Actively managing beta risk

Exchange traded funds have emerged as important instruments for investors and advisors. That’s not surprising, but the way they’re being used might be: once touted as the ultimate buy-and-hold vehicle – buy the stock market for the equity risk premium and forget about individual stock volatility or manager underperformance – ETFs have become another tool in the kit of active managers, including advisors.

Joseph Witthohn, an analyst in the investment strategy group at Janney Montgomery Scott LLC in Philadelphia, wholeheartedly endorses ETFs. Witthohn formerly analyzed mutual funds, and now builds model ETF portfolios, but the profusion of ETFs has him worried. Some ETFs “have gotten too cute,” he said during last week’s Exchange Traded Forum organized by Radius Financial Education in Toronto.

He points to leveraged ETFs – since they roll over everyday, they have disappointed many unsuspecting investors with their tracking error. Where the investor was expecting twice the 5.5% return of the Standard & Poor’s 500, they got 1.1%.

A different offering

Clearly, ETFs open up new risks for investors, and confusion is a key risk in the fast-growing ETF marketplace – many don’t fully comprehend what the product is and what it is supposed to do.

Still, that’s the evolution of the industry suggests Richard Kang, chief investment officer at Emerging Global Advisors in New York. ETFs are the top of the daily trading charts, and they represent somewhere between 25% and 30% of the volume on U.S. stock exchanges.

Kang himself is involved in creating emerging market ETFS, which he says offer a more diversified exposure than traditional emerging market ETFs. Those, he suggests, are just leveraged plays on Canada – given their high resource component. But sector and infrastructure ETFs offer something different.

That poses challenges for people like Tyler Mordy, director of research at Hahn Investment Stewards in Toronto. Hahn runs ETF-only portfolios. But they actively trade the underlying portfolio because “markets aren’t very rational.” It’s a “risk-on, risk-off” trade – selling asset classes rather than stocks when they are expensive, and buying them when they are cheap.

So all the old arguments about broad-market ETFs seem to have been turned aside. They are tactical trading tools.

Indeed, Jim McGovern, managing director and CEO of Arrow Hedge Partners Inc., in Toronto notes that hedge funds are “power users” of ETFs. Leveraged ETFs are a favourite play – sometimes, he says half ironically, because retail investors don’t know what they’re doing.

Moving targets

But that’s the broader marketplace.

On an investment firm level, ETF investing takes the form of portfolios with specific characteristics. Given the transparency of information – it reports trades and holdings daily, rather than the six-month time lag associated with a mutual fund – active management is simplified.

But the math isn’t. That’s because more and more advisors are fine-tuning ETF portfolios to minimize volatility, not to maximize return. That’s what Ioulia Tretiakova does as director of quantitative strategies at Pur Investing.

She manages to achieve a constant volatility, to create downside protection, since she finds rebalancing to a 60/40 portfolio inadequate. The reason: “risk in the market has changed,” she points out. Volatility is a moving target. That was true in the dot-com bust, but also more recently, during the financial crisis, when spread between government bonds and corporate bonds gapped out.

“What we propose is that when volatility is low or stable, this is a more investor-friendly environment, this is probably a time to put more money in risky asset classes,” she says. And conversely in high volatility environments, such as 2007-200, “that’s probably the time to take some risk off the table.”

Reducing volatility

But, risk remains. Greg Burgess, a portfolio manager at New Haven Asset Management in Toronto, warns, “you can blow up an individual’s wealth with ETFs as easily as you can with an individual securities or mutual funds. In fact, ETFs are mutual funds…Remember, most investment products that blow up tend to have three-letter names: MBS CDS.”

He urges advisors to remember that, “at the end of the day an ETF is just a reference portfolio of securities. Sometimes the securities are liquid, sometimes they are illiquid.”

In any case, “if you’re using ETFs, it’s a very active process because you’re constructing portfolios.”

Portfolio construction starts with a reference benchmark, for example, the S&P/TSX 60, which has outperformed 95% of mutual funds. But that didn’t mean it provided an absolute return. Instead, over the past five years, there was an 8% return “with extraordinary volatility.”

“There were a lot of people who bought ETFs in 2007 who didn’t like them in 2008.”

Still, investors can buy an ETF for 17 basis points and get the tax efficiencies. That makes them attractive, but equally, dangerous.

“Our job is [to ask] how do we make that better,” Burgess says. The answer probably involves a heresy in the buy-and-hold ETF universe. The goal is not to replicate index returns at the cheapest-possible cost.

“Our objective is generally to reduce volatility, relative to that index. We take a lot of tracking error.”

Tracking error is a risk. But it might be a better risk than the alternative.