Capital-Protected ETFs: Seeking Alpha via ETF?

More ETF innovation coming out of Europe. This one is from Societe Generale Asset Management and it’s an ETF traded on the Euronext Paris that is linked to the Dow Jones EURO STOXX 50. What’s new is capital protection (albeit only partially) on the long position.

So, there’s some downside protection but the first thing that I’m thinking is how much? Not just how much downside protection, but how much is this added benefit going to cost me?

Here’s the press release (.pdf).

According to this site, “In the case of a market decline, exposure to the index is adjusted to less than 100%, the difference being transferred into a money market placement until the markets rebound. The portfolio insurance method guarantees a partial capital protection of 80% of the net asset value of the ETF on 31st of December of the preceding year.”

At first, the wording might seem to suggest a form of constant proportion portfolio insurance [CPPI] is used; a commonly found mechanism used in structured products with a principal guarantee wrapped in. Societe Generale, and their subsidiary Lyxor, are not only well known (at least in Europe) for their ETF business but for their hedge fund and structured product business which actually preceded their ETF work. Many hedge fund products all over the world are built with this type of guarantee (specifically CPPI) with SG as the guarantor.

However, CPPI includes the use of leverage which is not mentioned here. In fact, there is mention of a maximum of 100% exposure to the index. This could be a simple vanilla structure where in the case the market continually goes down, there is an increasing proportion put into money market instruments. At some point, a threshold is hit and the portfolio is completely in cash equivalents such that at the end of the calendar year the return will be enough to provide the required 80% capital guarantee.

What comes up next in the same press release is nothing more than a description of pure active management in this ETF: “Every quarter, SGAM Alternative Investments’ analysts and fund managers examine the market in detail and anticipate future trends in order to determine the optimal participation in the index performance. Thus, during stable or bullish up markets, the exposure to the index can reach its maximum of 100%. If the market declines, investors will be under-exposed to the market with the aim of maximizing the partial capital protection.”

So not only is there a mathematical formula which measures the allocation between the index and cash so as to properly provide the required 80% guarantee at year-end, but there is also a quarterly reset mechanism where managers determine what starting proportion -- I suppose anywhere between 0 and 100% -- of the portfolio’s assets are to be invested in the index.

I’ve written recently quite a bit about the merging of the two extremes in investment management:

* Passive: with discussions on ETFs, and
* Active: with particular attention to hedge funds and private equity investing).

This new ETF is another example of this. On the one sense, it’s an ETF meant to track an index. But on the other hand, they’re also talking about managers who “examine the market” and “anticipate future trends” to basically decide if the ETF should have full exposure in the index it’s tracking or not. If I’m not mistaken, this will be the first ETF to not be fully invested in an index (albeit for minimal cash positions as a logistic reality).

Just as significant, the active management process does not seem to be built on some form of “rules based” methodology but something more subjective. I thought fundamental indexation was mixing things up in the ETF industry. Now this!

You might have noticed a pattern in my past few blog entries with my attempt to further explore the new ways that the concept of passive and active investment management are being blended together. Question: Although ETFs have always been about exposure to beta (market risk), is this ETF all about seeking alpha (manager skill)?

Furthermore, are we to see a major divergence in the ETF marketplace where one group tries to follow Vanguard to the low-cost model where others add unique properties to take fees in the other direction? This new capital protected ETF can’t be cheap and I would be surprised if it had an MER under 100bps.

Bottom line: Will sophisticated investors pay the increased fee over the comparable plain vanilla ETF for the active management and guarantee structure when other simpler and cheaper strategies (moving to cash, option strategies) are available?

Comments

[Susan:]

Hmmm...
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managers who “examine the market” and “anticipate future trends”
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So, what we have here is essentially a new high-cost (for an index fund) "market timers" fund.

Is there anything really new here (except for this being an ETF)?
Any doubts that they will, over time, underperform their index?

2006 Nov 10 08:13 PM

[jardine:]

Powershares PRF and new ETFs from Wisdom Tree are just the start. The passive - active managment pendullum is swinging back to active products.

2006 Nov 11 07:23 PM