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Is Sophistication Or Simplicity Better With ETFs?

Exchange-traded products mean needless complexity to some, but to others offer flexibility and tactical advantage. There’s been a proliferation of ETF products in Europe but many people prefer a simple, straightforward ETF that replicates a major index.

Mucking up a simple, transparent product, or adding tools for portfolio construction and completion?

Exchange-traded products and their myriad uses mean needless complexity to some, but to others offer flexibility and tactical advantage. There’s been a proliferation of ETF products in Europe — the majority made synthetically using unsecured debt, structured products and swaps, explains Deborah Fuhr, ETF guru and until very recently managing director of ETF strategies at BlackRock. “But most people prefer simple, ETFs that fully replicate a major index — knowing that the product has bought the underlying securities of the index,” she says.

However, there are times when an investment strategy calls for a more sophisticated ETF. “Rather than buying and then selling emerging markets securities when you suddenly feel the investment is going to lose money, it’s more difficult to get out of the investment quickly because it involves foreign currencies. But it’s easy to borrow an emerging markets ETF and short it to put on a hedge as protection for your portfolio.”

In the month of June, 9.6 percent of ETFs were shorted, equaling 1.9 billion shares, she adds. When possible or feasible, investors can short the underlying basket of securities to put on a hedge. “And if you own an emerging markets ETF you, can lend it — adding to its appeal — the flexibility to go short.”

As with any product or service, familiarity breeds clever ideas for new uses. It’s the same thing with financial instruments like exchange traded products. Ingenious money managers devise new methods for use.

To Rob Stein, managing director, founder and portfolio manager at Astor Asset Management, more sophisticated ETFs are a wonderful product and tool. “I identify a sector I think is going to go up and that will affect the asset allocation but by using a unique ETF, I believe we can keep the process simple and strategic.”

Stein runs an investment strategy — the Astor Asset Management Long/Short Balance Program that exclusively uses ETFs: Inverse ETFs for short exposure generally ranging from 0 to 30 percent depending upon macroeconomic factors, for example. The portfolio purchases long equity ETFs of diversified non-correlating market sectors during expansions, and when the economy is contracting, uses defensive positioning ETFs with inverse market exposure. “It could be a two-time single leverage or a one-time double leverage — beneficial, unless the market moves linearly,” he reasons.

Such thinking also runs through other ETF families. “The key benefits of ETFs, of simple, broad exposure are retained with more sophisticated ETFs,” says Russ Koesterich, global chief investment strategist at iShares, a founding member of the newly launched BlackRock Investment Institute. “After all, some may have more sophisticated needs. I see these ETFs as offering choice, not complexity — adding innovation by delivering a richer palate,” he says.

More sophisticated ETFs are used by investors tactically, allowing for more granularity.

As an example, he notes that one can buy an emerging markets ETF that would give a heterogeneous group of countries. “But if you want just Russia and Brazil, let’s say, you can choose a more flexible trading tool, taking a large position on an intra-day tradable ETF that’s more digestible to the market.”

Many use sector ETFs to short, Koesterich continues. “Say I like technology, so I buy a technology ETF but I’m worried about semiconductors. I can borrow a semiconductor ETF and short it to hedge out that exposure.”

In general, the iShares strategist feels that sophisticated ETFs offer more flexibility, target what you want to concentrate on and offer so many choices that institutional investors are using them more and more, which he thinks speaks to their ease of use.

Russell Investments launched its first suite of ETFs in May with the Russell Discipline ETFs, tracking customized indexes and focusing on aggressive growth, consistent growth, growth at a reasonable price, low P/E, equity income and contrarian.

The next suite launch, the Russell Factor ETFs are beta funds to help investors minimize or enhance exposure to high beta, low beta, high volatility, low volatility and high momentum risk factors, benchmarked to the Russell 1000 and Russell 2000 indexes.

“We’ve been licensing indexes to other ETF providers who’ve taken advantage of their design and construction,” says David Koenig, investment strategist at Russell Investments. “We researched the market and see that there are unique exposures not already available in an exchange-traded product. We see them as complementary to investors’ portfolios.”

“Why mess with plain, simple ETFs? It’s true that they’ve been wildly growing at a 27 percent compounded growth rate for the past five years,” he notes, “but we see this as a large opportunity and feel there’s still significant growth ahead as we offer additional tools for managing exposures and risks.”

This is especially true because investors are jittery about elevated volatility and that correlations are lining up among asset classes. “There’s a growing awareness of these factors among institutional investors,” says Koenig. “They are identifying risk more granularly. Sophisticated ETFs speak to investors’ greater awareness of risk in general and market risk specifically. There’s also a yearning for greater diversification for portfolio completion strategies.”

Investors are hedging risk exposures using multi-factor models — for beta, volatility and momentum trading strategies. The factor products are offered in conjunction with Axioma, the risk analytics and portfolio construction firm whose models are widely used in the industry. “We identified an opportunity,” Koenig says. Especially since the crisis of 2008-2009, awareness and need for risk modeling has been heightened. And because they’re ETFs, they remain transparent in terms of holdings and methodology, while still gaining exposure to risk. “You’re not giving up any of the benefits of basic ETFs but you’re gaining exposure to risk management factors — for intended rather than unintended risk.”

Pension funds, hedge funds and trading desks like that they can manage risk levels with a cost-efficient vehicle that’s highly advantageous, he continues. “Other ways that have been used, like derivatives and customized portfolios, are a whole lot more expensive.

Sophisticated ETFs are more focused, offer greater control in constructing portfolios and greater precision than plain vanilla ETFs.”

Still, there are concerns with more complex ETFs. For example, Hong Kong’s Securities and Exchange Commission mandates that if an ETF uses derivatives, it should have the marker ‘X’ in its name. A similar system is being called for in the UK. Farley Thomas, the head of exchange traded funds at HSBC, says: “We have had some investors who were not able tell if their investment is swap-based or not. It would be a good start for the UK to have a system similar to Hong Kong.”

Thomas says HSBC has no plans to launch a swap-based ETF and believes that providers of swap-based ETFs should clearly identify in all product communications that the investment approach relies solely on derivatives to deliver the investment performance.

In March 2010, our Securities and Exchange Commission (SEC) stopped approving swap-based ETFs while it conducts a review, which is ongoing. Complexity or useful to portfolios? The answer varies with investors strategies.

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