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Researchers: If index funds are a commodity, why are their fees so divergent?

2 July 2008

Last week, we told you about a paper that suggested price competition in the mutual fund industry was somewhat less than robust.  Rather than lopping all mutual funds into one pot and comparing their fees, the authors of that report examined the fees of individual funds relative to their Morningstar category average.  While not as ideal as examining the active management delivered by each fund, this approach loosely categorizes funds by their level of active management (e.g. the small cap growth category has a higher level of active management than the large cap value category).

Although not directly examined by that particular paper, one category that makes no denials about its lack of active management is the S&P Index Mutual Fund category.  These (almost) purely passive funds are the subject of another paper by the same authors available here.

In “Institutional S&P 500 Index Mutual Funds as Financial Commodities: Fact or Fiction?” John Haslem, Kent Baker and David Smith examine whether index funds are really are all the same and whether they are truly “commodities”.

They find a wide variation in the fees (and therefore the performance) of S&P index funds.  This is counter-intuitive given their common Investment strategy, but even more counterintuitive when one considers that institutional investors should be less likely than retail investors to pay unwarranted fees.

While the market for index funds isn’t homogenous, the researchers find that at least it’s a lot more competitive than other mutual fund categories.

It turns out that the price of an index fund has a lot more to do with the economics of managing a fund, not the investment strategy itself.  For example, large funds and funds with small minimum investments tend to charge larger fees.  Comment the authors:

“If institutional investors priced S&P 500 Index funds as commodities, they would be unlikely to continue to commit new money to chronically high-cost funds, while much lower cost alternatives existed. On the other hand, if these investors could not meet the minimum initial purchase of low-cost funds, their opportunity set would be restricted.”

Since the underlying investment strategy is exactly the same across this category of fund, any difference in fees should translate directly into lower returns.  Not surprisingly, this is what the authors found.

So why on earth would you want to buy a fund that was virtually guaranteed to underperform?  There are a number of reasons, say the authors:

“…investors in the institutional realm may value fund features beyond the expense ratio. For example, such investors may value the availability of a wide variety of funds including money market and other index funds offered by the family and the cost of these other funds…high-cost institutional index funds come from families that offer greater choice to investors, or that offer low cost funds elsewhere in the family…”

The growing interest in portable alpha and alpha/beta bifurcation will likely bring these funds into more direct competition with products such as index futures, swaps and ETFs.  So it will be interesting to see if fee deviations like the ones described in this paper become more closely linked to tangible attributes.  In other words, will there eventually be a base (commodity) fee and a Chinese menu of other attributes (low minimum, an option to switch to another fund in the same family etc.) 

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Non-market-cap indices dissed in Europe this week

18 June 2008

Rob Arnott, the outspoken proponent of “fundamental indexation” might want monitor what’s being said in Paris this week.  Arnott is the owner of the patent for “non-cap-weighted indices” (see related posting).  But IPE reports that Alain Dubois, the head of Lyxor Asset Management a SocGen subsidiary, told a conference audience:

“It could create a market phenomenon, like reduction of very high market caps, and could lead to performance of these indices just because everybody invests in them…It is an interesting trend, but should be arbitraged as soon as possible.”

Piling on was Tomas Franzen, head of AP2, one Sweden’s national pension funds who apparently added:

“…it is the market-cap-indices that are flawed and not necessarily the alternatives that are, per se, intelligent.”

Arnott might not actually disagree with this assessment since he has often referred to fundamental indexation as simple common sense (see related posting).  In either case, the value of his patents is probably doing just fine.

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Silos, flesh wounds, the “disintermediation” of poultry, and a call to action

4 June 2008

More from London (see yesterday’s posting for background)… 

A pension plan as a financial services firm

As some pension funds begin to shift from funds of funds to single-manager hedge funds, they usually create what amounts to their own internal fund of funds.  The only difference between this fund of funds and a “real” fund of funds is that the pension has only one client: its own pension plan. 

It turns out that this view of the hedge fund portfolio as a sort of arm’s length asset manager with only one client can also be applied to the pension fund as a whole.  That’s how one major private pension fund described it to a gathering here in London today – as a “financial firm that produces pensions.”

This view also has implications for “liability-driven investing” (LDI).  Some said that the process of liability-matching and return-enhancing should be kept separate within this financial services firm.  For example, one major pension fund here created a team focused on removing interest rate and inflation risk (via a “matching portfolio” designed to match the plan’s future liabilities to pensioners) and a separate team focused solely on trying to squeeze additional returns out of those assets.  In true arm’s length fashion, the “return portfolio” is required to literally borrow assets from the matching portfolio – creating a real economic incentive to beat the short-term rates charged on this internal loan.

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Report: “Exposure yardsticks may provide little insight about a fund’s alpha potential”

15 May 2008

Whether one is referring to a 1X0/X0 fund or to some other long/short variant like a market neutral fund, there is often an implicit assumption that the “net exposure” provides all the insight required into the return potential of the fund.  For example, many commonly assume that 130/30 funds are “beta neutral” and therefore that the “30/30″ portion will generate pure alpha.  But what if that short-extension was just offsetting?  To use an extreme example, if it was 30% long the S&P and 30% short the S&P, then there would be no alpha.

A research paper by Morgan Stanley (available in the Morgan Stanley research dossier at AllAboutAlpha.com) reminds us that dollar-weighted exposure is not synonymous with beta-weighted net exposure.  But the paper, another in a series by Marty Leibowitz and Anthony Bova, also argues that the beta-weighted net exposure doesn’t really tell us a lot about the potential information ratio (alpha/tracking error) of the fund.  To gauge the potential IR of a fund, one should instead look at the ratio of “active” long positions to “active” short positions - or what Leibowitz and Bova call the “active ratio”.

The active ratio, they argue, is more descriptive of the risk/return dynamics of a fund than the more recognized dollar-weighted or beta-weighted net exposure.  They say the Active Ratio can reveal how long/short funds and 130/30 funds are really just first cousins:

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Does “Sentiment Beta” beget “Sentimental Alpha”?

14 May 2008

Pensions & Investments published a special report earlier this week on the increasingly important role played by academics in today’s world of investment management.  It contains a series of articles on the plethora of professors who augment their modest academic salaries with (lucrative) consulting gigs for asset managers.  One of the articles in the report that caught our eye was about Malcolm Baker of Harvard and Jeffrey Wurgler of NYU.  The duo has been writing about behavioral finance for several years. 

Behavioral finance has often been touted as the successor to the CAPM since it aims to explain how the grand old model doesn’t hold up under empirical analysis.  Unfortunately, behavioral finance has so far lacked a unifying theory of its own capable of galvanizing the field of finance.  Still, Baker and Wurgler borrow from the lexicon of the CAPM to propose a measure they call “Sentiment Beta”. 

As P&I points out, some big names have taken notice.  Bruce Jacobs of Jacobs, Levy tells the newspaper:

“This type of work is important especially in today’s markets, which has been characterized by wave after wave of investor sentiment — the tech bubble, the bursting of the tech bubble, the housing bubble, the bursting of the housing bubble, the credit bubble and the bursting of the credit bubble…”

At first blush, “sentiment beta” sounds kind of redundant.  After all, doesn’t beta itself capture market sentiment?  If sentiment rises, the market rises.  And if the market rises, high-beta stocks rise anyway, right?

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Alpha-centric investing described as a “seismic shift”

9 May 2008

We have always argued that actively-managed mutual funds are essentially a marketing package for two fundamentally different formations: a large deposit of beta and a vein of pure alpha.  Unable to travel either the peaks and valleys of beta or the undulating topography of pure alpha, mutual fund companies long ago found a neutral territory that seems to have satisfied investors worldwide for over 50 years.

Now the landscape is changing.  Or perhaps more accurately, investors are now expressing a desire to try their hand at portfolio construction using basic ingredients such as cash, beta, and alpha. 

This FT article (”Equity fund outflows bring need to adapt“) is a must read for anyone who thinks we’re nuts.  The newspaper describes the changes facing the asset management industry as nothing less than a “seismic shift”.  Kevin Parker, the head of Deutsche Bank’s $800 billion money management business tells the FT:

“On one side, you have exchange-traded funds and, on the other, you have [private equity firm] Blackstone and the hedge funds. It leaves firms like ours, traditional long-only buy-side firms, needing to make some very tough decisions.”

The FT also cites Jim McCaughan, CEO of Principal Financial Group as an advocate of alpha-centric thinking:

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Passive managers spark space race with launch of new satellites

13 March 2008

Yesterday, we mentioned an unreleased academic study that measured the aggregate “cost of active management” in US equity markets.  We concluded with remarks from one particularly staunch proponent of efficient markets.  But even he left the door open for active management (presumably where markets were less efficient). 

Assembling such an active/passive portfolio lies at the heart of alpha/beta separation.  But since the term “alpha beta separation” conjures up memories of high school math club, marketers of asset management services have coined the term “core/satellite” investing (where “core”=passive and “satellite”=active).  What’s striking is that, rather than being ridiculed by traditional passive managers, core satellite is being embraced by them.

For example, this brochure from Barclays (iShares) is subtitled “creating harmony between index and active strategies”.  It says:

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Hedge Funds shouldn’t fear “The Blob”

6 February 2008

Bloomberg Columnist Michael Sesit warned last week that mutual funds and hedge funds better watch out for an invasion by ETFs.  He quotes one expert as describing ETFs as “The Blob” from the 50’s sci-fi movie that consumes everything its in path.

He picks up on a theme espoused by his late colleague, Chet Currier in a December 2006 column on how mutual funds may someday become “obsolete”, when he observes: 

“To some degree, index-linked products are already eating active managers’ collective lunch. Based on the almost $1 trillion invested in index-based products in the U.S. — up 2,610 percent since 1993 — the active-management community is losing about $12 billion a year in management fees, [Adam] Sussman [of the Tabb Group] says.”

But throughout the column he paints hedge funds with the same brush:

“Lower expenses, the failure of most active-mutual fund managers to beat their benchmarks, the growing number of thematic and specialty ETFs, and the funds’ flexibility suggest they will attract investment that otherwise would flow to actively managed mutual and hedge funds.”

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S&P’s New Dividend Indices: Really alpha or just alternative beta?

30 January 2008

While we’re on the topic of indices containing alpha (see Tuesday’s posting), check out this “alpha producing” index launched last Friday by S&P.   

In a move sure to sow confusion among passive investors, S&P says it’s new “Dividend Opportunities Index” (index methodology).  In a press release announcing the launch, Tim Eisenhauer, VP of Standard & Poor’s Index Services says:

“The launch of these two indices underscores Standard & Poor’s commitment to producing alpha generating strategy indices with a methodology designed to provide returns over and above traditional benchmark indices…”

As first blush, these indices seem to produce something pretty special.   But is it alpha?  Here is a chart from the fact sheet:

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130/30 Indices: True indices or like playing chess against a computer?

7 January 2008

During the final months of 2007, Credit Suisse and S&P both launched what they called “130/30 indexes”.  CS didn’t say much about their methodology at the time, but S&P published the entire index construction approach online.  After reading that approach on November 20, we wrote the following:

“…here’s the thing we don’t quite get: why would you want to benchmark yourself to another active manager? There is no common risk factor underlying these funds that can serve as a benchmark. There is no “130/30 beta”. In fact, all a 1X0/X0 program aims to accomplish is to lever pre-existing alpha for greater returns if alpha is already positive or greater losses if alpha is negative. As IPE reports, a speaker at a recent conference referred to 130/30 as just a “prescriptive technique”. How do you index a ‘prescriptive technique’?”

Clearly anticipating such a line of questions, the developer of the Credit Suisse index, AllAboutAlpha Hall-of-Famer Andrew Lo of MIT, addressed this question head-on in his December 11 paper on 130/30 indexation (”130/30: The New Long-Only”).  The paper has generated quite a bit of chatter recently (the subject of this Pensions & Investments story today and a column in the Economist this week.) 

Say Lo and co-author Pankaj Patel:

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“Chicago Beta”

6 November 2007

As a follow-up to our posting yesterday on the folly of going on a fishing expedition to find common risk factors, here’s a great example of an apparent beta factor that may (or may not) indicate some underlying return driver.

According to this story in Chicago Business, hedge funds based in the Windy City were up 7.45% in Q3 vs. only 2.44% for the rest of the industry.  What can one possibly conclude other than the fact that Chicago hedge fund managers are smarter than the rest of us?  Well, maybe that such returns are demanded since Chicago hedge funds are riskier than the rest of us?  Or that, just maybe, it was a statistical fluke?

The point is that many hedge fund investors are return-chasers.  They will pile into merger arb strategies after a couple of good months, or re-allocate to distressed when it beats credit over a quarter. 

So return-chasers, why not dump your current funds and re-allocate to Chicago?  Why not?  Because that’s a goofy idea, that’s why.  About as goofy as return-chasing itself really.

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New product re-defines “oxymoron”

5 November 2007

There is no doubt that the line between passive (beta) and active (alpha) investing is becoming blurred.  “Actively managed ETFs” are a great example.  So are “passive” hedge fund replication products that reply on what appears to be an active, albeit primitive, trading strategy.  In fact, many investors now recognize that the active management of passive indexes is a primary source of active alpha.   

The key to creating “alpha out of beta” is the existence of a set of liquid and transparent indexes.  One of the hallmarks of good index is its ability to capture some underlying market dynamic, like the equity risk premium or the price of gold or some “exotic beta”.  But an index of active managers?

That’s just what Active Index Solutions has devised.  According to the firm’s website, their apparently French-inspired “Actifindexes” were:

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The Patent King of Pasadena

17 June 2007

Lawrence Carrel at TheStreet.com writes about the “Godfather of Fundamental Indexing” last week.  Rob Arnott, founder and CEO of Pasadena-based Research Affiliates not only invented fundamental indexing, but he apparently also patented the idea.  As Carrel discovers, however, critics are quick to point out that fundamental indexing bears a remarkable resemblance to simple old-fashioned value-investing. 

In fact, Carrel points out that ETF manufacturer WisdomTree never even sought permission from Arnott before launching their own ETF based on the same concept.  Says Carrel:

“It was also a challenge to Rob Arnott, the godfather of fundamental indexing. Arnott’s investment firm, Research Affiliates, had licensed the first ETF based on a fundamental index a year earlier and filed a patent application for all indices based on fundamentals. But WisdomTree didn’t seek Arnott’s blessing for its new products. In essence, the firm was saying that fundamentally weighted indexing isn’t the property of Research Affiliates but of the entire world.”

The patentability of business processes came to the fore late last century in the froth of the tech bubble.  In fact, Alpha Male himself even applied for provisional patent protection on an e-business process that he thought would someday make him a rich man (he still thinks it’s a cool idea).

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Overlays Wake Up From Long Slumber

12 June 2007

Here’s a piece of little-known trivia:  When this website was being conceived, the leading candidate for a name was “ActiveOverlay.com”, not AllAboutAlpha.com.  But the term “overlay” was generally used to describe active currency management, not active equity management.  Besides, “ActiveOverlay.com” elicited a lot of blank looks among those not familiar with institutional portfolio management techniques.   So we eventually settled on the more mainstream name in use today.

Since that time, active overlay has also come to refer to the process of tax management in unified managed accounts (see posting).  But it never seemed to catch on as a term used to describe alpha-centric investing techniques such as 130/30 (which can be alternatively described as a beta portfolio with an active overlay).  In fact, a Google search of “active overlay” returns precious few citations referring to equity overlay management (a.k.a. beta overlays or long/short overlays).  

AllAboutAlpha contains only one posting (out of 300+) on the topic.  In 2004, the Canada Pension Plan began using an active overlay strategy that amounted to synthetically shorting against their $80 billion passive portfolio.  The CPP awarded four $500m “notional mandates” to manage in a market neutral (read: all alpha) strategy.  But that was three years ago.  Since then, no one seems to have seen much of the term “overlay”. 

However, after several years asleep in the woods, ”Overlay-Van-Winkle” seems to have stumbled into town by way of this Hedgeworld piece (free registration required).  It’s a little thinner, hasn’t showered in years and has a long “mountain man” beard.  But most alarmingly, it seems to also have amnesia.  And no one is sure exactly who it is, or what it’s supposed to do now…

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Study suggests wealthy avoiding mutual funds in favor of indexing

6 June 2007

As regular readers will know, we believe that unbundling active and passive management leads to greater fee transparency, more flexibility and ultimately more tailored portfolios.  While this trend may not be immediately apparent in the day to day decisions made by advisers and investors, it reveals itself in the twin growth trajectories of ETFs and hedge funds (see related posting).  ETFs, after all, are the cheapest way for an individual investor to buy pure beta and hedge funds - believe it or not - are often a cheaper way to buy active management than purchasing it embedded in mutual funds. 

So when we see headlines suggesting that the wealthiest American investors are shying away from ETFs, we wonder what’s going on.  Yesterday, a few media outlets picked up on an interesting study by Advisor Perspectives that showed index funds comprised less than 4% of the portfolios of the wealthiest American (and, supposedly, the most sophisticated investors).  This does sound low.  And so it’s no surprise the headlines rang out: Wealthy hold few assets in indexed funds, and Study: High-Net Worth Investors Not Keen on Index Funds.  Conclusion: smart investors shun indexing.

But after a detailed reading of the study and a phone call to its author, Advisor Perspectives CEO Robert Huebscher, it appears the universe is still unfolding as we have hypothesized.  

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Passive Management: ETF “dark matter”

1 May 2007

Last week’s Economist piece on the ballooning ETF industry contained a chart that gave us pause (right).  It illustrates not only the growth of ETFs (vs. traditional open-ended index funds), but also the overall growth of indexing (currently over 16% of all US equity mutual funds).  While 16% may sound high, that’ nothing compared to the hidden ETFs buried within all US equity mutual funds.  It’s as if there is a huge amount of “dark matter” hidden between active stock picks. 

We were reminded of this study by Martijn Cremers & Antti Petajisto of the Yale School of Management (originally written last summer and covered in these pages but recently updated).  Cremers and Petajisto propose a new measure of active management to complement the traditional market correlation measure (a.k.a. “tracking error”).  Instead of looking at a fund’s return stream to infer the size of its active and passive components, the new metric actually measures the deviation of each holding from index weights.  Cremers & Petajisto suggest this measure be used as a complement to, not a replacement for, tracking error.

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Under the hood, new ETFs are same tools used for “portable alpha”

2 February 2007

“These ETFs Bring Hedge Fund Tactics to the Mainstream”

By: Rob Werry, SmartMoney.com
Published: January 31, 2007

For individual investors, ETFs are the easiest way to satisfy the beta requirement in an “alpha-centric” portfolio.  This article illustrates how those ETFs now contain ingredients that are more exotic than you may have thought.  No longer are ETFs simply bundles of stocks.  Now, 2X levered and -2X levered (i.e. 2X short) ETFs provide individual investors with essentially the same tools used by institutions for “portable alpha” and its related strategies. 

Behind the scenes, these ETFs are the same bundles of derivates used by institutions.  For example, the ProShares Ultra Short ETF uses futures and options to allow investors to hedge particularly aggressive long bets.  Institutional investors do essentially the same thing.  Their much heralded “Portable Alpha” involves using futures and options to isolate alpha - only without paying an intermediary (ProShares) to package it for them.    

So as this article says, using these products puts individual investors “next to hedge funds and big institutions”.

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Barclays PhD’s Build Hedge Fund Giant Inside No. 3 U.K. Bank

5 January 2007

By: Edward Robinson, Bloomberg News
Published: January 5, 2007

This article provides an interesting follow-up to a Barron’s piece in October on BGI’s “Triumph of the Nerds” that also discussed the Genesis of BGI - a team that included William Sharpe, Eugene Fama, Fischer Black, Myron Scholes, & Barr Rosenberg.  Not since the movie “The Breakfast Club” have so many cast members gone on to achieve such celebrity.

Not surprisingly, BGI agrees the line between hedge funds and long-only investing is an artificial one. 

“Institutional investing is undergoing radical change, according to (Blake) Grossman (BGI CEO)…’We think this artificial divide between long-only and long/short is one that’s destined to become extinct over the next several years,’ Grossman says.”

BGI’s bifurcated alpha/beta approach (i.e. hedge funds/ETFs) has sent its stock skyward, prompting some analysts to speculate about where the firm will be an acquisition target. 

“BGI and Barclays Capital have helped make its British parent a potential hot property. On Dec. 11, Barclays rose to a then- record of 746.50 pence a share after Merrill Lynch & Co. analysts Brian Bedell, John-Paul Crutchley and Edward Najarian wrote to investors that Bank of America Corp. might be interested in buying the bank.”

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Fidelity Practically a “No Show” in ETF Arena

23 October 2006

By: David Hoffman, Investment News
Published: October 23, 2006

Smaller events on the PGA and ATP Tours always have a problem attracting the big names.  Take, for example, the Canadian stop on the ATP Tour.  It seems that every year the top players fall victim to some freak injury right before the Rogers Cup.  Thankfully, they always recover by the next weekend when they are able to compete in the (much more lucrative) US Open.   Ditto for golf’s Canadian Open. 

But the ETF industry is no Canadian Open.  As this article shows, the ETF sector is the Masters of the investment management industry.  So why has Fidelity taken a pass?

Like the “accident-prone” athletes above, Fidelity might just be making so much money on its active management that it can afford to take a pass.  Or, like these athletes, it may be just saving itself for the big show:

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EVENT: EDHEC Business

9 October 2006

Date: November 21 & 22, 2006
Location: Paris
Organized By: EDHEC Business School

EDHEC Business School in France has published several top-drawer research papers on the alternative investment industry - particularly on how institutions ought to view alternatives in the context of an overall portfolio (just try typing “EDHEC” into the search box on this page).  This conference tackles portable alpha (a.k.a. “core-satellite”) investing from the ETF perspective.  If Alpha Male was Parisian, he would undoubtedly attend this event next month.  Readers on the Continent should definitely try to check this one out (please report back to us).

According to the conference programme, the event will tackle the following questions, among others:

“What are the benefits of the core-satellite approach? How to use ETFs in the core-satellite model?”

“Can ETFs be used to support the structuring of investments in new asset classes (commodities, real estate, etc.)?”

Session will cover the following topics, among others:

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Triumph of the Nerds

8 October 2006

By: Mark Veverka, Barron’s
Published: October 9, 2006

This article in Barron’s illustrates how the successful bifurcation of alpha and beta (and their re-combination in the form of alpha-centric investing strategies like portable alpha) leads to world domination in the money management business.  Out of nowhere in the 90’s, Barclay’s Global Investors has launched not just a massive passive management (ETF) business, but has also laid on top of that a $350 billion-plus quantitative active management (read: hedge fund) business.  BGI is now the second largest money manager on the planet (after UBS).  

“Long revered in institutional circles for its brainy methodologies, BGI emerged as an innovator in index-investment strategies about 35 years ago. (Vanguard popularized them among individual investors.) Barclays now oversees more than $1 trillion in portfolios that use indexing as their key strategy.”

“Its active-management business, which is 100% quantitative and includes a highly lucrative hedge-fund operation, is a huge success. BGI is the largest risk-controlled active manager in the U.S., with $369 billion in assets.”

But like Citigroup (and potentially others), BGI may face challenges integrating the culture (and compensation schemes) of both passive and active (hedge) investing:

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The Best Investors You’ve Never Heard of - Here’s how Barclays Global beats the market–and why you can’t.

27 September 2006

By: Justin Fox, Fortune Magazine
Published: June 16, 2003

This article is several years old, but provides some interesting historical context to the current paradigm shift in portfolio management.  From William Sharpe, to Barr Rosenberg’s “Barr’s Bionic Betas” (eventually renamed BARRA…where was that corporate branding firm when he really needed them?), to Ronald Kahn and the triple Ph.D.’s at Barclays, this makes for an interesting read.

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The Cult of Beta

15 September 2006

By: Alpha Male 

Before an unfortunate laboratory accident (involving mice trained to recognize Greek letters) left Alpha Male with strange  blogging superpowers, he was a mild-mannered marketing executive with a $300 million long/short equity hedge fund. While at said hedge fund, Alpha Male learned a useful lesson about Beta:

All Betas are not created equal. 

This statement may sound trite. Of course Betas are not created equal! You can have betas to an infinite number of factors from the S&P500 to the price of zinc to bond spreads, right? And by the same token, just because your portfolio has a beta-weight net exposure to the S&P500 of zero does not mean it has a beta-weighted net exposure of zero to zinc or spreads.  Besides, Betas assume normality - which is not always a safe bet.

“True” and “True” and “True”.  But I am referring here to betas to the same factor and I am assuming returns are normally distributed.  

You can’t imagine the frustration experienced by the portfolio management team when a 1.0 beta stock falls out of bed on a day when the market was down only slightly. Why did this happen in the absence of news that might “push” it out of bed? On the same day, a stock with a beta of 0.9 might even have been up slightly. What gives?

The problem is that beta has been elevated by Bloomberg and Morningstar to cult status. Too often, investors blindly expect beta to predict short term security behavior. Perhaps in the 1970s when typical portfolio turnover was still under 500x a year, beta was a more useful measure. But it’s not a very useful metric in today’s short-term (hedge fund) investing world.

A quick trip back to finance class will illustrate why.

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ETFs and SMAs: Side By Side

14 September 2006

By: Sydney Leblanc, Financial Advisor Magazine
Published: August 1, 2005

This article for advisors covers ETFs in general.  However, the author makes an interesting observation about the role of ETFs in an SMA for purposes of hedging market risk and essentially creating portable alpha.

“ETFs can also be used as hedging instruments. They can be optioned, margined and shorted. According to ETF pioneer and developer Gary L. Gastineau, a managing member at Summit, N.J.-based ETF Consultants LLC, the short interest in ETFs tells the real story behind their popularity. “The interesting thing is the short interest in the typical ETF is about 20% of the shares outstanding,” says Gastineau. “As of year-end 2004, total ETF assets were reported at $226 billion. If you add the short interest, it’s 20% higher. So in effect, there are a lot more long positions in ETFs than have actually been issued, which means they’re even more popular than they get credit for.”

As Washburn mentions above, some ETFs provide a natural hedge through their low correlation to other securities in the portfolio. Tactical asset allocators, however, may find ETFs an easier venue through which to create portable alpha, according to Pruitt. “ETFs create a marketable vehicle for an index that can be shorted via an option. It’s certainly more available (than index options).”

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ETFs: An Advanced Alternative to Indexation

28 August 2006

By: Yang Rong
Published: March 6, 2006

Yang Rong’s observations about ETFs support their use as an alpha-isolation tool by hedge fund managers.  Which begs the question, “why just hedge funds?”.

Excerpts: 

“ETFs are often used for shorting purposes due to their intra-day trading rules, which not only help hedge funds to remove regulatory issues, but also generate revenue from lending the stock and cutting down on the total expense ratio (TER) of other ordinary funds. Such advantages attract a great many fee-based institutions and hedge funds. Brokers have reached agreements with various ETF managers on creations and redemptions and will therefore get the fund to issue more shares if necessary, which guarantees the fund liquidity. Additionally, as futures contracts are only available on the main stock market equity indices, whilst there are many more ETF offerings, ETFs could easily have more exposure (such as sector exposure) than futures contracts.”

“a relatively small minority of Europe’s institutional investors are using ETFs today, and a large number of reputedly sophisticated institutional investors have little to no interest or knowledge of the products owing to insufficient education on ETFs. Most European pension funds place ETFs in the same category as hedge funds, private equity funds and other alternatives.”

…In a strange way, European institutions are correct to place ETFs in the same category as hedge funds since these are the two base components (”genes”) of any active portfolio.

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Trends in Exotic ETFs

28 August 2006

By: Yang Rong
Published: February 20, 2006

The explosion of the ETF industry now provides many more tools for alpha extraction and porting… 

Excerpts:

“Commodity ETFs: Commodities in general are typically a good hedge against inflation and stocks over a sustained period. The value of commodity ETFs is tied directly to the value of the commodity in question.

“Dividend ETFs: The intention of Dividend ETFs is to give investors opportunities to access dividend paying companies. 

“Inflation-linked ETFs: The inflation-linked ETFs commingle with the characteristics of ETFs and those of bonds or indices; they are supposed to improve interest rate risk management.

“REIT ETFs: Nowadays, Real Estate Investment Trusts (REITs) are attractive as diversifiers that tend to have stock-like returns and risk and pay high dividends, but are relatively uncorrelated with other asset classes.

“Semi-active ETFs: Some ETF providers like PowerShares LLC take a semi-active approach to investing. This method pegs ETF products to non-traditional “intelligent” indices built by using quantitative analysis, such as special microcap indices or small groups of stocks.”

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Defending an ETF Portfolio

4 July 2006

By: Richard Kang, Meridian Global Investors
Published: January 2005

Excerpts: 

“The combination of the long position in the small cap fund and the short position in the Russell 2000 (assuming roughly equal dollar amounts) looks a lot like a market neutral long-short position, one subset of hedge funds. 

“Only recently, with the explosion of index funds, ETFs and alternative investments have retail investors had the tools to build portfolios in a similar manner. Like ETFs, we have also seen an explosion in the interest and money invested in alternative asset classes, especially hedge funds and so called “absolute return strategies”.

“What investors have to understand is that passive instruments, such as the ETFs, provide a portfolio exposure to beta or market risk with the potential to receive returns. Use of alternative investments, and in particular “absolute return strategies” such as hedge funds aim to provide alpha and, ideally, very little beta. In other words, their returns normally aim to be determined, not by market movements, but by the active decisions made by the manager. Any changes in allocation from passive to active managers equates to a transfer of market risk to manager risk.

“The combination of indexing and alternative instruments, (beta providers and alpha providers respectively) has been used by institutions for years…

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