By Murray Coleman
The market for exchange-traded funds shifted earlier this year into active management. Now, it has moved into hedge-like strategies.
The First Trust Enhanced 130/30 Index (JFT) has launched in the form of exchanged-traded notes.
Like its sister ETFs, the new ETN holds a portfolio of stocks. Unlike ETFs, such ETNs are issued and marketed by a large financial institution.
In this case, JPMorgan Chase (JPM) is working with First Trust Advisors, developer of the ETN's underlying benchmark.
ProShares has a similar type of 130/30 portfolio in registration. But it hasn't come out yet. That means JPMorgan has captured first-mover status among exchange-traded products in the popular hedging strategy.
"We are excited about working together with JPMorgan on this innovative product that provides a convenient way for investors to gain exposure to this 130/30 strategy," said Dan Waldron, First Trust's senior vice president.
The portfolio is a modified equal weighted total return index designed to offer 130% long and 30% short exposure to selected large capitalization U.S. publicly traded equity securities.
JFT is expected to charge an annual expense ratio of 0.95% and will be rebalanced quarterly.
"It certainly represents a step-up in sophistication in terms of the types of products available to individual investors through exchange-traded products," said Roger Nusbaum, chief investment officer at Your Source Financial in Phoenix, Ariz.
The 130/30 type of strategies are largely used by hedge fund managers, although open-end mutual funds in recent years have also started implementing the formula.
In such a leveraged strategy, portfolios take a 130% long position with its assets. At the same time, another 30% is invested in short positions. The idea is to wind up with net 100% long exposure.
But here's the wrinkle. Such 130/30 funds basically achieve that overall allocation by using three different buckets: a long position, a short position and a leveraged-long position.
"The 100% long position is similar to your normal portfolio," Nusbaum said. "With the leveraged-long 30% and the short 30%, you can pair those off against one another to implement more sophisticated strategies."
For example, say JFT had been around for awhile and put its leveraged-long portion into energy stocks. Then, it might've used the other 30% to short financials. Of course, energy has soared in the past 12 months while financials have been hit hard.
In theory at least, such a 130/30 tactic would've given the fund terrific results.
But some challenges could be in-store for an ETN trying this sophisticated strategy.
"At big turns in market cycles, some open-end mutual funds in this alternative strategy really have really done poorly," Nusbaum observed.
But he has no concerns that the ETN will have a problem tracking its index. "The issue is that the index uses growth factors and value factors to determine long positions," Nusbaum said.
Growth factors used by JFT are: three-month price appreciation, six-month and 12-month price appreciation. The other growth factor is one-year sales growth.
The other half of the picture is the selection process for value names added to the ETN's underlying index. Those will be ranked by factors including: book-to-price, cash flow-to-price and return-on-assets. Also, aggregate rankings of both the growth and value factors will be included in long positions.
The long positions will be chosen from top ranked stocks in a universe of 2,500 large caps. Besides the combined value and growth factors, the index will weed out names based on certain liquidity screens. No ADRs, REITs or limited partnerships will be included.
The short positions will simply reflect the lowest ranked stocks in the methodology. The complete process will be repeated and names adjusted accordingly each quarter.
A big portion of the process relies on momentum in this particular index, notes Nusbaum. "The nature of market bottoms is that they turn into bull markets, often with no real fundamental justification. When you've got a process relying on fundamentals and momentum, it could very possibly miss big turns in market cycles that happen very suddenly," he said.
At the same time, Nusbaum believes that a fund like this would work best in mature bull markets.
"If that turns out to be the case, then this isn't an ETF that would be ideal to simply buy and hold," he added.
While ETFs are exposed to market volatility, ETNs also carry the added risk of losing their value if the issuer's financial health crumbles to the point where it can't repay the notes.
But also important to consider is that such risks of bankruptcy have some positive elements. ETNs differ enormously from the vast majority of other structured investment products through being accessible over exchanges. Most structured notes - by some estimates, 90% of even the highest-quality short-term issues - don't provide such liquidity for investors.
Although impacted by the ongoing credit crisis, seven of the 15 analysts polled by Thomson/First Call who regularly cover JPMorgan rate it as a buy. The other eight have placed a hold recommendation on the stock.
One of those with a neutral rating on the stock, Goldman Sach's William Tanona, lowered his earnings forecasts on JPMorgan earlier this week. He told clients that while the company's better-positioned than its rivals, clouds over credit markets are likely to continue to be a drag on earnings in the near-term.
Another risk pointed out by JPMorgan executives recently is the firm's bailout of rival Bear Stearns (BSC).
On Thursday, Bear Stearns shareholders are set to give final approval of the deal at $10 a share. A year ago, the 85-year-old firm was trading around $154 per share.