September 2010

ETFs: magic and mystery

sweets2Advanced users of ETFs can leverage and short sell them. Felix Goltz and Lin Tang, of the Edhec-Risk Institute, explain how these uses can fit in with portfolio practices  
In our last issue (Funds Europe July/August 2010), a first article in a series on exchange-traded funds (ETFs) based on research carried out as part of the ‘Core-Satellite and ETF Investment’ research chair sponsored by Amundi ETF, we looked at ETFs from different asset classes. This month, we turn to more specific ways of using ETFs. These strategies offer more flexible approaches to investors than simple long positions in a given asset class or segment. We provide below an overview of advanced types of ETF products, as well as of advanced ways of using ETFs in portfolio practice, and the key issues of tracking error and liquidity.

Inverse ETFs
Inverse ETFs, also called short ETFs, are supposed to provide investors with the inverse of the performance of an index, which is achieved through short selling. In addition, these ETFs provide investors with the money market interest on the amount invested and interest earned on the short position.

Leveraged ETFs
Leveraged ETFs provide investors more aggressive exposure to the underlying index, without the operational hassles of making leveraged investments themselves. Leveraged ETFs usually attempt to provide constant leverage in such a way that the excess returns of the index are magnified by, say, a factor of two for the holder of a leveraged ETF. There are also leveraged versions of inverse ETFs, so investors can magnify their inverse exposure in a simple trade.

Inverse and leveraged ETFs have attracted a lot of attention since their launch in 2005. With these ETFs, investors can easily magnify returns, hedge portfolios, and manage risk without any operational hassles about margin accounts or margin calls. By late 2009, there were 113 leveraged and inverse ETFs in US and 53 in Europe. Assets under management have exceeded $28bn (€22.1m) in the US and $5bn in Europe, according to BlackRock.

Despite the popularity of these instruments, the mechanics of leverage create more risk for investors than do traditional ETF structures. First, leveraged and inverse ETFs must be rebalanced on a daily basis to keep their returns on a multiple of the returns of the underlying index. This rebalancing may have an impact on the liquidity and volatility of the underlying index during the closing period of the market.

Empirical results imply that the long-term performance of leveraged and inverse ETFs would deviate from the promised returns (Lu, Wang, and Zhang 2009). This suggests that leveraged and inverse ETFs are suitable for short holding periods rather than for long-term buy-and-hold strategies.

Regulatory concern
Complaints in the US about the long-term underperformance of leveraged and inverse ETFs have come to the attention of regulators. In June 2009, the Financial Industry Regulatory Authority (Finra) underscored the problems with leveraged and inverse ETFs. In August, Finra, together with the Securities and Exchange Commission (SEC), stated that inverse and leveraged ETFs were not suitable for buy-and-hold investors. Following these warnings, Edward Jones and UBS announced they would suspend sales of leveraged and inverse ETFs to their clients; Morgan Stanley and Wells Fargo later announced they would put leveraged and inverse ETFs under review; the state of Massachusetts stepped in to examine the sales practices of big leveraged ETF providers.

The large providers of leveraged and inverse ETFs have defended their products. The objective of leveraged and inverse ETFs is to achieve promised return on a daily basis. The products should be monitored by investors every day, or even rebalanced frequently so that the target return will not be missed. It is not suitable for simple buy-and-hold investors.

Finra has put in place a new margin requirement, in effect as of 1 December 2009, for leveraged ETFs. Under the old rules, the maintenance margin for any long ETF was 25% of its market value and the margin for any short ETF was 30% of its market value. Therefore, the maintenance margin requirements for leveraged and inverse ETFs were unrelated to the promised leverage. Under the new rules, these margin requirements will increase by a percentage commensurate with the leverage of the ETF, not to exceed 100% of the value of the fund (Finra 2009). In this case, a leveraged ETF, which promises a return three times that of the underlying index, must maintain 75% of the margin.

Although leveraged and inverse ETFs came under intense scrutiny in 2009, investor interest in these instruments did not wane. Morningstar estimates net inflow to leveraged and inverse ETFs of $12.16bn over the year 2009. In the same year, more than 30 new ETFs were launched in the US alone.
In short, the liquidity advantage of leveraged and inverse ETFs, which have attracted growing attention in recent years, makes them suitable for short-term trading. Indeed, both academic research and regulatory investigations have suggested that these ETFs are more suitable for short-term investment than for long-term buy-and-hold strategies.

Options on ETFs
Options on ETFs began trading on derivatives exchanges shortly after the introduction of ETFs. These instruments are limited to a relatively narrow range of the most successful ETFs. The possible advantages of these options include precise exposure to the underlying fund, minimum investments lower than those required by index options, as well as physical delivery of the underlying asset if the option is exercised (index options, by contrast, are settled in cash).

Shorting ETFs
Unlike traditional index funds, ETFs may be sold short. Since ETFs can be borrowed and sold short, long/short strategies are possible. With these strategies, long/short exposure to different style or sector indices can be used to capitalise on return differentials between categories while maintaining low or zero exposure to market risk. As a temporary way to become defensive without incurring transaction costs and undesirable capital gains, this mechanism can be used in various ways, including more sophisticated trading strategies involving shorting some combination of several indices. In addition, ETFs can be sold short, as part of a purely speculative trade, to take advantage of market downturns.

Lending ETF units
ETF units held by an investor may be lent out to generate additional income for the portfolio. Interest paid by the borrower of the ETF may compensate for management fees and generate income above the management fees in the ETF.

Tracking error and liquidity
Tracking error and liquidity are the two most crucial criteria for evaluating the quality of an ETF. So it is important to know how to assess them.

There are many ways to assess the tracking quality of an ETF. First, and quite evidently, it is possible to analyse the difference between the returns on the ETF and those on the index. Second, the correlation of the two assets can be used to determine the tracking quality. Another simple method of analysing tracking error is to compare the mean returns of both assets. There are, however, more sophisticated means of evaluating tracking error. These means include asymmetric or downside tracking error (which is the relative return equivalent to downside risk measures such as semi-variance in an absolute return context) or co-integration analysis.

The second key issue with indexing instruments is liquidity. Practitioners, of course, are highly familiar with liquidity, but the finance literature has yet to come to a consensus on theory and on empirical methodology. Practitioners, for example, have long used a number of liquidity measures, but academic articles continue to debate their merits. Popular liquidity indicators are market spreads, turnover, and assets under management.

Of course, the number of transactions in ETF shares is not necessarily indicative of the liquidity of an ETF. For several reasons, in fact, ETFs may be classified as highly liquid even if relatively few ETF shares change hands. The first is that the market maker has a contractual obligation towards the stock exchange and towards the ETF provider to fulfil its role as market maker for a given transaction size and with a determined maximum spread. Therefore, even if trading volume is low on a given day, ETF investors can trade at any time of the day. The second reason is that in Europe most ETF transaction volume actually takes place off exchange, either by trading ETF shares over the counter or at unknown NAV. The volume traded on exchange is thus not a reliable indicator of the actual transaction volume.

The true liquidity of an ETF is the liquidity of the underlying securities. After all, any deviation of the price of the ETF from the price of the basket of securities is easily arbitraged away through the creation and redemption mechanism. This arbitrage depends only on the liquidity of the underlying securities. As described above, the market maker swaps ETF units with the ETF custodian for the basket of securities of the ETF, so it is the liquidity of securities in this basket that matters.

Felix Goltz, PhD, is head of applied research and Lin Tang is a research assistant at the Edhec-Risk Institute

©2010 funds europe

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