ETF Special Report

Some people are born complainers. Take John Bogle, founder of the giant Vanguard mutual fund family, for instance. In a recent op-ed piece written for The Wall Street Journal, Bogle grumbled that proliferation of exchange-traded funds (ETFs) could lead investors and their advisors astray. It was only a matter of time until trading overwhelmed diversification as the driving force in the ETF world,

Some people are born complainers. Take John Bogle, founder of the giant Vanguard mutual fund family, for instance. In a recent op-ed piece written for The Wall Street Journal, Bogle grumbled that proliferation of exchange-traded funds (ETFs) could lead investors and their advisors astray.

“It was only a matter of time until trading overwhelmed diversification as the driving force in the ETF world,” Bogle writes. “Of the 690 ETFs in existence today (including 343 in registration at the SEC), only 12 represent broad market segments, such as the Standard & Poor's 500.”

Bogle, to be sure, saves most of his vitriol for fundamentally weighted ETFs put out by groups, such as PowerShares Capital Management and WisdomTree Investments (see accompanying article on page 34). Bogle only obliquely swipes at recently launched funds offering leveraged and inverse exposures to the venerable S&P 500 and other broad market benchmarks. But no doubt leveraged and inverse ETFs cause him great bouts of dyspepsia.

Leveraged and inverse index portfolios, of course, are nothing new — to Bogle or to other financial pros. They've been around for nearly a decade in a mutual fund format. ProFunds Group first brought these to market in 1998, but had to wait until 2006 to get ETF analogs, known as ProShares, into retail advisors' (and retail investors') hands.

ProShares now seems to be on an ETF roll. “Since we launched the original eight ProShares in June 2006,” says CEO Michael Sapir in February, “we've amassed $3.4 billion in ETF assets. Inflows average $100 million per week.”

That's some serious coin. If that clip is sustainable, ProShares could easily double its assets within a year's time.

Not For Everyone, But Popular Anyway

So, who's flipping coins in Sapir's direction? And why? “Our best information suggests that 40 percent of our ETF assets come from registered reps,” says Sapir. “While the flow from wirehouses is substantial, we also see assets from a broad spectrum of broker/dealer reps, including those of regional firms.” That said, the majority of cash inflows seem to come from RIAs, either hedging client assets or pursuing sophisticated alpha-hunting strategies.

Leveraged and inverse funds, say some market observers, aren't for the buy-and-hold crowd. “I think you could live a very happy life without them,” says Morningstar senior analyst Dan Culloton. “You need to be a pretty sophisticated trader to be able to use them.”

Even for defensive purposes, you have to possess a certain level of mathematical sophistication to get a hedge sized properly. That's because the bogey for the funds is beta, not compound returns. Beta represents the correlation between variation in a fund's daily price and that of its benchmark. Meaning, the avowed goal of the Short S&P 500 ProShares (SH) is to yield the inverse daily price performance of the S&P 500 index (SPX). The UltraShort S&P 500 ProShares (SDS) is supposed to deliver twice the inverse beta of the benchmark.

Table 1 illustrates the differences in returns earned by SPX-based levered and inverse ETFs for a seven-month bull run following their 2006 launch. Notice that SH, with a beta of -1.15, more than fulfilled its mandate, yet produced a market return equivalent to -69 percent of SPX. Similarly, SDS's market return was -143 percent of SPX's despite a beta of -2.14. A short position in the SPDR Trust (SPY), on the other hand, would have fairly well matched the SPX return for the period fairly well.

To illustrate comparative hedge effects, imagine shorting SPY at $140 just ahead of a five-day run of 1 percent declines. Ignoring tracking error and spreads, SPY would be at 133.14 (140 × 0.99 ^5) at the end of the fifth day, a 4.9 percent gain. Over the same period, a long position in SH initiated at 88 would have gained 5.1 percent (88 × 1.01^5-1), a 0.2 percent better return than the short sale. The reason? In a market decline, SH increases in value, augmenting the position's size and compounding the gain.

If the market instead gained 1 percent per day for five days, SPY would end up at $147.14, for a loss of 5.1 percent, but SH would give away only 4.9 percent of its value — the compounding effect in reverse.

Of course, the differential in expenses, tracking error and spreads between the ETFs impact the compounding effect over time, but, clearly, the use of inverse funds can leave a portfolio with some residual risk. Chart 1 illustrates the early cumulative performance of SPX-based ETFs.

For this reason in particular, Barry Ritholtz, chief investment officer for New York's Ritholtz Capital Partners, says inverse ETFs are “good products for hedging in accounts that either cannot short or use options. They're also superior to mutual funds, but inferior to shorting traditional ETFs.”

Ritholtz's big-cap exposures includes the Nasdaq-100 (NDX) universe, so hedging the performance of the junior market is vital. “The names with the highest beta tend to be Nasdaq-100 issues, so we mostly use the Short QQQ ProShares (PSQ) and the UltraShort QQQ ProShares (QID) to hedge, depending upon our clients' risk tolerance.”

Ritholtz treads the hedge fence gingerly. “Although we have discretion in these accounts, we heed our clients' wishes. A client, for example, may say, ‘I don't want to be short stocks, but you can hedge.’ QID is perfect for them. Another client may tell us. ‘We want to be at least 90 percent long.’ A 10 percent position in PSQ can get us there.”

No one should be surprised to learn that the compounding effect is exhibited in NDX-based ETFs as well, as illustrated in Table 2. In fact, betas are tighter in ETFs based on NDX than those based on SPX. The closer a fund's actual beta is to its target — plus or minus 1 or 2 — the less likely a rounding error in the hedge.

Largely, beta tightness springs from greater liquidity. There's nothing “junior” about the NDX-based market compared to that of SPX-tracking funds: the median daily volume of QQQQ is better than 1.5 times that of SPY.

There's a direct relationship between liquidity and beta in both markets, too. Liquidity can be measured by comparing the aggregate dollar impact of price changes over time, reduced to an index. The liquidity index represents the number of shares that must be traded — disregarding changes in the underlying index — to “move” the ETF's current market price 1 percent. The higher the number, the more liquid the market.

Double Your Inverse

By and large, the actively traded funds, QQQQ and SPY, are the granddaddies, and, to a much smaller extent, double-inverse QID and SDS. This is indicative of the usage pattern for these portfolios as advisors utilized double-inverse portfolios both defensively and offensively.

Many money managers use the double-inverse portfolios to get the best of both worlds — long market exposure coupled with a levered short — bringing portfolio risk down towards that of a long call. With the inverse portfolios, managers can extend a fund's ownership horizon, turning short-term into long-term holds.

That's about all these new portfolios are good for, according to David Krein, president of New York's DTB Capital. “I see them as more defensive, rather than offensive weapons,” says Krein. “I don't really see a compelling need for leveraged ETFs [in general], but the inverse funds are different. The inverse funds can be used to hedge exposure.”

Other advisors, however, think the positive beta-levered portfolios can be building blocks for alpha strategies. Some advisors combine levered ETFs with actively managed portfolios, following a “core-satellite” approach for their clients. Using half (or a quarter, if margin is used) of an investor's risk capital to buy a double-beta broadbased index fund leaves the other half (or three-quarters) to be deployed in search of excess returns.

Others, like Cambria Investment Management portfolio manager Mebane Faber, sees the utility of a levered products device that can create risk parity among the asset classes employed in a portfolio. “You allocate half your capital to your desired equity exposure, levered 2-to-1,” says Faber, “and place the excess capital in bonds, or if attempting a portable alpha exposure, in listed hedge funds and alternatives.”

These are not waters to be crossed without a good book to read — namely a prospectus. Risks like that represented by the beta-liquidity link may not be fully appreciated by investors or their advisors, according to The Index Investor editor Tom Coyne. “What these new ETFs do is make it much easier to implement a leveraged approach, without making all the risks involved quite as clear,” Coyne warns.

Mark Manning, an advisor at Ohio-based Butler Wick & Co., offers his own caveat about double-levered funds. “My partner and I use the ETF's quite extensively in our managed accounts,” he says.“I think only experienced traders should use double-inverse portfolios. One thing for sure is that I would always use a protective sell stop on these funds in the event of a major market run.”

EXCHANGE-TRADED FUND PERFORMANCE AND LIQUIDITY
(July 31, 2006 - February 28, 2007)
Index or Fund Return (% of SPX) Beta vs SPX Median Daily Volume Median Daily Price Change* (Volatility) Liquidity Index (% of SPY)
S&P 500
(SPX)
10.20% -- -- 0.07%
(8.61%)
--
SPY
(Long 1x SPX)
10.23%
(100%)
1.08 67,763,050 0.07%
(8.95%)
122,891,511
SSO
(Long 2x SPX)
13.96%
(137%)
2.36 89,550 0.10%
(18.97%)
291,983
(0.24%)
SH
(Short 1x SPX)
-7.04%
(-69%)
-1.15 48,550 -0.05%
(9.32%)
526,415
(0.43%)
SDS
(Short 2x SPX)
-14.55%
(-143%)
-2.14 305,800 -0.10%
(17.80%)
2,328,289
(1.89%)
* Last trade price, close-to-close Source: Commodity Systems Inc., Brad Zigler
EXCHANGE-TRADED FUND PERFORMANCE AND LIQUIDITY
(July 31, 2006 - February 28, 2007)
Index or Fund Return (% of NDX) Beta vs NDX Median Daily Volume Median Daily Price Change* (Volatility) Liquidity Index (% of NDX)
Nasdaq-100
(NDX)
16.71% -- -- 0.11%
(14.63%)
--
QQQQ
(Long 1x NDX)
16.79%
(100%)
1.02 109,192,650 0.11%
(14.61%)
1,530,600,714
QLD
(Long 2x NDX)
22.42%
(134%)
2.25 448,700 0.16%
(31.28%)
788,822
(0.05%)
PSQ
(Short 1x NDX)
-12.22%
(-75%)
-1.08 79,250 -0.09%
(15.28%)
765,521
(0.05%)
QID
(Short 2x NDX)
-24.37%
(-146%)
-2.07 2,208,600 -0.18%
(24.57%)
16,757,673
(1.09%)
* Last trade price, close-to-close Source: Commodity Systems Inc., Brad Zigler
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