ETFs on the Outperformance of Two Securities

by: ETF Wanderer

IndexIQ has recently filed for products to synthetically replicate hedge fund strategies. This is an interesting development for “retail” hedge fund investing. There is a widely held belief that hedge funds earn their returns through identification of market inefficiencies and by superior investment selection, i.e. by producing "alpha". However, the majority of hedge funds generally trade the most efficient markets and an alternative explanation of the hedge fund alpha is that the alpha is actually an alternative beta, i.e. basically an exposure to unavailable-to-retail asset classes, such as size or value-growth bet in the equity markets.

There are two common ways to construct the beta. The first way is the regression approach. Put simply, pick a hedge fund peer-group performance index and carry out a regression with existing asset class and rebalance frequently. This is called "synthetic replication". Replication products made a lot of news in 2007 - but that is not what people really want.The big problem with "synthetic" replication is that the replicated product can deviate substantially from the original.

Secondly, now that a few replication products are already in the market, the performance or the replication efficiency in real environment is seen to be quite different from their backtests.

What most people really want (the second approach) is the true replication, but cheaply – for instance, as an ETF. It is commonly believed that true replication needs to be done using a trade-based approach and can involve holding a lot of stocks or other securities and rebalancing them frequently which in turn may not hold favor with retail investors. Hence, the trade-based approach may seem difficult to commoditize.

But this view is incorrect and offering true replication products is actually simpler than we think. All we need to do is to offer products on the outperformance of one security over the another – and we can have a successful retail hedge fund market.

Alternative Betas from the Equities World

Let's consider a few of common bets that are deployed in the equities world by the quantitative long/short and market-neutral managers.

(i) Size bet - the idea that small caps will out-performance large caps.

(ii) Value bet - the idea that value will out-performance growth. Often, the bet is combined with profitability measures that are correlated, such as higher return on equity stocks will outperform lower return on equity stocks etc.

(iii) Emerging market bet - the idea that the emerging market will out-perform developed markets.

(iv) Momentum / analyst / sentiment behavior bets - the idea that stocks with good 1 year momentum will outperform poor momentum. Momentum being a higher frequency strategy, it is usually combined with correlated lower frequency measures like: stocks with positive earnings surprises; or increases in positive recommendations; or increases in the number of analysts revising upwards; etc will outperform the opposite.

The more difficult part is that many of these bets have very little alpha - and one needs a mechanism to get a levered effect (without the cost of levering). Let us consider how one can consider the replication of these hedge fund bets for retail investors.

Consider the size bet. For the sake of simplicity, let us assume we can't buy on margin. There are currently two possible ways to construct a size bet by the retail traders:

Approach 1: Buy 50% of capital in the Ultra Russell2000 ProShares ETF (NYSEARCA:UWM) (double daily iShares Russell 2000 Index ETF (NYSEARCA:IWM)) and 50% of capital in the UltraShort S&P500 ProShares ETF (NYSEARCA:SDS) (double inverse daily S&P 500 SPDR ETF (NYSEARCA:SPY)). However, buying/selling levered ETFs has two issues: (a) 50% of capital in 2x levered products essentially gives just a 1x or un-levered product; (b) these levered products provide double the "daily" returns, not monthly or quarterly, and there are arguments to support that this may be both desirable or undesirable.

Approach 2: Directly buy a product that gives the difference in the returns of SPY and IWM. This can be currently done via structure products or options.

Many firms offer structure products to retail clients that pay the difference between two stock indices. For instance, there is the exchange traded structure note (RAO) from Morgan Stanley. However there are too many issues with existing structure notes. Take the example of RAO - the payoff on the long side is 3*max(ret1-ret2,2%). While apparently it is 3x levered product on the size bet, but a cap of 3*2% = 6% means that the maximum return is capped at 6%,  essentially negating any benefits from the leverage if one gets the size bet right. The payoff on the downside is borne fully by the buyer of the structure. While the potential gain is highly limited, the potential loss is uncapped. Most similar structure products have similar faults and designed to benefit only the issuers.

Another way for direct investing (with leverage) could be to use options, for instance a vertical call spread with one leg on SPY and another leg on IWM. But options have their own nuances - more often than not, one can be right on the direction and still lose on the options due to volatility issues.

In conclusion: there aren't currently any good ways to directly trade many of hedge funds bet, even one as simple as a size bet.

But it is not difficult to offer such a product as an ETF. For example, many of the current levered and inverse ETFs are constructed via swaps. Many OTC institutional swaps are available (or can be combined) that pay the difference in returns of two indices, in the same way as the swaps that have been used to construct the levered and inverse products.

For the retail investor to get a genuine hedge fund like investing feature, what we really need are ETFs on the outperformance of two products. Similarly, other products could offer a version of the Sector/Country/Industry rotation ETFs (e.g. Claymore/Zacks Sector Rotation ETFs (NYSE:XRO) and (CRO), etc) with an equivalent short side of the trade and make them market-neutral or beta-neutral, i.e. ETFs which will not just hold the best sectors/countries etc, but also hold short the worst sectors/countries.

There is really no limit to equity based outperformance products to broad market bets like size or value. One can even offer sector specific bets, e.g. low NPA (Non-Performing Assets)  banks will outperform high NPA banks, high/increasing Same-Store-Sales retail firms will outperform low/decreasing Same-Store-Sales etc.

Other Markets

Currently the only outperformance products available are those based on carry trade such as Powershares DB G10 Currency Harvest Fund (NYSE:DBV). Some outperformance ETF products offer on the alpha factors of the fixed income markets (again in levered version) that trade on differences in various rates mostly via swaps, e.g.

(i) Asset swap, e.g. long a par swap and short a maturity-matched treasury bond

(ii) Curve strategy (micro), e.g. long a belly swap with a 50/50 weighted butterfly

(iii) Curve strategy (macro), e.g. steepener at the front end of the curve or long maturity minus short maturity swap rates

(iv) On/off the run treasury bonds, e.g. long off the run, short on the run

(v) Bond future basis, e.g. spot price (cheapest to deliver etc) minus conversion factor times futures price

(vi) Butterflies, e.g. 2-5-10 year, 2-10-30 year, 10-20-30 year, 5-10-20 year etc

(vii) Mortgage, e.g. GNMA TBA rates minus 2 year swap rates etc

(viii) Volatility, e.g. volatility of long maturity swaption minus the short maturity swaption, etc

Those who work in the fixed income space with institutions probably already know these trades listed above. But I don’t want to describe each of the above trades in this article, else we will lose focus. The important point is that each of the fixed income outperformance strategies above is a different asset-class from the usual long-only fixed income space – and have the potential to offer both returns and diversification.

Similarly, outperformance ETFs can be easily provided from the credit market, e.g. products based on AAA minus AA spreads etc, prime versus sub-prime or ABX versus treasury rates etc.

Education for Retail Investors

One of the key reasons why most hedge funds are basically outperformance traders is that they have the sophistication to create these asset classes. Just the ability to create or trade these alternative betas doesn’t mean that hedge fund managers will naturally do well – there is a whole lot of market timing (e.g. which betas?) and/or asset allocation decisions that affect performance.

Most retail investors, on the other hand, do not even know that these asset classes (or alternative betas) exist. If we really intend to commoditize hedge products to the extent of offering them to the retail investors, what we first need to do is educate them on these alternative betas or alternate classes – at least on the benefits from diversification.

Only when these outperformance products are available via ETFs AND liquid enough to be traded without significant bid/ask, will the retail clients be able to construct their onw hedge funds (without paying 2-and-20).

Lastly, it is also important to know that for any product to succeed in the long run, the short term performance immediately after or around the launch should be very good. Retail investors invariably chase performance – and that’s unlikely to change.

Disclosure: no position in any of the securities mentioned.