this would be any special offers given by companies working to help farmers replant. The CEO of Monsanto mentioned recently on CNBC that his company will not be charging full price for seed that is replanted as a result of flood damage. This is certainly a nice corporate gesture in a time of loss for farmers, and a time of higher food prices for all.

As reported a few days ago at the Financial Times, the Federal Reserve is reviewing whether or not to consider changing or loosen existing restrictions for non-bank holding companies, allowing them to take larger stakes in the banks without getting regulators involved. Some private equity firms have been interested in taking larger stakes, and providing the banks with much needed capital, but have stayed away due to existing limitations. Currently, companies that are not holding companies are prevented from owning more than 25% of a bank, and even less if they hold a board seat. Holders of large positions are also required to make what are called "source of strength" commitments, in essence agreeing to put up additional funds if necessary. While private equity funds are willing to take initial positions, many are reluctant to keep funding a decreasing asset.

The review by the Fed is in response to the need from banks to raise additional capital. Sovereign wealth funds provided some initial capital, but many have been shying away from U.S. financial companies, even at their current cheaper levels. To date banks have raised as much as $400 billion, but may need closer to $1,300 billion. To close the gap, the Fed may be forced to loosen restrictions in order to provide new ways to get the necessary capital to the struggling financial companies. The fact that the Fed is even considering such actions gives you an idea of how worried they are that another failure could develop. Even today there is an article in Vanity Fair discussing how rumor may have been the main contributer for initiating the run on Bear Stearns. The last thing the Fed, or the U.S. economy needs right now is for worries of capital concerns to cause another financial company to go under. Given the recent price action in LEH, C, JPM, MER, MS, and GS, the market certainly seems to be hinting at this possibility. Given that the Fed has its hands tied with regard to interest rates, unconventional approaches, such as making it easier for private equity to invest, or continuing to work through the discount window, may be its only current options.

The Guardian is reporting that foreign sovereign wealth funds are increasing investment in London hedge funds, in particular funds of funds. The capital increase is coming at a good time for the hedge funds as the credit crunch has decreased debt funding. The magazine Hedge Fund Manager Week is reporting that sovereign wealth funds are on average looking to increase alternative investment allocations from 1% to 10% of total portfolio assets.

Are you interested in wind energy, but don't have billions to invest like T. Boone Pickens? Are you afraid that you are going to pick the next pets.com, and not ebay.com? Don't fear. IndexUniverse.com is reporting that the PowerShares Nasdaq OMX Clean Edge Global Wind Energy Index (ticker: PWND - prospectus) is expected to begin trading next week. It is actually not the first wind ETF. A few weeks ago, the First Trust ISE Global Wind Energy Index Fund (ticker: FAN - prospectus) hit the market. The PWND ETF will begin with 31 companies in its portfolio. The FAN ETF currently has 67 companies. Both have a high level of global diversification, which makes sense, given that I am not sure how they could even find 31 companies in the U.S., let along 67, with a significant exposure to wind energy. As a result of reaching out to global players, PWND is able to list that 90% of its companies are pure-plays. FAN has about 66% pure-plays. What is a pure-play? As defined, most of the business in the company must comes directly from wind energy - or specifically, the company must either produce 1,000 megawatts of energy, or generate $1 billion a year from wind-related power. Non-pure-plays include companies such as General Electric and Siemens, each which have significant interest in wind energy, but for which wind is still a relatively small profit center when compared to other business operations.

In addition to capitalization requirements and weighting rules, the funds also differ in the way they pick their companies. PWND uses a quantitative-based system, while FAN uses more fundamental analysis. Since the methodologies used by each are different, both are expected to deliver similar, albeit different returns. Given that wind energy has been growing at almost 30% per year globally, and crude oil and natural gas are continuing to trade at high levels, wind energy should continue to generate interest and electricity as countries going green begin using less coal to fuel their power plants. Nonetheless, if tax breaks expire, and crude oil and natural gas come back to "normal" levels, interest in wind energy could fall back a little, adding some potential volatility to returns.

Given the global nature of the funds, and that the industry is just beginning to gain exposure, many of the pure-play wind companies are not well-known. For the FAN ETF, major holdings greater than 5% include Vestas Wind Systems, Repower Systems, Gamesa Corp Tecnologica SA, and Hansen Transmission International NV. Given that the PWND ETF follows the Nasdaq OMX Clean Edge Global Wind Energy Index, major components can be found here. The top five holdings greater than 1% include Zoltek Companies (ZOLT), American Superconductor Corporation (AMSC), KHD Humboldt Wedag International, General Electric (GE), and FPL Group, Inc. (FPL). Other U.S. listed companies in the FAN include AES Corp. (AES) and Xcel Energy (XEL).

Recently there was an interesting, albeit somewhat disturbing article at Platts discussing something many of us don't want to admit that we know is coming - higher electricity prices. I know, electricity prices are already high for many of you, along with just about everything else. I am not talking about those high prices, I am talking about the really high ones that are just around the corner. The ones that will result from higher commodity prices, which only seem to keep going higher. The ones that will continue to result from the lack of a coherent energy policy. The ones that result from environmental legislation, which if not carefully considered (no matter how good intentions), may have the ability along with higher commodity prices to bring the power system to its knees. The ones that unlike higher gasoline prices, which are high but still can be paid to purchase the commodity, may not even give us the opportunity to pay higher prices to receive services during a blackout. Yes, those are the ones I am talking about.

According to the Energy Information Administration (EIA), 49.0% of electricity is generated from coal, 20.0% from natural gas, 19.4% from nuclear, 7% from hydro, 1.6% from petroleum, with the remaining 3.1% from other sources, part of which are alternative energy sources not listed (solar, wind, etc.). Approximately 9.5% of electricity generation is currently from renewable sources. If Congress has its way, this number will increase as restrictions on carbon emissions get enacted. While everyone would like to see lower carbon emissions and a cleaner environment, such legislation will have consequences, many of which will be unintended (ethanol anyone?). Hopefully some of these consequences will be considered as we move forward as a country toward developing some type of energy policy, because while we all know about the high cost of gasoline, and the impact that burning this fuel has on our environment, we are also beginning to feel the effects of ethanol mandates, which even with their good intentions are producing unintended consequences of higher food and commodity costs. Unfortunately, electricity prices are the next form of energy that is likely to feel the effects of high commodity prices, regulation, and legislation in a way that is similar to the current impact of high crude oil prices.

Edison Electric Institute expects U.S. consumption to grow by 30% by 2030. Currently, the average U.S. household uses 21% more electricity than it did in 1978, and household consumption is expected to grow by 11% more over the next 20 years as home computer and air conditioning usage continues to rise. To support expected increased usage, infrastructure will also need to be improved, but it too is not keeping up. Desire and action are not enough. Even if we begin today to upgrade the power system infrastructure, it will not come cheap. Infrastructure costs are also going up as both copper and steel prices have been on the rise, affecting towers, transmission lines, and transformer cost. Yet demand will not wait as we hope for lower commodity costs in the future. The North American Electric Reliability Corporation expects peak demand to increase by 18% over the next 10 years, while committed resources are expected to only increase by 8.5%. Not only are services in doubt, but reliability is in jeopardy.

But it potentially gets worse. Congress and both of the presidential candidates are taking about instituting some form of cap-and-trade of carbon emissions (see a previous post for some of the lessons learned from cap-and-trade). The Regional Greenhouse Gas Initiative program begins next year in ten eastern states that already have cap-and-trade rules in place, although some business and governments are already getting nervous and beginning are proposing to place ceilings on the RGGI imposed allowance costs - on the order of a $2/allowance cap (Correction: The Business & Industry Association is pushing to get the caps included, but they are not yet in place as originally written). Without ceilings, some estimate the RGGI would add up to $120 million per year to electricity rates.

Congress is also considering the Lieberman-Warner Climate Security Act of 2007 for regulating greenhouse gas emissions through market-based solutions. While market-based solutions sound better than regulation to some, the Energy Information Administration is expecting the legislation to add between $30-325 per year per household by 2020 if enacted into law, with costs growing over time. The EIA forecast GDP losses from $444-1,308 billion over the 2009 to 2030 time period.

Fortunately, the U.S. has an abundance of coal, but increases in environmental regulations will prevent it from rising above its current 49% generation use levels, and this number is likely to decrease as companies continue to stop building coal-fired generation, and instead switch to cleaner burning fuels. Even if coal were to be used, coal prices are also going up - doubling over the last year as demand from China and across the globe increases. Alternatives sources such as wind power are increasing, but it is still insignificant, hydro has been decreasing, and nuclear power, even if approved and scaled to the level needed (a big "if") is at least 10 years away from receiving the necessary approvals, components, and build-time necessary to get it on-line. The cost to build and fuel nuclear plants is also not getting any cheaper.

That leaves natural gas, which has been reaching new highs over the last year and does not look to pull back anytime soon. Given that natural gas powered generation sets the marginal prices of electricity in much of the U.S., and that natural gas prices are increasing, it does not take much deductive logic to know that is going to happen to electric power prices. As carbon constraints are imposed, natural gas-fired generation, which is often used for peak generation, will now increasingly be used for normal capacity generation. Yet, as mentioned in a recent post, domestic LNG stockpiles are falling as shipments of LNG to the U.S. are instead going to Spain and Japan given the willingness of these countries to pay higher prices. Furthermore, if you consider that crude oil has at times traded with a 6-8 multiple to natural gas (see post), and you expect crude oil prices to either rise or not correct much from their current levels, then natural gas is likely to continue to rise from its current price.

And of course, all of this says nothing of the expected increase in hybrids and electric cars, or other green vehicles expected to run on hydrogen (which requires electricity to separate the hydrogen), or even run on natural gas itself. Each will facilitate an increase in natural gas and electricity prices. So in short, if you though that the inconvenience of not being able to take your normal Sunday drive or extra trip to Grandma's house was painful, you may experience even greater stress on your wallet as electricity prices begin responding to current commodity prices. When consumers have to cut back on air conditioning, reduce lighting, realize that their hybrids are not quite as economical as they thought, suffer planned brownouts, or even worse, an unplanned blackout, then Congress will begin to see the you know what hit the fan - assuming of course that there is any affordable electricity around to actually power the fan.

IndexUniverse.com is reporting about a new global index fund offered from Vanguard, called the Vanguard Total World Stock Index Fund. The new fund tracks the FTSE All-World Index, which currently weights the U.S. at 41% and the rest of the world at 59%. The index includes both developed and emerging markets, covering approximately 2,900 large and mid-cap stocks from 47 different countries. Talk about diversification. Investor, institutional, and ETF shares are offered. The fund trades under the symbol VT on the NYSE Arca exchange.

Not to be outdone, Northern Trust has registered, but not yet offered, an ETF to be called the Dow Jones Wilshire Global Total Market Index Fund. What a mouthful. The index will cover 58 countries and more than 12,800 companies. Can you say transaction costs? At least one broker will be happy.

As recently discussed in a post at Bull Bear Trader, the exchanges were beginning to join up with the operators of the various dark pools of liquidity. Now both the Financial Times and the WSJ are reporting a new union between the London Stock Exchange (LSE) and Lehman Brothers. Per the agreement, the LSE will offer trading of European companies that don't currently list on its exchange, matching buyers and sellers across more than ten European countries. The new service will be based on the Lehman Brothers dark pool trading environment. The multilateral trading platform, called Baikal, is expected to combine algorithmic trading functionality with dark pool liquidity. The venture with Lehman is hoped to allow the LSE to gain exposure into dark pools trading, and get back exchange volume that has been moving to other platforms and environments. According to the Tabb Group, dark pools currently account for about 10% of daily U.S. trading volume.

The recent trends toward dark pools and specialized trading has caused the exchanges to lose out to new electronic trading platforms that are aimed specifically at servicing computer-driven algorithmic traders. Such algorithmic traders are increasing responsible for driving trading volume and providing liquidity. Such threats are causing the margins in the public order books to come under increased pressure. Electronic-based algorithmic trading is also cited for the increase levels of volume and short-term price spikes that are seen in a number of equities and commodities. Unlike in the past, it is not that unusual anymore to see crude oil spike up or down $3-4 in less than an hour as a flood of buying or selling pressure hits the market from electronic orders.

The move to decimalization, with price spreads down to the penny, is also making it difficult for some specialists to create a market that is both profitable and also offers the level of liquidity that is required at each price point. Some market operators are even arguing for going back to larger spreads, such as a nickel, in order to increase the number of shares offered at each price and keep the exchanges in business, but it is doubtful the regulators will allow this. As more market participants use dark pools, the exchanges will look to move more trading volume to this environment due to the cost advantages over the public order books. As a result, the price transparency, increased liquidity, and smaller spreads that decimalization was ironically hoped to provide retail traders is likely to be compromised.

There is an interesting article in Barron's this week regarding catastrophe bonds. Basically, catastrophe bonds are similar to normal bonds in that you invest a principal in return for periodic coupons. Once the bond matures, you receive your principal back - hopefully. The hopefully part is where these bonds are slightly different. Yes, with all bonds you have the risk of losing your principal, but for cat bonds it is less about credit risk, and more, obviously, about catastrophic risk. In most cases this is a binary proposition. If there is no event, you get all your money back. If there is an event, you do not get anything back. In return you get a nice coupon to compensate for the risk you are taking. After Hurricane Katrina, one cat bond tranche was offered by Swiss Re with an annual coupon of near 40%. In fact, cat bonds have returned over 33% from 2005 to this May, ahead of the 19.1% offered by the Lehman High Yield Corporate Bond Index over the same time frame. A additional benefit of cat bonds, beyond the high yields, is that their returns are often uncorrelated with the returns of other equity or fixed income investments, providing another vehicle for diversification.

Cat bonds were designed as a way for insurance companies to remain solvent if an event they insured does occurs. Insurance companies could simply buy reinsurance, passing the risk on to another insurance company, but there is the worry of too much correlation to the event. As an alternative, they could sponsor a cat bond. In short, the company would create a special purpose entity (yes, I know what you are thinking) that would issue the cat bonds with the help of an investment bank. Investors would then buy the bonds and receive a coupon with a defined spread over Libor. This spread can be as little as 0.5% to 20% or more depending on the event and the likelihood of its occurrence. Recent catastrophic events also have an impact on defining the spread. You can get a little more background on cat bonds here and here.

Since cat bonds often involve the creation of a special purpose vehicle, some investors are a little worried that some reinsurance companies are moving beyond their specialties. They are also concerned that by moving the risk off balance sheet, companies are preventing investors and the market from knowing the real exposure each company is taking. Cat bonds do allow reinsurance companies to survive and be less exposed if a major event does occur. Therefore, companies are less exposed by taking out insurance themselves, but off-balance sheet items are more difficult to value and risks are less transparent. The effects on market participants, such as Munich Re, Swiss Re, Liberty Mutual, Allianz, and Hannover Re, among others, is difficult to tell. On the other hand, the benefits to the investment banks underwriting the bonds, such as Barclays Capital, Deutsche Bank, Lehman Brothers, Goldman Sachs, and Swiss Re Capital Markets, among others, is a little easier to see and quantify, along with the potential returns for institutional investors, who at this point are the only ones currently receiving cat bond distributions.

As mentioned in the Barron's article, to date only one cat bond has been triggered, implying a low probability of catastrophic events occurring, or at least the ones that are being underwritten. Then again, the last two years have seen a lower level of terrorist events and major hurricanes. In fact, the last two hurricane seasons, which have been forecast to be strong, have fortunately been milder than expected. This year is once again forecast to have an active hurricane season. Hopefully the forecast will be wrong again, and cat bond investors will get a return of principal, and the people on the coasts and around the globe will be spared from another major event.

I wrote in a recent post how Barclays was getting into the physical trading of crude oil. Now IndexUniverse.com is reporting that Barclays is launching a new iPath Exchange Traded Note (ETN) targeting carbon emissions - the iPath Global Carbon ETN (ticker GRN). As cap-and-trade becomes more prevalent, it is expected that ETN funds tracking carbon emissions will become more popular. Some estimates have the global carbon market being worth more than $50 billion a year. Talk about making money out of thin air.

For the uninitiated, Investopedia (here and here) and Wikipedia give an overview of ETNs. In short, ETNs were first introduced by Barclays in mid-2006 and represents a type of senior, unsecured, unsubordinated debt security that is similar to other forms of debt (since it has a maturity date), but is different in that ETN returns are based on the performance of some other primitive (be it a stock, index, carbon emissions, or anything else). Unlike normal bonds, no periodic coupon payment are made, and your principal is not protected. On the other hand, they can be traded on exchanges and shorted, similar to ETFs. Since they are like bonds, the value of the ETN is affected by the credit rating of the issuer, and is therefore impacted by credit rating changes. This may explain why more ETNs have not been issued in the current environment.

Why use them instead of ETFs? There are a number of advantages (see Wikipedia for an overview), but basically they offer flexibility and tax advantages (see iPath for additional overview of ETN characteristics). Since there is no interest payments and dividend distributions, neither incurs a tax. Capital gains also only occur when the investor buys or sells the ETN - not when gains and losses are taken by the fund, as with a mutual fund, or when securities must be sold due to composition changes in an index, as with ETFs. ETNs are essentially treated as a prepaid contact (like a forward contract), allowing the difference between the sale and purchase to be treated as a capital gain, deferring the tax payment. ETNs also have no tracking error, unlike ETFs which have to buy the underlying assets or futures, thereby producing an inevitable, albeit usually small, tracking error. ETNs do not hold the underlying asset, but simply promise the match the index. This is another area where credit risk potential creeps-in. In a sense, you are trading tracking error risk for credit risk. ETNs also offer the flexibility to gain exposure in areas that are difficult for ETFs to replicate (such as carbon emissions), and allow for the deployment of strategies, such as momentum investing.

Of course, not everything is rosy (see the April USA Today article). In addition to credit risk issues, ETNs also have the disadvantage of being illiquid at times, although as they become more popular, it is hoped that this will be less of a problem for individual investors. Redemption issues do exist for institutional investors. There is also a worry that current tax benefits will be removed/modified by the IRS, which is still considering tax treatment of ETNs (see update) and likes to say "show me the money." There is the potential that the IRS will tax profits as interest, and not capital gains (which long-term are currently only 15%). Single currency ETNs have already been ruled on, and are now being taxed at ordinary income tax rates. Finally, as with all products that offer a specific investment strategy, there are risks with each strategy. Yet, for ETNs this gets magnified since there are now more options available, and as a result, more potential risks for those choosing strategies without understanding the goals, risks, and fit to their current investment portfolio. After all, not everyone wants to worry about whether sub-prime credit problems are going to affect their carbon missions ETN investment, or whether crude oil being in contango is good for their commodity spread ETN.

Note: When researching about ETNs to see if there was any new information to include for this post, I did run across the following on the Investopedia site: "While the benefit of active management is arguable, there is no disputing the value that financial engineering has brought to the financial markets since deregulation took hold in the early 1970s. Financial engineering has made our markets more liquid and more efficient. The advent of ETN is no different. However, as with any new product, there are unanswered questions." Given all the negative connotation around the term financial engineering, this is refreshing. Then again, this article may not have been updated for a while. Nonetheless, every now and then you have to take what you can get.

The Financial Times is reporting that Barclays Capital is planning to enter the shipping business. The bank is attempting to increase its commodities exposure by hiring ships on long-term charter to move oil, gasoline, and diesel. As opposed to gaining exposure by taking derivative positions, Barclays hopes to cash in on the prices involved in hiring ships, which have been up more than 50% in the last six months. The move also allows them to support their new venture into the physical trading of oil. Physical trading allows for a more predictable price since you are not at the mercy of the spot market prices.

Of interest is how moving the physical commodity adds a new level of risk to banks hiring a fleet of ships on a long-term basis - the risk of an oil spill. For this reason, some companies go slowly with physical trading, transporting what are called "non-persistent" oils, such as gasoline, which dissipate in the water quickly. Given all the credit problems that banks are already dealing with, it is hard to image any would want to even consider adding additional exposure in this way. In fact, even though such a move is not unprecedented for banks, this may tell us more about the weakened ability of banks to generate revenues using traditional means, such as investment banking and making loans. It also makes you wonder whether the shipping industry has reached a short-term top, and whether some commodities themselves may be nearing a peak. Maybe speculation is beginning to reach a little too far.