Recently, we hosted Stuart Rosenthal, CEO and Co-Founder of Factor Advisors, the company behind the FactorShares ETF lineup, here at the ETF Database headquarters. In our wide ranging conversation, we discussed how Stuart got started in the ETF business, what factor investing entails, as well as the potential benefits of using the ETF structure to bring this concept to the masses.
ETF Database (ETFdb): How did you get into the ETF business?
Stuart Rosenthal (SR): After serving five years as an Air Force Officer, I started my investment career at GMO which is a Boston firm with a quantitative focus. I began as an analyst and quickly learned the ropes of institutional investing, asset allocation, and risk analysis. From there, I moved to Rampart Investment Management, a boutique specializing in volatility management using options to add value through yield enhancement (covered call-writing) or hedging portfolio risk via protective puts and other options strategies. I learned the business from the best derivatives practitioner in Boston — Harry Markopolos — who early on cracked the Madoff case using forensic options analysis.
I took that experience and moved to Credit Suisse where I worked in a group called Volaris which, similar to Rampart, focuses on volatility management. That is where I met Karlheinz Muhr who had started Volaris some years prior. There, I ran U.S. portfolio management for high net worth clients and institutions, managing multi-billion dollar portfolios spanning yield enhancement and protection strategies.
I left Credit Suisse a little more than two years ago, and together with Mr. Muhr and his former professor, Richard Roll of UCLA Anderson School of Management, formed Factor Advisors to commercialize factor–based investments via factor ETFs, or FactorShares.
ETFdb: Professor Roll is known for his research around the concept of factor investing. How has his research shaped the products you now offer?
SR: Professor Roll's background revolves around the concept of factor investing or factor as an asset class. Over the past 20+ years, Professor Roll and other academics have shown that diversified portfolios, consisting of dozens or often hundreds of securities, could be summarized according to no more than five to ten common factors, each representing a unique driver of investment risk and return. Dr. Roll is perhaps best known for his empirical work related to Stephen Ross' arbitrage pricing theory (APT) which is a model or framework for thinking about portfolios according to macroeconomic drivers.
So what does that mean? Well, an example of a macroeconomic factor is the shape of the interest rate curve or unexpected changes in the difference between ten year and two year interest rates. Similar factors consist of unexpected changes in industrial production, GDP or inflation. These are just a few examples of underlying drivers of risk and return within the APT framework. Other factors are fundamental or based on traits that are common across companies such as market capitalization, book value, etc. Our goal is to bring to the marketplace FactorShares which are factor ETFs using a spread-based framework [see FactorShares Debuts New Breed Of Leveraged ETFs].
ETFdb: When you were starting the company, what is it about the ETF structure that grabbed you? There are a lot of ways to offer this strategy, why use ETFs? And on the flip side if you are an investor, why choose ETFs?
SR: Increasingly, ETFs are providing cost-effective access to alternative strategies that may have been around for years as active mutual funds but otherwise off-limits to non-institutional investors as passive investments. Specific to spread trading strategies and other factor-based investments, the ETF format provides for convenient and liquid access to alternative investments that can be used to hedge different types of portfolio risks or used as part of a broader diversification strategy.
For example, global macro strategies that are applied by many hedge fund managers consist of relative value views spread across different asset classes — small caps perhaps outperforming large caps, emerging market stocks outperforming developed market stocks, etc. — and implementing those views using a long/short construct. A global macro manager often thinks about investments in a relative value framework and adds value by allocating capital accordingly. Likewise, at Factor, we think about investing in a relative value framework and with ETFs as the preferred platform, have sought to empower self-directed and sophisticated investors with the tools necessary to, let us say, build their own global macro strategy using FactorShares.
ETFdb: How would someone go about gaining exposure to a spread trade before this strategy was introduced into exchange traded products?
SR: Traditionally, spread treading has required trading a long and a short position. This requires paying two commissions, one for each position to initiate the trade. Ordinarily, spread trading costs twice as much as a single position, requiring active management, monitoring and periodic rebalancing. By integrating these two positions as part of a spread trade into a single ETF, we believe it may be cheaper than a do-it-yourself approach to managing those positions separately.
With each FactorShares ETF, a one dollar investment targets two dollars of long exposure to one market segment and two dollars of short exposure to another market segment upon daily rebalancing. In the aggregate, this targets a 4:1 gross leverage ratio because one dollar invested is providing four dollars of total market exposure.
ETFdb: Is spread trading another technique “democratized” by ETFs? What is it about this strategy or asset class that may be potentially appealing to investors?
SR: We believe so. Spread trading strategies have two potential benefits that investors and traders have been pursuing for some time. The first benefit is uncorrelated returns, which may provide diversification potential.The second benefit is hedging stemming from the short position within each fund.
For example, FactorShares 2X Oil Bull/ S&P500 Bear (FOL) provides long exposure to the oil futures market and simultaneously short exposure to the S&P 500 futures. Because of the short exposure to the S&P 500 futures, FOL will typically have a negative correlation to other long S&P 500 positions in the portfolio. For the first five weeks the product had been trading, beginning in late Feb 2011, FOL had a negative correlation with the S&P of -0.5, primarily due to the negative exposure to the S&P 500 that is represented in the Fund [Five ETF Strategies For A Sideways Market].
ETFdb: Who did you have in mind when building this product? What types of traders and investors are these built for?
SR: We make it very clear, like a lot of other alternative ETFs in the marketplace, that these are intended for sophisticated investors that do their homework, become educated, and are familiar with the product. The familiarity can come from reading the prospectus and by coming to great sites like ETFdb.com to educate themselves on how these products work. Over time, we believe factor investing using FactorShares and similar offerings will become a mainstream form of alternative investing throughout the ETF industry [see all the FactorShares ETFs here].
Disclosure: No positions at time of writing.
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