The growth of Exchange Traded Funds (ETFs) has caused significant change in the investment industry. This article identifies a few of the new investment techniques and strategies that have been either affected or enhanced, by the proliferation of ETFS. This article assumes some rudimentary knowledge of the Capital Asset Pricing Model (CAPM) methodology and also of some elementary hedge fund strategies.
In future, new investment techniques will increasingly be created using these methods.
What are Exchange Trade Funds?
According to the Securities and Exchange Commission (SEC), ETFs are listed companies whose purpose is to mimic an index, asset class or even investment style. Within index ETFs, they offer a low cost option to achieve exposure to that index. They also give a way to achieve diversified exposure to an index, but with only having to buy one stock. They are seen as being suitable for retirement investors who want diversified and low cost exposure to an index.
Growth in Commodity ETFs
Index funds exist to track global equity indices like the S & P 500, Russell 2000, Hang Seng, and Nikkei. Similarly, exchange traded funds have been created to track Equity Sector indices, such as Oil Services companies or Pharmaceuticals. Asset class ETFs offer exposure to all major asset classes, such as fixed income ETFs, property, currencies, and commodities.
In fact, commodity ETFs are one of the fastest growing branches of the ETF family and can track things like Gold, Silver, Oil, and Lean Hogs. Investment style ETFs offer exposure to various mechanically defined investment styles such as Value or Growth. For example, a Value ETF might buy stocks based on book value, price to earnings, dividend yield or some other value metric.
The Death of the Top Down Stock Picker?
Top Down investors typically focus on formulating a macro-economic view which will then guide them into manifesting this view by stocks exposed to this view. For example, if an investor favours consumer discretionary, they might start researching Luxury Goods companies. This is how traditional top down stock picking has worked. However, excgange traded funds pose challenges to the rationale for this model.
If the idea is to take a top-down view, then surely the investor should want to diversify as much as possible in order to reduce stock specific risks with his portfolio. For example, he may want systemic risk/reward in exposing himself to the oil companies sector, but without the stock specific risk of being overweight an individual stock like, say BP. ETFs offer a low cost way to get diversification within the sector that his top down view has guided him to.
Tactical Asset Allocation with ETFs
Asset allocation enthusiasts claim that the majority of performance and risk can be explained by asset class selection. Therefore, investors should not focus on alpha generation within an asset class but rather focus on selecting the right asset class. Indeed there is a growing trend towards tactical asset allocation with the hedge fund industry.
Using ETFs, hedge funds can go long/short within a matrix of asset classes and never expose themselves to risk with an individual vehicle (stock or bond etc) within the asset class. This represents a ‘pure beta’ whereby the investment manager rejects aloha generation in favour of trading asset classes against each other.
Index/Sector Arbitrage using ETFs
Contrary to the approach outlined above, many investors want exposure to ‘pure alpha’ based strategies rather than a beta based approach. In other words, they don’t want directional exposure to an index or asset class. They prefer to be market or index neutral. These investors tend to believe they can outperform an index or benchmark through selection of individual components within it.
ETFs work perfectly with this strategy. For example, this strategy could involve shorting an Oil Services index whilst buying a collection of Oil Services companies that the stock picker believes will outperform the index. Therefore the direction of the index or companies won’t matter, all that does, is his outperformance of the index.
Statistical Arbitrage Strategies
This style of investing encompasses some elements of tactical asset allocation but deserves its own sub-heading because of its breadth. Stat arb strategies usually involve mean reversion or trend following techniques within instruments or asset classes. These relationships are defined statistically and investors look to trade based on continuation or break down of these relationships. For example, investors could trade paired indices against each other.
Stat arb strategies lend themselves perfectly to ETF usage because investors can get low cost and liquid exposure to these indices. In addition, an ever increasing range of ETFs is creating new opportunities for this type of strategy
The Future of ETF Investment in Hedge Funds
This article has highlighted some of the changes that ETF growth and usage is having upon investment strategies. With the disappointments of traditional long-only mutual fund performance over the last ten years, it is only natural to expect these kind of strategies to grow in popularity. ETFs have a prominent role to play in this growth and, it is reasonable to expect continued growth from here-on. In particular, hedge funds are seen as expanding their usage of ETFs.
Source
SEC"Exchange-Traded Funds," SEC Release Nos. 33-8901, IC-28193, 73 Fed. Reg. 14618 (March 11, 2008).
