Today, ESMA will publish draft rules designed to protect ETF investors – although active managers and other industry participants have called for sweeping rules to curb ETFs, those calls haven’t filtered down on the regulatory front, at least when it comes to this first piece of rulemaking.

The focus of ESMA’s rules will be improving the quality of information ETFs provide to investors. They’ll also ask ETFs to disclose their securities lending practices and give greater detail about the securities they hold. The regulator stopped short of handing ETFs the killer “complex” label that would mean investors have to buy them from advisors.

All this is good news for the industry – and it could just point to regulators’ softening stance on exchange-traded products in the future. I think it’s also good news for investors – pushing ETFs into the advisor realm really would have been a huge mistake in my view, especially for a product that has been deservedly lauded as an investment democratizer in the retail space.

Surprisingly, amidst all the disclosure rules, ESMA did not address one factor that has dogged investors and could provide a real risk – tracking error. It happens more than you think in an industry that is meant to provide value to investors by closely tracking an index. Variation in performance on either side of the index can cost investors and it does bear scrutiny by regulators in the future. Will US regulators look more closely at this? Probably not – the most vocal ETF critics haven’t really set their sights on this issue, choosing instead to focus on the role of derivatives and the importance of collateral. However, EDHEC thinks it’s worrying and said so in this paper published last week.

No doubt, ETF providers will now be looking now to US regulators as they produce their own recommendations for the future of the industry. But if ESMA is any indication, it could be a much smoother ride for ETFs that some thought previously.

Active managers and hedge funds have long relied on a factor-based approach to build their strategies. New ETFs such as those launched by Russell last year focus on specific factors like beta, volatility and momentum.

Factor-based ETFs offer a way for investors to manage risk based on individual securities without having to employ other strategies like options or futures. For institutions that currently use hedge funds to either mitigate or enhance risk in their portfolios, factor-based ETFs could evolve into an interesting alternative – one that allows institutions to take directional bets on where they think the market is headed, without having to pick individual stocks.

The some are asking is whether or not factor-based ETFs could take market share from the hedge fund industry. Probably not right now. But as they gain liquidity and keep costs low, they could provide some serious competition, especially in the cost-conscious pension space.

Factor-based ETFs have also brought attention back to hedge fund replication, an approach that became popular just before the financial crisis, but fell out of favour as hedge fund returns took a hit during tough times.

Along with Russell, other providers have been getting into the factor game — Credit Suisse has launched several more hedge fund replication ETNs and two startups, QuantShares and FactorShares, are also moving into the space.

Whether or not pension funds will bite remains to be seen – but it’s a compelling approach that they should at least consider moving forward.

Both the SPDR Barclays Capital High Yield Bond (NYSEArca: JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG) dropped 2%.

So what does this say about ETFs?

First and foremost, it adds more fuel to the fire regulators are lighting under the ETF industry. Regulators are worried enough about he potential of ETFs to negatively influence equity markets – now there’s room to blame them for rattling debt markets too. Indeed demand for junk ETFs has surged substantially in a relatively short period of time — ETFs tracking high yield bonds now exceed $22 billion, up from just $2 billion just three years ago.

Of course, that’s a drop in the ocean compared to the $1 trillion in US corporate speculative-grade debt market – but ETFs are now among the biggest holders of benchmark securities like Las Vegas giant Caesar’s Entertainment Corp. And that puts ETFs in a very powerful position according to comments made by Jason Rosiak, head of portfolio management at Pacific Asset Management in Newport Beach. Last week he told Bloomberg that price swings for junk bonds were seven times higher in November than May. ETFs are to blame he argues.

This large concentration of holdings by ETFs has had a dramatic impact on individual issues according to Rosiak – and it’s made it hard for some to raise capital. “When the market is up the offers on these issues will be higher and conversely when the market is lower, or there are expected outflows, bids dry up quickly or are lower on the names held in the ETFs.”

If easier access to high yield bonds through ETFs is indeed rattling the market, it could have a knock-on effect for pension funds that are increasingly looking to junk bonds to enhance their credit strategies. As the ETF market expands into new asset classes and areas of focus, maybe it’s time for another layer of due diligence: the potential for ETF flows to impact pricing.

The question for plan sponsors is should pension funds start to examine the role ETFs play in moving the securities they hold? Is it a risk factor? And in the end, should it really matter if ETFs are bringing more capital and (arguably) more liquidity into some asset classes?

Depending on what regulators decide about the role (or non-role) ETFs play in market volatility, I think it’s definitely worth considering. The question is, what do you think? Feel free to share your comments below.

But the biggest sign of the times has to be PIMCO’s effort to become the first money manager to create an ETF version of its flagship Total Return fund – one of the biggest mutual funds in the world. This could just be a game changer for the ETF industry – and it’s a glimpse of how the ETF world could look in the coming years as they put the squeeze on the costlier mutual fund space.

Other new forms of actively managed ETFs are also in the works. BlackRock has submitted an application with the SEC to allow them to offer actively managed ETFs that don’t divulge holdings daily. And SSgA is seeking to offer active strategies that are essentially ETFs composed of other ETFs, in the same vein as fund of funds strategies.

These developments show how quickly the ETF space is changing as providers look to provide products that cannibalize the far more established mutual fund space.

Of course a key barrier in 2012 could be regulatory holdups – regulators are already wary of the ETF space and they could take some extra time to kick the tires of these new products. Time will tell – at least the year ahead definitely promises to be interesting.

Not so today according to a recent paper from the International Monetary Fund that is raising alarm bells about the growing role of asset managers – including ETFs – as a major source of funding for banks through the shadow banking system. In their paper, The Non-Bank-Bank Nexus and the Shadow Banking System authors Zoltan Pozsar and Manmohan Singh argue that asset managers are now a dominant source of demand for non-M2 types of money. In fact, they act as “collateral mines” for the growing shadow banking system.

Regulators need to understand and account for the money demand side of the asset management business especially because it is the place where long-term savings are turned into short-term savings: maturity transformation that is a result of changes in portfolio management, portfolio allocation decisions and securities lending.

The authors call this reverse maturity transformation – plan sponsors might call this, more simply, mismatch risk. Except that the paper shows it’s happening on a huge scale, with ETFs and other asset managers part of a long and tangled collateral chain worth trillions.

It’s an interesting take on the ultimate power of the shadow banking system – what’s worrying is that regulators haven’t really factored this into the way they approach financial markets.

As the asset management industry grows, propelled at least in part by ETF assets, this collateral mine is going to become a lot deeper and a lot darker unless regulators redefine their model of how financial systems work.

In mainstream investment circles, most investors are not yet familiar with the term impact investing. The JP Morgan and Rockefeller Foundation report: “Impact Investments: An Emerging Asset Class”, and the growing body of research on related topics does not easily fit into traditional asset allocation paradigms at the moment.   Most people have not been exposed to the concept of investing in civil society organizations, and the often jaw-dropping stories of social entrepreneurs are way off in the shadows of business entrepreneurs.

Another extremely important issue is the barrier that prevailing narrow interpretations of fiduciary duty can create.  There are examples, such as the work Mercer released on climate change earlier this year, which demonstrate that it is in the best interests of institutional investors to seriously consider the financial implications of environmental change on their portfolios.

Read the full interview here.

In this Q&A with finance professor Jeremy Siegel, Institutional Investor seeks out some academic perspective on the issue. Siegel, who teaches finance at the University of Pennsylvania’s Wharton School is also an adviser to ETF sponsor WisdomTree. Which means you need to take his comments with a healthy grain of salt.

Siegel says that ETFs can’t possibly move markets or distort the prices of individual stocks as some critics claim. For one thing, the market is simply too small and even inverse funds can’t possibly be driving prices the way some people say they do.

As he points out:

The volatility we see in today’s markets is not linked to those ETFs. A lot of people who own inverse funds see declining returns, and they don’t understand that the returns are supposed to go down. They don’t understand that inverse funds may be well correlated with oil prices on a day-to-day basis, but over time they get a deteriorating asset. It is sort of like a put. It’s hard to explain to investors. You don’t have a sudden downside, but the price you pay for that is a deteriorating asset. I don’t think ETFs raise the level of systemic risk at all. I don’t understand the mechanism. The size of the ETF industry is still very small compared to mutual funds.

The Q&A makes an interesting read – in addition to tackling the relationship between ETFs and market volatility, Siegel also brushes off concerns over the riskiness of inverse and leveraged ETFs (“The risks are borne by the buyer” he shrugs).

In all, I think Siegel makes a few good points – especially when he notes that the size of the ETF industry is still very small compared to mutual funds.

But is he off base (and possibly showing some bias) on some of his other assumptions? I’ll leave that for you to decide and discuss below….

What is an equity minimum risk strategy?

It’s a systematic and disciplined investment approach where the objective is to construct a portfolio of stocks with the lowest volatility available at that time in the market. Equity minimum risk strategies are also known as low volatility or minimum variance strategies. The unique property of this approach is that stocks are optimally weighted in the portfolio based solely on individual stock volatility instead of expected return. The resulting portfolio aims to achieve a higher return-to-risk ratio than the market portfolio.

Are they just another new investment fad or does this strategy actually have legs?

Equity minimum risk strategies are not a new concept or gimmick. They are well grounded in applied academic research and have been discussed for over 20 years in the investment management community. But they’ve become more relevant today because of investor interest in strategies that address concerns over spikes in equity market volatility.

In fact many would argue that the equity risk premium does not actually apply to cap weighted benchmarks as investors are not supposed to be rewarded for risk that is diversifiable.

Over the 12.5 years ending June 2011, an equity minimum risk strategy averaged more than 35% lower volatility than the market while outperforming it by 5.1%. The beta of the low risk strategy over this period was 0.40 or 60% lower than the market.

Are pension funds looking seriously at equity minimum risk strategies?

Equity minimum risk strategies are extremely compelling for pension funds today for the simple fact that they allow you to capture the equity risk premium with lower volatility then the market. This is exactly why one pension fund in Quebec has invested in them. These strategies offer a better equity match for liabilities than most other equity strategies. In the asset/liability space, less equity volatility leads to lower asset/liability volatility.

By way of example, over 12.5 years ending June 2011, our Canadian equity minimum risk strategy averaged nearly 40% lower volatility than the market (i.e. 9.7% volatility vs. 15.8% volatility). This translated into 34 % lower tracking error relative to long bonds for the equity minimum risk strategy in comparison to the S&P/TSX Composite Index (i.e.10.9% vs. 16.5%).

Read the rest of this post on my blog at Benefits Canada’s ETF Resource Centre.

High yield bonds have been good to yield-hungry investors in recent years. In fact, 2010 was one of the best years on record for the asset class.

This month, though….not so much.

In the wake of the U.S. downgrade by S&P, the high yield market experienced a sharp turnaround: high yield debt essentially stopped trading on both August 5^th and August 8^th as investors ran away from risk assets.

For plan sponsors keen to move at least part of their high yield portfolio, it meant they were stuck in an illiquid market.

But there was one bright spot: high yield ETFs experienced record liquidity while the rest of the market stopped trading for two days.

Here’s how it played out. On August 5^th, when the US high yield over-the-counter market was basically frozen due to lack of liquidity, the iShares iBoxx $ High Yield Corporate Fund (HYG) had a volume of 4.6719 million shares.

Then, on August 8^th, when liquidity was still too thin for comfort in the US high yield market, HYG’s volume spiked to 6.4915 million shares.

At least something was moving in the high yield space.

I’ve written before about ETFs as an escape hatch in illiquid markets. Because they tend to be a lot more liquid than the underlying asset class, adding a layer of ETFs to a portfolio means you have a bit of wiggle room when markets freeze up.

And given the fact that markets probably haven’t finished punishing policymakers for their dithering in Europe and the US, an ETF escape route is starting to look better every day…