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Why ETFs (and Why Strategic Beta ETFs)?

Why ETFs (and Why Strategic Beta ETFs)?

Source: istockphoto.com

Highlights:

• 3D Asset Management prefers exchange-traded funds (ETFs) because they are 1) cost-effective, 2) tax-efficient, and 3) more transparent than other publicly-traded vehicles, such as open-ended mutual funds. 
• ETF product innovation has democratized retail investing by giving exposures to retail investors that had been historically only available to institutional and professional investors.
• What about the disruptions ETFs experienced during the August 24 sell-off?  This was due to the fact that many of the underlying stocks did not trade that morning rather than some structural defect of ETFs.  If the underlying securities do not trade, then it will be difficult to get a true underlying mark for the ETF (that is why you don’t want to trade ETFs using market orders, especially in the morning).    
• Trading ETFs have proven to be more efficient and more liquid than trading their underlying baskets.  This is due to the capital markets tools available to the market-making authorized participants who have an incentive to ensure the ETF’s price and underlying net asset value do not diverge.  In effect, the ETFs can serve as a price discovery tool for what the true underlying value of the basket of securities are on a real-time basis.
• The reason why strategic beta (or factor-based) ETFs are gaining in popularity is this notion of buying ‘active management in a box’.  Most of what you get from a typical active manager can be systematically captured in a rules-based approach. 
• 3D’s value-added comes from building an elegantly designed and dynamically-managed ETF portfolio that serves as a core, foundational holding either on a stand-alone basis or within a broader program.  We build globally diversified equity and fixed income portfolios where we dynamically manage our exposures to where we believe we are best compensated for the risks involved while still delivering the underlying risk/return characteristics of the asset class.

With the beginning of the new year, we find it a helpful exercise to revisit some of our fundamental investment principals and share these thoughts with our partners and clients.  With much that has happened this past year, what could be more of a basic issue to revisit then this one?

Why ETFs?

It can be summed by this: You know what you’re buying and you have a real-time pricing mechanism to gauge the value of what you’re buying.  And you can get this desired market exposure in a more cost-effective and tax-efficient manner versus other publicly-traded vehicles. 

With respect to transparency, most open-ended mutual funds are actively managed, so investors have a basic idea of what they’re getting, but this can change depending on the active trading by the fund manager.  In contrast, many ETFs (those that file for passive exempted relief with the SEC) track an underlying benchmark, so the investors can be reasonably confident that an ETF will deliver the desired market exposure. 

The first ETFs tracked traditional market cap weighted benchmarks such as the S&P 500, followed by region/country/sector equity indices, and more recently, alternative beta or factor-based investing.  Factor-based investing amounts to a rules-based approach for constructing a portfolio.  For instance, ETFs that focus on higher dividend or dividend growth stocks design rules for screening or scoring stocks based on these attributes.  The ETF sponsors then work with an index provider (either 3^rd party provides such as MSCI, S&P, Dow Jones, FTSE or companies that offer self-indexing services such as Solactive) to construct and manage the tracking index.  For a relatively low fee, an investor can get the desired exposure they are seeking (in this case a dividend-focused portfolio).  In effect, ETF product innovation has democratized retail investing by giving exposures to retail investors that had been historically only available to institutional and professional investors. 

Active funds also tend to be more expensive (the fee assessed for management skill) and less transparent (holdings only disclosed on a quarterly basis with a 45-day lag).  They are also less tax efficient than ETFs.  The ETF creation/redemption structure allows for in-kind transfer of securities so that existing ETF investors are unaffected from a capital gain that may be generated due to other investors exiting from the fund.  In contrast, open-ended mutual fund managers are required to sell positions to deliver cash when investors leave the fund, potentially generating a taxable gain that could impact existing holders.  In addition, ETFs tend to exhibit lower turnover than actively-managed funds as turnover typically occurs with quarterly rebalancing and semi-annual reconstitutions; many ETF managers focus on tax efficiency as a goal so as to minimize the distribution capital gains due to rebalancing. 

Much has been published on the underlying mechanics and advantages of ETFs.  Here are some published articles we recommend:

The ETF Toolkit (Powershares)

ETF Trading and Liquidity: A Deeper Dive (Charles Schwab)

Dynamics of Fixed Income ETF Trading (SPDRs – Requires Registration)

ETFs Solve Mutual Bond Fund Problem (Matt Hougan from ETF.com)

Tax Essentials: How to Keep More of What You Earn (iShares)

The microstructural advantage of ETFs is the share creation/redemption process by how the vehicles are traded and valued.  APs serve as the primary agents for creating and redeeming shares.  But it is the presence of the secondary market that affords APs the flexibility to minimize the frictional spreads between the ETF’s net asset value (NAV) and quoted share price.  Quoting the SPDRs document:

“The liquidity in the secondary market, along with the creation and redemption mechanism, provides investors with the potential to transact at fair and orderly prices with minimal market impact.”

The key is the arbitration incentive that exists for APs to ensure that the spread between the ETF’s price and NAV do not diverge too much.  Here is a quote from the Schwab document on how the arbitrage incentive works:

                “How is it that ETFs generally trade close to their [internal fair value or IFV]? It’s all about arbitrage—which drives APs to minimize the differences between an ETF’s market price and the IFV via the creation/ redemption process. When an ETF’s market price moves above its IFV, market makers step in, selling ETF shares until the supply is exhausted. If, during this process, a market maker sells more shares than it owned, it takes a “short” position in the ETF. To balance that short position, the market maker can simultaneously purchase the ETF’s underlying securities in the secondary market, creating a long position in those securities. Those long securities can then be exchanged in an in-kind transaction, the creation unit, to create ETF shares—ETF creation. The market maker then delivers those acquired securities, reducing its long position, in exchange for ETF shares to cover its short position. The newly created ETF shares increase the supply in the marketplace, as well as the ETF’s total assets under management (AUM). The result of this trading activity is that the market price of the ETF closely approximates its IFV.”

Are there structural defects that can cause ETFs to trade away from the underlying value of its basket? The ETF price/NAV disconnect that occurred on August 24, 2015 was more due to the fact that many of the underlying stocks did not trade that morning rather than some structural defect of ETFs.  If the underlying securities do not trade, then it will be difficult to get a true underlying mark for the ETF (that is why you don’t want to trade ETFs using market orders, especially in the morning).  But ETFs that track illiquid markets such as high yield and emerging markets can still trade at much higher volumes without causing too much disruption in the underlying securities.  This is due to the market-making activity of the APs where large share redemptions can be addressed through other capital market tools rather than resorting to the primary market.  Primary market transacting involves taking an in-kind amount of ETF basket securities in exchange for redeeming ETF shares and the selling those securities back into the marketplace rather than holding onto them as inventory.  Ultimately, ETFs can serve as a price discovery tool for illiquid markets where the underlying markets may not be reacting as quickly to the ETF price activity (see the Matt Hougan article on how high yield ETFs were better equipped to handle the December sell-off versus open-ended mutual funds). 

Bottom line, if it were not the presence of authorized participants and their market-making activities, ETFs would be no different than closed-end funds where price can diverge from NAV (and stay that way for long periods of time). 

The rising popularity of Strategic (Alternative) Beta ETFs

The reason why strategic beta, whether single or multi-factor versions, is gaining in popularity is this notion of buying ‘active management in a box’.  Most of what you get from a typical active manager can be systematically captured in a rules-based approach.  For active growth managers, just buy momentum and quality factors.  For active value managers, just buy ‘value’ and dividend factors.  For an all-in-solution, buy a multi-factor ETF where the diversification amongst the individual factors produces a return profile where the whole is greater than the sum of the parts.  And you can easily capture the size premium that comes with most active managers as they tend to exhibit a smaller cap profile than traditional cap-weighted indices.  Typically, the excuses you hear from an underperforming active manager is that their style is out-of-favor, yet no credit is attributed to that style when the manager is outperforming (it’s all skill, of course).   

To their credit, Fama/French (from Dimensional Fund Advisors) were right all along even though the market structure has evolved beyond the DFA fund offerings with the advent of ETFs.  Most of what you get from an active manager can be systematically captured through alternative beta (in the case of F/F, size, value, and market risk account for most of this systematic capture).  Not all factors will work in all regimes, that’s why you need to be diversified across different styles of factors.  Although they’ve refined their strategies to incorporate profitability, DFA has suffered the last couple of years because they’ve put all their eggs into three factors (value, size, market risk), having dismissed other factor premia such as low volatility and momentum as flash-in-the-pan or uninvestable. 

3D’s Value Proposition as an ETF Strategist

3D’s value-added comes from building an elegantly designed and dynamically-managed ETF portfolio that serves as a core, foundational holding within a broader program.  We build globally diversified equity and fixed income portfolios where we dynamically manage our exposures to where we believe we are best compensated for the risks involved while still delivering the underlying risk/return characteristics of the asset class.  At 3D, it is not dynamic versus tactical or active versus passive, but dynamic AND tactical…active AND passive.  Both have a role to play in a program, but the mix depends on the starting philosophical standpoint of the advisor.  If the advisor professes to believe in active management, then they should spend their limited resources identifying the true alpha opportunities that exist out there (whether concentrated, go-anywhere, or alternative strategies) rather than on finding the next outperforming large cap or fixed income manager.  Let 3D provide that core-foundational component to your program as well as our turn-key support you won’t find with other strategic, buy-and-hold (set-and-forget it) asset allocators or robo-advisors.