(Editor's Note: The following is ex-Morgan Stanley analyst Paul Mazzilli's monthly research note for IndexIQ and part of the firm's latest ETF Insight newsletter.)

In May, equities rallied for a third consecutive month for the first time in many years. The S&P 500 Index was up 5.6% for the month, and has now reversed the sharp losses of January and February (up 3% YTD). We believe that the worst of the recession may be behind us, and we are starting to see signs of improving fundamentals. History indicates that the equity markets tend to hit bottom in the middle of a recession and historically have posted significant returns over the following year. Thus, we believe that investors who wait for the economy to improve before buying stocks could miss significant gains. In this changing environment, financial advisers and investors continue to seek ETF strategies that will perform well and add portfolio diversification.

After dropping throughout the first quarter, net ETF assets are now up over $55 billion for the year due to net cash inflows of $29 billion and the recovery of the equity markets since March. Although there have been a number of interesting new filings, the actual issuance of new ETFs has slowed and has more than been offset by a much higher than usual number of liquidations. Interest in traditional equity ETFs continues to wane this year with total outflows of $35 billion. There were also net outflows in ETFs investing in developed international markets but renewed interest has resulted in strong inflows to broad emerging market and Brazil and China ETFs.

• In contrast to equities, Fixed Income ETFs had net inflows every month this year with another $4.1 billion in May bringing YTD net inflows to almost $20 billion.
• Leveraged and Inverse ETFs still show significant growth. Although there are issues regarding tracking error and tax efficiency, they attracted $19 billion in new flows in 2009, as these types of ETFs continue to be favored by active traders.
• Investors continue to embrace ETFs as an efficient means of gaining exposure to alternative asset classes. Commodity ETFs had over $18 billion in net cash inflows this year and SPDR Gold, which took in $11.8 billion, is now the second-largest US-listed ETF, with over $35 billion in total assets.
• Hedge Fund ETFs are now available that seek to provide the diversification benefits of hedge funds without their structural impediments, namely lack of liquidity and transparency,[1] and high fees.
• IndexIQ’s IQ Hedge Family of products seeks to replicate the risk and return characteristics of hedge funds by using factor and quantitative analysis. We use ETFs in the portfolio as proxies for the common factors driving hedge fund returns. IQ Hedge products seek to replicate the various hedge fund styles (Global Macro, Emerging Markets, Long/Short, Market Neutral, Event Driven and Fixed Income Arbitrage).
• The IQ Hedge Multi-Strategy Tracker ETF (NYSE Arca: QAI) may serve as a core holding for larger investors seeking allocation to hedge fund strategies given its alternative beta exposure. For smaller investors, I believe QAI is a way to efficiently get exposure to this asset class.
• The IQ Hedge Macro Tracker ETF (NYSE Arca: MCRO) was just launched as the first ETF designed to replicate the risk and return characteristics of global macro and emerging markets hedge fund strategies. These two strategies have been shown to historically perform well after market dislocations.[2]

ETF Market Developments And Trends

• The US-listed ETF market grew in terms of assets under management in May, increasing to $588 billion (versus $535 billion at the end of April and $530 billion at the end of 2008).
• The number of US-listed ETFs has continued to decline this year, as 42 ETFs were closed. Northern Trust exited the business, liquidating 17 ETFs, and PowerShares trimmed their ETF roster (eliminating 19 ETFs). In May, MacroMarkets LLC announced that it would be terminating the MacroShares $100 Oil Up Trust (UOY) and the MacroShares $100 Oil Down Trust (DOY), with trading scheduled to cease on June 26. The funds had combined assets of approximately $20 million.
• We expect to see continued closings, as there are still over 150 US-listed ETFs with less than $10 million in assets. However, new ETFs that match investor needs continue to gather meaningful assets, and I do not see ETF liquidation as a negative sign of the health of the industry.
• New ETF issuance slowed, with only 29 new ETFs being launched so far this year. However, new issues increased in May, with three new sponsors entering the market.
• New products from established issuers in May include The WisdomTree Dreyfus Emerging Currency Fund and the Van Eck Market Vectors Brazil Small-Cap ETF, both of which should benefit from renewed interest in emerging markets.
• The first family of ETFs offering exposure to sectors in emerging markets was launched by Emerging Global Advisors, starting with the EGS Emerging Markets Energy and EGS Emerging Markets Metals & Mining Funds.
• Grail Advisors launched The Grail American Beacon Large Cap Value ETF - the first ETF to use a team of three active managers using qualitative stock-picking processes.
• Finally, bond giant Pimco launched its ETF, with the debut of the Pimco 1-3 Year U.S. Treasury Index Fund with an initial expense ratio of just 9 basis points.
• In addition to launching its first ETF, Pimco filed six more fixed-income ETFs across the Treasury yield curve and the first ETFs to break the TIPS market into short- and long-term categories.
• We believe interest in ETFs from BlackRock and Pimco are encouraging signs for the growth of the ETF market.
• In conjunction with a white paper “How to Save the Mutual Fund (Before It's Too Late),” SwanDog Strategic Marketing launched its own Mutual Fund Doomsday Clock to call attention to the need for firms to focus on the problem at hand. SwanDog founder Dave Swanson stated that "Pimco's brilliant brand play, through the launch of their short-term treasury ETF, sets the Doomsday Clock at 25 minutes to midnight."

Cash Flows Into ETFs

• According to data from the National Stock Exchange, US-listed ETFs have experienced positive cash flows of over $29 billion in 2009, of which $17 billion occurred in the month of May.
• Traditional US equity ETFs experienced net inflows in May for the first month this year of $1.8 billion but YTD total outflows are still over $35 billion. The SPDR S&P 500 Index ETF (SPY) had net outflows of almost $30 billion so far this year. Other ETFs tracking broad-based US and International Indexes have had significant outflows.
• The trend out of emerging markets ETFs reversed in March and April and accelerated last month. In May, over $4.4 billion went into four ETFs investing in broad emerging markets and Brazil and China, bringing the YTD total to over $9.8 billion in these ETFs.
• Commodity ETF cash flows were over $18 billion so far this year but slowed in April and May. The biggest gainer was SPDR Gold, which took in $11.8 billion for the year, and is now the second-largest US-listed ETF, with over $35 billion in total assets. While interest in oil ETFs has slowed, the US Natural Gas ETF took in over $800 million in assets in May, bringing its YTD total inflows to $1.7 billion.
• Fixed-income ETFs had net inflows every month this year with another $4.1 billion in May, bringing YTD net inflows to almost $20 billion. In contrast to 2008, when investors were seeking high-quality and short-duration exposure, the biggest gainers in 2009 are investment-grade and high-yield bond ETFs. Through May, over $4.5 billion went into the iShares iBoxx Corp Bond ETF. Another $4.0 billion went into the iShares Barclays TIPS ETF, as some investors believe government stimulus will bring back inflation.
• Leveraged and inverse ETFs took in another $18.7 billion in new funds so far this year. Cash flows in these high-volume products show changes in investor sentiment. There were strong inflows into double- and triple -ong broad markets and financials ETFs in January and February. However, starting in March, new money went into short products as the markets rallied. In April and May, the biggest inflows in this segment were to the Direxion Financials Bear 3x ETF, which now has YTD inflows of over $4.5 billion.

Sources: National Stock Exchange data, IndexIQ research

Past performance does not guarantee future results.

Endnotes

1. Traditionally, hedge funds are seen as not being transparent since they typically do not provide investors with information relating to the holdings in their portfolios.

2. May 2009 Credit Suisse White Paper, “Global Macro – A Bridge Over Troubled Water.”

Paul Mazzilli is a senior adviser and member of the advisory board at IndexIQ, a developer of alternative investment products. He works with IndexIQ in connection with the firm's product development. Most recently, Mazzilli was director of Morgan Stanley's ETF research team. He was also responsible for overseeing Morgan Stanley's strategic equity portfolios and asset allocation models using ETFs.