Wednesday,
August 16, 2017 - New-to-Market: This blog series
highlights ETFs that have recently gone public and reflect those strategies
currently most in demand by investors. While ETFs are not eligible for ETFG
Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months,
our goal is to highlight cutting-edge investment strategies that have recently
embraced the ETF structure – we hope you enjoy this special series of posts!
With over 2,000 ETPs listed in the US with nearly $3
trillion in AUM, it’s easy to think that almost every unique trade strategy has
a product tied to it, but, the truth is that innovative products are often hard
to find. The industry has come a long way from the standard index replicators;
the strategic funds formerly known as “smart beta” have soaked up billions in
new assets this year while social impact and multi-factor ETPs are all the
rage. There was even a short period of time where 4x funds looked like the
coming thing, but it seems that most new funds are simply variations on an
existing theme; a different index here or an alternative weighting system
there.
A number of the ETPs on our list of recently launched products
stood out to us, but one in particular, the Virtus Enhanced Short U.S.
Equity ETF (VESH)
might serve one of the most challenged segments of the ETP markets. Eight years
into the second-longest lived bull market in history has made short selling
less a “lonely” activity and more “suicidal” as tacking against the euphoria
has generally been a career killer, leaving only a handful of funds for
investors to choose from. Our database has 138 inverse products with a total
AUM of almost $20B and excluding the levered ETPs, intended for short-term
protection, brings the list down to 57 products with a total AUM of just $6.5B.
Looking at funds that only give you exposure to the equity market, reduces the
list of ETPs even further to only 26 leaving to risk-conscious investors
decidedly lacking in options.
The Virtus Enhanced Short U.S. Equity ETF (VESH) does things a little
differently than most of the existing inverse equity ETPs in two unique ways.
Levered or not, nearly all of the inverse equity products are passive funds
that track specific, well-known market cap based indexes except for the
AdvisorShares Ranger Equity Bear ETF (HDGE), an actively
managed product that shorts individual equity names based on bottoms-up stock
research.
While VESH
is also actively managed, it’s strategy is ‘rules-based’ and more in-line with
its passive kin but while employing a more nuanced strategy than larger inverse
funds. In fact, if those rules were wrapped into an index that went long
instead of short, VESH
would look more like a strategic beta fund that did sector positioning based on
the popular momentum factor than anything else, except its focus is obviously
on negative rather than positive momentum.
Bringing strategic beta to the world of inverse ETPs
might seem like simple evolution but Virtus has long been in the forefront of
bringing the best of academia to the market. In most of the academic research
around factor investing, researchers use market neutral strategies to test the
viability of the factor which involves taking both long and short positions
based on the factor being tested. Up until now, most ETPs have only used the
long side of that research given that most investors, big or small, are typically
only interested in long exposure. Recognizing an underserved market, Virtus has
taken the unique position of giving investors exposure to the other side of the
research in that short portfolio to produce potentially more symmetrical
returns.
Launched in late June of this year, Virtus brought the
fund to the market with a simple goal; outperforming 100% of the total return
of the S&P 500 Index and it does so by recognizing that, in the eyes of
investors, not all sectors of the market are created equal. First, investors
need to recognize that the fund is essentially two strategies rolled into one,
with 50% in a monthly rebalanced short position against the S&P 500 while
the remaining 50% is built around a sector rotation strategy, perhaps one of
the most common and easily recognized investment strategies used by investment
professionals. Rather than focusing on individual names like HDGE, at the end
of each month, the GICS sectors comprising the index are ranked by their
trailing 9-month returns with the 5 worst performing sectors being identified
to be sold short using futures contracts removing the nonsystematic risk of
individual stocks while simultaneously embracing a more contemporary strategy.
While the newly launched fund lacks a track record, it’s
easy to see the potential advantages of such a strategy, especially in a market
like we find ourselves in where even a 5% correction has become a distant
memory. While the 50% of the portfolio invested in short S&P futures should
help traders focused on hedging by keeping the fund in-line with the broader
market, the other half focused on specific underperforming sectors could
potentially reduce the drag of an inverse position on a broader portfolio in a
rising market.
Even in a year like 2017, there remains a wide degree of
dispersion between sector returns with energy stocks deep in the red while real
estate and consumer staples names continue to lag the broader market by
hundreds of basis points. This dynamic, in part, helped VESH narrow its loss in its
first full month of trading with a 1.17% loss in July compared to a -1.91%
return for the unlevered ProShares Short S&P 500 Fund (SH).
But it’s also easy to imagine how that could quickly lead
to investors finding themselves with large, unintentional sector wagers as most
of 2017’s laggards are in the smaller subsectors of the market. Energy stocks
may be the biggest losers this year but make up less than 6% of the market
while real estate and consumer staples stocks, the next two worst performing
sectors, make up 3.5% and 8.5% of the market respectively. To keep that from
happening, the short positions are weighted proportional to how much they make
up of the S&P 500. In its first full
month of trading, VESH
was short all three of the above sectors along with healthcare and utility
stocks and while investors might have wished for more energy exposure, the
fund’s rules based weighting system kept the allocation just under 8% of the
total fund.
The other thing that VESH does differently than most
inverse products is that it doesn’t have the daily reset that SWAP based
products contain. The daily reset that SWAPs go through is what causes the
divergence between their expected daily return target and their longer time
frame returns. This reset compounds daily moves. Using fully collateralized
futures positions that are rebalanced on a monthly basis, Virtus is trying to
provide a product that can be held for a longer time frame while minimizing any
divergence between the product and its target exposure of outperforming -100%
of the total return of the S&P 500 Index.
Finally, while the product is actively managed, it also
has a relatively low management fee of 55 bps. This puts the product closer to
the majority of long-only, passive strategic beta funds rather than existing
short strategies which usually come with a higher price tag. In fact, VESH’s 55
bps fee is substantially below both actively managed HDGE (175 bps) or passive
funds like SH at 89 bps, which significantly reduces the potential cost for
those more anxious investors to hedge their equity exposure.
So even if the broader market’s relatively flat
performance, despite a summer of perpetual crisis in Washington and sabre
rattling overseas, has some wondering whether we’ve reached a new “permanently
high plateau,” know that a firm at the cutting edge of investment research has
used the lessons of strategic beta to bring the first truly innovative inverse
product to a market that might soon desperately need one.
Thank you for reading ETF Global Perspectives.
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