By Paul Amery
There are signs that the ETF market is heading towards much greater fund complexity. Could we have more disclosure, please?
For the firm this is a major event, in many ways: this will be iShares’ first offering of short exposure to its ETF investors; it’s a departure from the firm’s tradition of following cap-weighted benchmarks (the new ETF will track MSCI’s factor-weighted USA Barra Earnings Yield index (pdf)); and it’s a further example of the ETF market leader’s recently announced shift towards offering more actively managed products.
In principle, providing strategies to investors in ETF format that allow shorting, as well as long investment, is a potentially huge new business area. Historically available only behind prohibitively expensive hedge fund fee structures, short-selling funds expand the investment universe in a logical manner.
After all, in a long-only fund, the most you can do if you don’t like the valuation of a stock is to leave it out or underweight it. If you can short sell, you can seek to profit just as much from the stocks you don’t like as from those that you do.
That, of course, brings you to the obvious conclusion that your long-short index is only as good as the model underlying it. Hopefully you can find one that does a good job of identifying the relevant stock performance “factors” and then weights accordingly.
I have three concerns, though, about this type of fund.
First, the overuse of similar factor models for quantitative equity exposure can be very dangerous. We saw a dramatic market blowup in 2007 for just this reason, an event that’s perhaps been forgotten. Once you add short selling into the portfolio management mix, the potential for costly errors, or simply losses resulting from “squeezes” and having to close positions at the least appropriate times, is clearly magnified. Information on how long-short ETFs manage their stop loss policies, however, is unfortunately non-existent.
A second concern about the spate of new long-short funds is that almost all those launched to date follow a 130/30 rule: 130% long, 30% short. To me the 130/30 concept was and is more the result of portfolio backtesting undertaken at the tail-end of a long equity bull market than anything else, meaning that the long-short bets are tacked on to a portfolio that maintains a fully invested long position. Why not 150/50 or 50/150? Or even market-neutral, so that an investor can take market bets elsewhere and use the long-short fund just as a way of adding value through stock selection? Having a set leverage ratio like this means you’re always going to be adjusting longs and shorts to keep in line, something that will result in additional trading costs.
Third, a 2008 Deal Sleuth blog highlights that managers of 130/30 funds have greatly increased opportunities to make money in non-transparent ways: from the spread between the interest rate charged to the fund when it borrows stocks and the interest rate paid on collateral, and from securities lending, to name just two examples. And that would be on top of the near 1% fee that these funds already charge.
“Investors in 130/30 funds should be wary of funds offered by large financial services institutions with affiliated brokerage and lending operations. The temptation of squeezing extra margin out of a 130/30 fund through low short rebates and high lending rates could be too great for bonus hungry executives to resist,” Deal Sleuth warns.
ETF providers’ record on the disclosure of information relating to their securities lending operations is unfortunately not good. BlackRock is one of the biggest players of all in stock lending, by the way.
I’m a fan both of offering short exposure via ETFs, and of the broader use of strategy-driven, non-cap-weighted indices. But the steeper price tag that comes with long-short ETFs and the significantly increased opportunities for other costs to be heaped on investors means that extra transparency on these new funds’ policies and operations will be paramount.