November 2013 Toroso Investments, LLC
ETFs ● The Business of Indexation Research compiled by Michael Venuto, CIO
Traditional Indexes and Float Adjustment “What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out "You can't buy the averages." It's time the public could. ....there is no greater service [the New York Stock Exchange] could provide than to sponsor such a fund and run it on a nonprofit basis.... Such a fund is much needed, and if the New York Stock Exchange (which, incidentally has considered such a fund) is unwilling to do it, I hope some other institution will.”
The index measurement world has traditionally been dominated by ranking index constituents by market capitalization. The first US listed ETF, SPDR® S&P 500 ETF Trust (SPY), which recently celebrated its 20th anniversary, is a market cap weighted index. The success of SPY and many other ETFs that followed prompted a significant change in weighting methodology, which began in 2006. The new methodology focused on market capitalization but adjusted the weighting for float, which meant companies with substantial insider ownership were allotted lower weights in the index. Consider the following chart: When Insiders Market Float Goes Indexed Products Own
Buy Down Less
Sell Up More
Therefore, products associated with these indexes can handle more assets because the product is not required to buy as many shares of stocks with substantial insider ownership and simplified their ability to fill these purchase orders. In other words, without float adjustment the size of the ETF may hit a ceiling or need to be capped. With these words, Burton Malkiel forever changed the business of security indexation. Although the NYSE did not listen to his advice, John Bogle did and Vanguard launched the first index mutual fund in 1975. Almost 40 years later, indexation represents 10% to 20% of all investing and with the massive, ever-growing pool of ETFs this percentage is likely to grow significantly. Toroso believes this growth creates both opportunities and pitfalls for ETF investors, and the key to success or failure in ETF investing lies in understanding index construction. Simply put, the democratization of the market, as envisioned by Malkiel and Bogle, is nearly complete; however, the transition of indexing from a benchmarking tool to an asset-gathering tool has possibly tarnished many of the benefits indexing provides for the average investor and created significant opportunities for the savvy investor.
The result of this change meant that many of the large index providers realized the scalability and profitability of their asset management/gathering business far outpaced their original revenue streams from licensing a benchmarking tool. Consequently, creating an index became a fast growing adjunct business to developing ETFs and new index providers entered the market to partner with ETF providers. And float adjustment opened the door to potentially higher volatility of the index itself. But the real benefit is the ability to handle significant volume with reduced efforts and thereby create profits for the providers.
Narrower Indexes or Sharp Knives The next wave of indexes targeted sectors, geographic regions, different market caps, growth and value style categories, or simple geometric alternatives like equal
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November 2013 Toroso Investments, LLC weighting. All of these have experienced huge success in asset gathering but have not always offered investors the desired/expected market exposures. For example, the sectors are often dominated by a few companies; market cap indexes overweight the largest rendering the smaller companies insignificant; the growth and value indexes have massive overlaps in holdings and returns; and finally the equal weighted indexes often have no benefit when compared to similar average market caps. Granted these statements are generalizations, and many sophisticated investors have successfully navigated these issues to profitable trades. The point is not that these are bad products because they are designed to raise money; rather the key is to understand the index methodology so one can invest in the targeted exposure, and hopefully enhance the return of the overall portfolio.
The Knives Get Sharper Two waves of fundamental indexation came next. The first was dividend or revenue weighting. These ETFs, from sponsors like WisdomTree and RevenueShares, started with slow growth, but more recently were able to capitalize on the low interest rate, yield starved market environment. These weighting schemes represent clear value for investors in certain economic cycles but they are not necessarily buy and hold vehicles, as some marketing departments would have you believe. For more information on the right time to hold these types of ETFs refer to “Toroso Commentary September 2013 Small Caps: What do you own?” PowerShares pioneered the second part of fundamental indexation through their RAFI methodology, which quickly found competition from First Trust and their AlphaDex series. Both of these methods focus on a number of fundamentals like Cash Flow, Book Value and Sales. In sideways or non-directional markets these ETFs have produced superior risk adjusted returns since these are the markets when fundamentals matter. During strong bull and/or bear markets these ETFs have provided much less value, possibly due to expenses which can be two to five times the cost of traditional beta ETFs, and secondarily the delinking of the underlying fundamentals in a momentum driven market.
The Knives Lose Precision The obvious next step was to move into active ETFs and leave the index behind. Without having an index to follow, the provider is given wider latitude in determining which securities will make up the basket for the ETF. Selling these ETFs has proven much more difficult than most market professionals expected. Passive ETFs have been
primarily viewed as tools to get precise exposures; whereas active mutual funds have been sold on incentives and performance, even though every piece of financial marketing material includes a disclosure warning that “past performance is not an indication of future results.” Active ETFs, like passive ETFs, have no way to provide incentives so they rely solely on performance and a good story or brand. Unfortunately, ETFs require volume to succeed as well; most investors will not purchase an ETF that trades only a few thousand shares a day no matter how superior the relative performance. So despite a few notable exceptions from companies like PIMCO, active ETFs have yet to truly succeed as asset gathering vehicles or investment tools for the masses. We believe it will take some time for active ETFs to gain a significant foothold in the space.
The “Experts Only” Category Now let’s discuss path dependent ETFs, which includes leveraged, inverse, futures based commodities and/or volatility. We use the term path dependent because these are almost always guaranteed to be poor long-term investments. For example, the leveraged ETF sponsor ProShares has raised through net creations close to $80 billion in assets yet currently oversees about $26 billion in ETFs. This comes from the nature of a daily reset index in a volatile environment. Simply put, the structure of these indexes causes compounding to work against the investor in nondirectional environments; so in theory, as well as practice, one could own equal positions in the two times long ETF and two times short ETF and still lose a significant percentage of money. The same phenomenon can occur in futures based commodity ETFs or the Chicago Board Options Exchange Market Volatility Index (VIX) focused ETFs but for different reasons. These structures often experience negative returns due to a concept known as contango, which is the difference between the cost of immediate exposure and future exposure. What this cost can be compared to is the storage and delivery cost of raw materials, which varies but can be quite expensive. For example, when utilizing ETFs to gain exposure to the VIX there is no physical delivery possible, so the contango is often very high. iPath S&P 500 VIX Short Term Futures Exchange-traded Note (VXX) is by far the largest product in this space and tracks the VIX short-term futures index. Since its inception in 2008 it has annualized at negative 59% return. But when used as a trading strategy, there are possible gains to be realized. Toroso believes investors should carefully employ these ETFs as either short-term trades or longerterm shorts.
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November 2013 Toroso Investments, LLC
The Current Frontier of ETFs Perhaps the most interesting form of an index as an ETF focuses on business characteristics. No ETF sponsor has focused on this methodology exclusively but a selected few have issued some ETFs. These ETFs strive to identify a characteristic of a business that should perform well in certain economic cycles. This includes companies that are buying back shares, companies with high relative insider buying, spin-offs, companies that have conviction buying from hedge funds and companies that exhibit high barriers to entry or long product life-cycles. The Appendix below provides the list of ETFs that, to our knowledge, make up this category. These indexes allow investors to target the characteristics that active mutual fund and hedge fund managers look for
in an equity but do so in a more diversified way. They also provide access to characteristics that may provide future growth or value exposure, rather than focusing on companies that have traditionally fit those categories. Using these ETFs in a portfolio may provide unique benefits typically missed in strategies built on the asset classes of modern portfolio theory.
In Conclusion Toroso believes ETF investing is not about filling points along the efficient frontier, but about solving for objectives within a portfolio. That is why we may employ any of these index methodologies at a certain time in the economic cycle. We believe in looking for the ETF with the best exposure that meets our clients’ investment objective.
Appendix Business Characteristic ETFs
Ticker
AUM (mil)
Expense Ratio
# of Holdings
Inception Date
AlphaClone Alternative Alpha ETF
ALFA
29
0.95
83
May 2012
Forensic Accounting ETF
FLAG
8
0.85
399
Jan 2013
Guggenheim Spin-Off ETF
CSD
557
0.65
24
Dec 2006
Global X Guru Index ETF
GURU
259
0.75
55
Jun 2012
Market Vectors® Wide Moat ETF
MOAT
494
0.49
20
Apr 2012
Guggenheim Insider Sentiment ETF
NFO
184
0.65
101
Sep 2006
PKW
2,117
0.70
198
Dec 2006
PowerShares Buyback Achievers
TM
ETF
Disclaimer -- This commentary is distributed for informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. Nothing in this commentary constitutes an offer to sell or a solicitation of an offer to buy any security or service and any securities discussed are presented for illustration purposes only. It should not be assumed that any securities discussed herein were or will prove to be profitable, or that investment recommendations made by Toroso Investments, LLC will be profitable or will equal the investment performance of any securities discussed. Furthermore, investments or strategies discussed may not be suitable for all investors and nothing herein should be considered a recommendation to purchase or sell any particular security. Investors should make their own investment decisions based on their specific investment objectives and financial circumstances and are encouraged to seek professional advice before making any decisions. While Toroso Investments, LLC has gathered the information presented from sources that it believes to be reliable, Toroso cannot guarantee the accuracy or completeness of the information presented and the information presented should not be relied upon as such. Any opinions expressed in this commentary are Toroso’s current opinions and do not reflect the opinions of any affiliates. Furthermore, all opinions are current only as of the time made and are subject to change without notice. Toroso does not have any obligation to provide revised opinions in the event of changed circumstances. All investment strategies and investments involve risk of loss and nothing within this commentary should be construed as a guarantee of any specific outcome or profit. Securities discussed in this commentary, including the ETFs presented in the Appendix, were selected for presentation because they serve as relevant examples of the respective points being made throughout the commentary. Some, but not all, of the securities presented are currently or were previously held in advisory client accounts of Toroso and the securities presented do not represent all of the securities previously or currently purchased, sold or recommended to Toroso’s advisory clients. Upon request, Toroso will furnish a list of all recommendations made by Toroso within the immediately preceding period of one year.
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