The fund industry sprouts exchange-traded products (ETPs) like weeds on a warm spring day. This makes it very hard to differentiate one from another. There needs to be better classification tools. Fund companies and index providers must step up their efforts to agree on standard definitions and educate investors about these differences.
As of year-end, there were 1361 ETPs, most of which most where exchange-traded funds (ETFs) and exchange-traded notes (ETNs). There are also 894 yet-to-be approved ETPs filed with the SEC, according to Heather Bell at IndexUniverse.com . This brings the total in circulation (or in some stage of filing) to over 2,200 products.
I’ve been a long-time advocate for an industry standard classification of ETPs to help investors separate one fund from another based on the fund’s underlying investment strategy and composition. A few years ago, I introduced a fairly simple index categorization system that makes a good starting point. In The ETF Book, I separate beta-seeking “benchmark” index products that track a market from “strategy” index products that are specifically designed to not follow a market.
Examples of benchmark products are beta-seeking ETFs such as the Vanguard Total Bond Market ETF (ticker: BND) and Schwab U.S. Broad Market ETF (ticker: SCHB). These funds follow broad, low-cost, capitalization weighted indexes.
Examples of strategy ETFs include Investco PowerShares FTSE RAFI US 1000 (ticker: PRF) and First Trust ISE Global Wind Energy Index Fund (ticker: FAN). PRF is a fundamentally weighted index that weights securities based on sales, dividends and other factors, while FAN tracks a narrow index of companies that focus on a wind power theme.
Beta-seeking benchmark index ETFs and strategy index ETFs are generally meant to be long-term investments. You put them in your portfolio for a long time in hope of achieving a desired return.
The second classification method described in The ETF Book divides indexes into nine segments based on strategy. An Index Strategy Map (see Figure 1) separates funds into buckets based on three common ways in which securities are selected and three common ways in which chosen securities are weighted in the index. All index-based products fall fairly easily into one of these nine buckets.
Source: www.portfoliosolutions.com
Index Strategy Maps have been publically adopted by ETFguide.com and internally adopted by Morningstar. They have not been adopted by any fund company or index provider, nor have they been adopted any standard classification methodology.
A third segment of ETPs has developed in recent years that do not fit into either a long-term benchmark or strategy category. These are short-term speculating and hedging strategies. The products are designed to be held for only a few days and some for only a few hours. For simplicity, I refer to all these products as “hedge.”
Hedge ETPs were first introduced by ProShares in 2006. Their “levered” and “inverse” beta funds are structured using futures and swaps to deliver 2x, -1x, or -2x the daily return of an index or market, as measured from one net asset value (NAV) calculation to the next. ProShares and competing Direxion Shares also offer levered funds that deliver 3x and -3x daily returns.
The marketplace was quick to adopt levered and inverse funds. Unfortunately, many individual investors and their advisors didn’t understand that holding these funds longer than one day often resulted in periods were the fund direction was opposite their expectation. Tracking problems are more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. This issue generated wide criticism of leveraged and inverse products and called for better disclosure.
The next phase of hedge ETPs came in the form of long-short funds and market-neutral funds. These products attempt to capture inefficiencies or anomalies in the marketplace by purchasing securities deemed to be undervalued and selling securities deemed to be overvalued, all in one fund.
The most recent phase of hedge ETPs has been factor funds. This strategy involves trading securities in pairs, one long and one short. For example, the FactorShares 2X: S&P500 Bull/T-Bond Bear (ticker: FSE) seeks to track approximately 2x the daily long return of e-mini S&P 500 futures and a -2x daily return in the U.S. Treasury Bond Futures. The company has launched several unique funds that leverage and short different indices.
One of the more interesting factor fund companies to appear recently is QuantShares. They developed a series of U.S. market-neutral ETPs that allow investors to leverage or short a value premium factor, company size factor, momentum factor, and market beta factor. QuantShares Chairman and CEO is Bill DeRoche. He is a former Navy A-6 fighter pilot, which makes him brilliant in every way except one — he wasn’t a Marine (full disclosure: I am a former Marine A-6 pilot).
This dimension in the ETP marketplace presents a reason to expand my industry classification from two broad types to three: benchmark (beta), strategy, and hedge. Beta funds are designed to track a market, strategy funds attempt be an alternative to the market, and hedge is a short-term bet for or against a market or factor. See Figure 2 for a visual reference that I created.
Figure 2: Beta, Strategy, and Hedge ETPs
The industry is still dominated by benchmark-tracking beta funds. However, the outer rings are gaining in popularity and in assets. There are a couple of reasons for this.
First, the costs go up dramatically as funds move away from the inner circle. Beta funds have expense ratios of around 0.2 percent per year on average, strategy ETPs have expense ratios approaching 0.6 percent, and hedge ETPs have fund expense ratios over 1.0 percent. Higher fees are one reason why the ETP industry is very interested in launching and promoting the more exotic strategies.
Second, the money going into ETPs is slowly making its way to the outer circles. Most investors still prefer ETPs for what they were originally designed for − low-cost market exposure. Some are willing to listen to new ideas. The hard part for fund companies is that there is no market for a new strategy when it’s introduced. Beta is bought; strategy is sold. This means a lot of selling, which moves us to the next issue.
The marketing of strategy and hedge ETPs is intense, and that leaves a lot to be desired. I often hear sales reps of these products call their strategies a “better beta” or “intelligent indexing.” That’s nonsense. There is risk and there is return. What has higher return, has higher risk.
I’ve written about the greater-than-thou marketing tactics used by ETP companies for many years. I’ve even coined a few terms and phrases to describe it; Spin-dexing, ETF pollution, and most recently, beta diarrhea. I have no issue with the strategies used in these alternative funds − it’s how the products are marketed that gets me going.
In conclusion, the ETP industry is no better at educating the public today than it was five years ago when a plethora of new products hit the street. Fund companies and index providers have a responsibility to step up their education efforts. There should be much more time devoted to unbiased instruction and far less time devoted to selling the sizzle. A standard ETP classification is part of this process. It’s time for the industry to step up to the plate and adopt standard indexing definitions and classification methods.
