Exchange traded funds (ETFs) in the U.S. had a remarkable year in 2015 with inflows of $230 billion and the assets under management at $2.1 trillion at year end, according to the Investment Company Institute (ICI), making it clear that ETFs are playing a greater role in investment strategies. Yet the rules-based ETFs have their detractors who say that they accelerate market turbulence and need more restraints.
A panel discussion, “Finding Opportunities in Global ETF Investing,” part of Bloomberg’s “Equity Forum 2016: Beyond the New Normal,” in mid-May reviewed the new landscape for ETFs.
Given the significant growth in assets in ETFs, panelists were asked if ETF usage has become more strategic than tactical in clients’ portfolios. The answer depends greatly on the clients being served and the ETFs available, panelists said.
“I think there are some products that almost become self-selecting as this [ETF] is going to be geared toward a strategic investor and this [ETF] is going to be tactical,” said panelist Josh Brown, CEO of Ritholtz Capital Management. “Then that gray area in between is more like the SMA [separately managed account] side, where it’s like, all right, yes you can use [an ETF] strategically long term, but can you use it for a specific tactical purpose.”
In fact, some of the latest ETF products can facilitate both strategic and tactical efforts, according to panelist Justin Sibears, managing director and portfolio manager for Newfound Research. “If I say I want U.S. equities brokered tactically, I can get that. But, I can get that with a factor-based approach that is a more strategic way to manage money, and get the best of both worlds. It doesn’t have to be tactical or be strategic. It can be both.”
The flexibility of ETFs extends to the creation of new strategies, which can serve an array of purposes.
Smart Beta ETFs, for instance, have become popular because they offer an alternative weighting strategy rather than an underlying traditional cap-weighted index. They also combine passive and active investing aspects with quantitative methods that help investors and firms find information that shifts the balance toward preferred instruments and provides clarity on problematic stocks. In fact, combining the smart beta approach with low-volatility has caused low-volatility ETFs to dominate SmartBeta ETF inflows this year, as investors attempt to outperform the market while limiting potential risks.
Another new strategy getting attention is dynamic currency hedged offerings, pointed out panelist Jeremy Schwartz, director of research at WisdomTree Asset Management. This type of ETF uses dynamic hedging that can time the attractiveness of the hedge by adjusting the hedge ratio based upon multiple factors such as interest rates, valuations, and momentum.
WisdomTree offers one such fund, DDWM, which tracks the performance of dividend-paying companies in the industrialized world outside of the U.S. and Canada. It simultaneously hedges exposure to fluctuations of the value of the applicable foreign currencies relative to the U.S. dollar.
Schwartz says that DDWM, which targets investors that want broad-based exposure, helped one institutional investor working with a market maker move nearly nine million shares worth $230 million and the process benefitted from dynamic currency hedging. “They were very happy. … They got the market they wanted,” he says.
Trendy strategies aside, when it comes to trading ETFs, sourcing liquidity, especially for large orders in relatively illiquid ETFs, is still a key problem for investors.
Yet for market makers like panelist Paris Smith, principal and senior trader at Wolverine Trading, these situations provide opportunities for competitive quotes via the exchanges (secondary market) and via the primary markets through the creation/redemption mechanism.
Even sometimes challenging bond ETFs, which Smith says are a “different animal” than other ETFs, can benefit from “a very efficient mechanism of continuous pricing” that is at the heart of ETF trading and keeps the markets moving.
But firms will need more than efficient price discovery.
Companies will also have to gather and review pricing information, historical data, and reports on daily holdings and creation baskets. Ultimately, as ETFs become more popular, market participants face the ongoing challenge of finding and keeping track of the ETFs that they want in a universe of global exchanges.