How ETFs Have Democratized Investing

by on March 10, 2011 | ETFs Mentioned:

ETFs have been praised for improving the investing experience in a number of different ways. They have been the catalyst for a shift towards low cost indexing strategies, and have placed strong downward pressure on management fees throughout the investing landscape. They have improved tax efficiencies and intraday liquidity, allowing investors to move in and out of positions throughout the day and construct more complex short-term trading strategies.

But arguably the greatest contribution of the ETF boom has been not the reduction in fees or the potential tax efficiencies; the tremendous growth of the ETF lineup has democratized the business of investing, opening up investment strategies and entire asset classes that have historically been accessible only to the largest and most sophisticated of investors. A significant portion of ETF assets are in “plain vanilla” products that offer exposure to domestic and international equities and U.S. bonds. And while the rise of ETFs have made it cheaper and easier to invest in these asset classes, the exchange-traded structure hasn’t exactly opened any new doors in this regard. But in other corners of the investable universe, the marriage of what were once considered “exotic” asset classes or strategies with the ETF wrapper have brought new types of exposure to all types of investors. Below, we highlight a few of the ways ETFs have brought certain investment strategies to the masses:

Leverage

Leveraged ETFs allow investors to amplify exposure to a desired index over a certain period of time, with most of these funds seeking to deliver leveraged results over a single trading sessions. Because these securities can be traded throughout the day, they have become popular with investors looking to bet on short-term movements in a specific sector or asset class; daily turnover for many leveraged ETFs often equates to a significant percentage of total shares outstanding. For smaller investors, achieving leverage can be a time consuming and expensive process; the introduction of leveraged ETFs allows for the implementation of relatively advanced strategies by purchasing a single ticker [see Five Critical Questions To Ask When Investing In ETFs].

ProShares and Direxion offer dozens of leveraged products across a variety of asset classes, including domestic and international equities, fixed income, commodities, and real estate. A handful of other issuers offer leveraged products as well, and the options within the leveraged ETP space are numerous. In addition to distinguishing between 2x and 3x exposure, different funds reset with different frequencies–thereby effecting the potential impact of compounding (both good and bad) on performance [see the Leveraged ETF Center].

According to data from the National Stock Exchange, leveraged ETF assets stood at nearly $30 billion at the end of February.

Commodities

A variety of academic studies have highlighted the potential value of an investment in commodities; the asset class has the potential to deliver positive long-term returns that exhibit low correlations with stocks and bonds. But accessing commodities has historically been a challenge for some investors; physical storage can be inconvenient, while the ongoing maintenance associated with futures-based strategies often results in less-than-optimal investment experiences [see The Ten Commandments Of ETF Investing].

But thanks to the introduction of commodity ETFs, establishing exposure to this asset class is straightforward and relatively low cost and low maintenance. Physically-backed products, such as GLD (gold) or SLV (silver) create economies of scale on the cost front, allowing investors to minimize storage costs and administrative headaches associated with physically holding a commodity. Futures-based funds maintain pre-determined rules for “rolling” holdings to avoid taking possession of the underlying, ensuring both low expenses and an orderly management process.

The commodity ETF space is both broad and deep; assets totaled more than $100 billion through February, and in addition to broad-based ETFs there are dozens of resource-specific products offering exposure to everything from corn to platinum to sugar [see the new ETF Screener to filter all commodity ETFs].

Hedge Fund Replication

Some investors have a hard time accepting that ETFs can mimic strategies implemented by hedge funds, a result of confusion over what exactly the objective of hedge funds is. There might not be an ETF that delivers the “shoot the lights out” returns that many investors associate with hedge funds,  but there are a number of products that have proven to be effective in providing low-volatility, non-correlated returns.

IndexIQ is a pioneer in this space, offering both a broad-based hedge fund replication ETF in QAI as well as more targeted options focusing on macro (MCRO) and merger arbitrage (MNA) strategies [see Guide To Hedge Fund ETFs].

Managed Futures

ETFs have become popular tools for accessing not only the core “building blocks” of portfolios designed to deliver long-term returns, but also for asset classes beyond stocks and bonds that can bring diversification benefits to a portfolio. Joining hedge fund replication products under the “alternatives” umbrella is the managed futures strategy, a technique that allows for both long and short positions in a variety of asset classes depending on momentum and other factors [see Using ETFs To Access Alternatives].

Managed futures can be time consuming and expensive to implement, especially on a small scale. The packaging of this strategy in the ETF wrapper not only eliminates these headaches, but provides the intraday liquidity and potential tax efficiencies that are characteristic of all ETFs. WisdomTree recently launched an active managed futures ETF (WDTI) that seeks to deliver returns corresponding to the Diversified Trends Indicator (the active exception allows flexibility in using futures, swaps, forwards, or other securities). WDTI can be expected to exhibit low correlation to both stocks and bonds, and the use of both long and short positions means that it could perform well regardless of overall market direction [see Under The Hood of WDTI].

Volatility

Indexes measuring volatility have been around and widely followed for decades, but it is only within the last several years that the idea of volatility as an investable asset class has developed. And more recently, the proliferation of ETPs linked to VIX-based indexes–there are now 15 products in the Volatility ETFdb Category–has made this asset class more widely accessible.

The appeal of volatility is linked to its strong negative correlation to equity markets; the VIX peaked during the financial crisis of 2008 and almost always moves in the opposite direction of broad-based equity funds. So volatility can be thought of as insurance for investor portfolios; in exchange for a premium–in this case, the “roll yield” resulting from contangoed markets [see Guide To VIX ETFs].

The aforementioned categories only begin to tell the story of the strategies and asset classes unlocked by the ETF boom that has taken place in recent years; additional examples include long-short funds, quant-based equity strategies, and even exposure to some small, hard-to-reach frontier markets.

Disclosure: No positions at time of writing.