Basket Trading With ETPs Gives Tactical Advantages And Market-Beating Returns

Summary

• Basket opportunities abound in the ETN space but can also be replicated via ETPs.
• Themes and rules can be highly customizable, particularly if the instruments used are single-stock ETPs.
• However, it's not always possible to consistently beat or match the performance of large-AUM basket "ETNs".

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"Baskets" are a pretty useful means of investing into a particular sector or theme with its inherent stock diversification benefits. While baskets are typically built with stocks and available as ETNs ("exchange-traded notes") or special index-tracking ETFs, an investor can build a "basket" using leveraged single-stock ETPs ("exchange-traded products") in order to get magnified exposure around a theme in light of market sentiments.

Here's a quick look into the ideas of "baskets" and a number of moments when baskets built with Leverage Shares ETPs have shown strong performance.

A few notes right at the outset:

• In practitioners' parlance, ETPs are very distinctive from ETFs. The latter feature quite heavily in retirement accounts but the former are predominantly deployed by sophisticated tactical investors. For a clear delineation in terms and landscape, click here to read a comprehensive summary.
• This article makes comparisons using single-stock ETP data versus the benchmark's. While the latter is publicly-available in most parts of the world, the former is usually available via some data vendors for a recurring fee or made available to investors by specific brokers who have onboarded these products. Leverage Shares' ETP data has been used in this article for a simple reason: I work there and am permitted to use this data for some articles. There are, of course, other ETP issuers; readers are advised to enquire with their preferred brokers to determine which ones are available in their region for analysis.
• Unlike ETFs, ETPs vary highly by issuer with respect to construction and fees. The complexity frequently confuses even brokers who conflate them with structured products (which they aren't). Since Leverage Shares' data is used, a comprehensive outline of the company's specific flavour of ETPs in terms of features, value proposition relative to popular structured products and things to keep in mind when investing in these products has been made available (click here to read the first part of seven, which discusses these matters in exacting detail).

Broadly speaking, when it comes to any leveraged single-stock ETP, "the trend is your friend."

Building a Basket

A "basket" is simply a collection of instruments that are traded simultaneously. The concept is familiar for investors who have previously invested in ETFs, which often provide exposure to a broad basket of stocks. Creating more targeted exposure via smaller baskets allows investors to choose their own investments rather than investing in too many products, some of which may not necessarily "belong". It's a particularly important tool for institutional investors and investment funds looking to hold multiple securities in certain proportions since simultaneous trades hold in place the portfolio allocation for each security.

It's not particularly difficult for investors to conceive and build a basket: all that's needed are a few building blocks around an idea.

The "first block" would be the type of security. In most of the example presented herein, the securities we use will be the company's 3X ETPs.

The "second block" would be the rebalancing frequency, i.e. how often would the ETPs be held before being rebalanced to the target exposure? In the examples presented herein, since the standard recommendation is that leveraged instruments shouldn't be held for more than a day, the basket rebalancing frequency is set at "daily".

The "third block" would be the invested amount. In the examples presented herein, an initial investment of $10,000 is made and the proceeds of thereof used to finance subsequent rebalancing.

The "fourth block" would be the allocation rule, i.e. in what proportion are the ETPs to be held? There are many modes of weight distribution such as market cap weighted, custom weighted, etc. In the examples presented herein, the allocation rule would be equally-weighted. The closing price of the previous day would determine the weight of each ETP held in the basket.

The "final block" would be the basket's theme. This is the central idea behind the investor holding the ETPs in question.

Throughout this article, two benchmarks will be used: the tech-heavy Nasdaq-100 (NDX) and the broad-based S&P 500 (SPX). The holding period for each basket will be a minimum of one calendar month.

Exploring Themes

The first theme would be the "Gig Economy" which will highlight gig superstars Airbnb (ABNB) and Uber (UBER). As the global economy recovered from the pandemic in Q1 2021 and lockdowns eased, it would be a fair assumption to make that these two stocks would do well.

Note: The outlook for Airbnb as well as Uber were covered earlier.

In the calendar month of February 2021, the basket of 3X Airbnb (ABN3) and Uber (UBR3) ETPs reached a performance of over 60% before closing out the month with a net 12% in gains. The benchmarks NDX and SPX were down 3% and up 0.9%, respectively.

The next theme will be "Streaming", which has been shaking up traditional broadcasting and cable services. Since Disney (DIS) has substantial properties in resorts and traditional broadcasting, it might be premature to include Disney in this category yet - despite the company owning both Hulu and the recently launched Disney+. Hence, this basket will comprise of the 3X Netflix (NFL3) and Roku (ROK3) ETPs.

Note: The outlook for Disney, Netflix and Roku were covered earlier.

The calendar month of June was particularly interesting here: the ARPU (Average Revenue Per Unit) numbers and estimates for Q2 2021 were released by the companies along with many industry experts and watchers making prognostications of what the financials as well as the ARPUs signified.

Over the calendar month of June 2021, after a period of uncertainty, the basket closed out the month with over 57% in gains. The benchmarks NDX and SPX were up 6.6% and 2.2% respectively.

Seasoned investors will likely know that "FATANG" - Facebook (FB), Apple (AAPL), Tesla (TSLA), Amazon (AMZN), Netflix (NFLX) and Alphabet (GOOG) (GOOGL) - are a popular basket of stocks that generates a lot of discussion among day traders, punters and financial media.

2020 was a trying year for these stocks. After the drop in February to the highs in subsequent months, Q3 2020 started out with a warning from many analysts that these stocks were outsized in their prices which led to another drop that quarter. However, these stocks persevered on the basis of strong earnings and other metrics.

In the calendar month of November 2020, the basket of 3X Facebook (FB3), Apple (AAP3), Amazon (AMZ3), Netflix (NFL3), Alphabet (GOO3) and Tesla (TSL3) ETPs yielded 24% in gains while the benchmarks NDX and SPX yielded 10.6% and 9.4% respectively. Continuing to "run" the basket till the end of December would have yielded over 37% in gains while the benchmarks yielded 16.3% and 13.5% respectively.

Bending the Blocks

A shrewd investor can modify the idea of baskets in many ways to yield opportunities even during market downturns.

For instance, if the "third block" were amended such that the invested amount remains capped at $10,000, i.e. regardless of the day's performance, the investor were to top up the investment amount and remained invested, a "modified inverse" FATANG basket - -1X Facebook (FBS), Apple (APLS), Amazon (AMZS), Netflix (NFLS) and Alphabet (GOOS) and the -2X Tesla (TS2S) ETP - would have yielded 17% in gains for the calendar month of February 2020 while the benchmarks were down 7% and 9% respectively. This proves to be an effective way to go short the mentioned stocks, or simply hedge exposure to the Nasdaq-100.

Readers should notice that this "modified inverse" basket even amended the "first block" in two ways: in addition to not using "long" 3X ETPs, the same inverse factor was not used for all companies since there was an expectation that Tesla would be hardest hit on account of lockdowns, et al.

This is an important distinction: it isn't necessary to pick only leveraged instruments. To complete a theme, an investor can select from a range of 1X Stock Trackers/stocks or select combinations of 3X, 2X and -1X factors in different underlying (and even the same company) to build out a variety of interesting strategies. In other words, the "final block" could determine what the first through fourth blocks need to be.

Also, while leveraged instruments are not usually held for more than a day, shrewd investors can weigh risks of being invested for more than a day and amend the "second block" to rebalance on a 2-day basis, a 5-day basis or more.

To illustrate the utility of "factor blending", let's consider two more themes. First, the "Chinese e-retail" theme. The online retail space in China is cut-throat and vicious with current leader Alibaba (BABA) constantly being challenged by up-and-coming risers. Two of these competitors are JD.com (JD) and Pinduoduo (PDD): both these companies focus on users in China's lesser-developed cities and villages (which Alibaba historically didn't). Also, unlike Alibaba's more-recent forays into the cloud computing business, these two remained rooted to the online shopping space.

Note: Alibaba, JD.com and Pinduoduo have been extensively covered earlier.

There was a widespread crackdown on Chinese tech companies by around Q2 of this year and the shares of affected companies tumbled, despite their fundamentals. However, by July, most companies had "taken their medicine" from the government and investor interest started rising since these companies were now "undervalued" in the market.

In the calendar month of July 2021, the basket of 3X JD.com (JD3) and 1x Pinduoduo Tracker (1PDD) ETPs reached a loss of over 11.6% before closing out the month with 4.3% in gains. The benchmarks NDX and SPX were up 3% and 2%, respectively. Continuing to hold the basket for the calendar month of August 2021 would yield about 14% in gains while the benchmarks were up 7% and 5% respectively.

It is very likely that this basket will continue to rise in performance as the stocks continue to recover lost ground.

There is an important distinction when it comes to Alibaba for this period: the company's stock teetered on the edge of heightened investor interest due to continued government scrutiny. If the 3X Alibaba ETP (BAB3) had been included in the basket, the basket would have yielded 4% in gains for the calendar month of July and yielded 15% in gains if held until the end of August. Hence, investing into the company in those months would not have given significant performance enhancement. However, whenever the company passes government scrutiny, the 3X Alibaba ETP (BAB3) can also be added to this basket for enhanced returns as the stock will likely race upwards from being "undervalued".

Now, let's consider the "NextGen Vehicles" theme. While Tesla and NIO (NIO) are crowd favourites producing high-cost, high-quality automobiles, the Hydrogen Fuel Cell (HFC) vehicle space has been quietly heating up as well. While both Tesla and NIO delivered as/above-expected results for Q2 2021, Plug Power (PLUG) announced in June that it is entering into a partnership with Renault (OTCPK:RNLSY) to enable the rollout of high-quality HFC vehicles in Europe and elsewhere.

In the calendar month of July 2021, the basket of 3X Tesla (TSL3), 3X Plug Power (PLU3) and 1x NIO Tracker (1NIO) ETPs reached a peak performance of over 12% before closing out the month with 8% in gains. The benchmarks NDX and SPX were up 3% and 2%, respectively.

ETN Replication and Size Limitations

The "third block" presents an interesting challenge: being invested in larger amounts via baskets often yields more profit. With larger amounts, allocations among instruments to reach "whole numbers" relative to the price of the instruments improve. This could lead to better performance.

For instance, consider the MicroSectors "+3X Long FANG+ ETN" (FNGU) which adds four companies to FATANG - Alibaba (BABA), Baidu (BIDU), NVIDIA (NVDA) and Twitter (TWTR) - weighs them equally and rebalances daily. This Exchange-Traded Note (ETN) is estimated to have close to $1.9 billion in assets under management (AUM).

FNGU can be replicated by using the 3X ETPs on Facebook (FB3), Apple (AAP3), Amazon (AMZ3), Netflix (NFL3), Alphabet (GOO3), Alibaba (BAB3), Baidu (BID3), NVIDIA (NVD3), Tesla (TSL3) and Twitter (TWT3) for a slightly lower expense ratio.

Note: Other costs, like the spread and brokerage commissions, have not been included.

Consider the month of January 2021 where these stocks continued to ride the highs from their closing days in 2020. It is a reasonable assumption to make that this basket would carry forward with solid gains. However, "third block" amounts yield different results for this basket.

Readers should note that "equally-weighted" in this case means the nearly same amounts are invested into purchasing each instrument and not the same number of instruments.

Let's consider the $20,000 case and examine the initial (starting) portfolio held. FB3 and NFL3 are very close to each other in price and the same is true for BAB3 and TSL3. However, when the investment is being spread across a large number of instruments, the difference in number of ETPs purchased (Note: fractional investments are not being considered in this illustration) is 13.3% and 4.8% respectively.

Also, since all instruments do not move in tandem with the same magnitude, performance contribution is not going to be the same. When scaling up to larger amounts, the relative price neighbour difference changes: in the $2,000,000 case, for example, the differences are 13.8% and 4.7%. This causes the variance in performance when scaling up or down the investment value.

At the $20,000,000 level, the ETP basket closes the month ahead of FNGU's gains by a paltry 1.2%.

In the year till date (YTD) until the end of August, this gap shrinks to -1.1%, i.e., FNGU leads the basket by a small margin.

In Conclusion

The "basket-building" exercise highlights some important lessons for investors:

1. When it comes to the top-tier baskets comprised of very high-priced instruments, it might pay to "go big".
2. Considering the fact that instruments like FNGU show very high variability in performance versus the benchmarks, "going your own way" in replicating popular instruments often makes sense for strategic players such as institutional investors but not necessarily the best option for retail investors.

Another important factor that an investor should consider is the gains: being invested in FNGU or the $20 million "ETP replicant" basket yielded around 32% versus the 18% in benchmarks. Meanwhile, a number of opportunities can be realized using themes that yielded much higher gains in a much shorter period. The key to each profitable "basket" example lay in understanding market sentiments around impacts from affecting externalities, the timing for company announcements, et al.

This highlights the value of making a tactical play. While it would certainly make sense to be invested in a large index fund or special ETN such as FNGU as part of an investor's "core portfolio", having funds ready to make tactical plays with short &leveraged ETPs in a "satellite portfolio" is a very strong value-building move. Alternatively, new tactical players can also use ETPs to get magnified exposure and performance while they weigh the benefits of building "core" and "satellite" portfolios.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Leverage Shares is an exchange-traded products issuer that offers daily-rebalanced products in leveraged/unleveraged/inverse/inverse leveraged factors. The company holds both long and short positions in a number of stocks, including those mentioned in this article, in order to construct the products offered to investors. Please consider risk factors carefully before investing in these products.