Alternatives ETF Center
As ETFs have gained traction with investors, the size of the product lineup has grown rapidly. What was relatively recently a few hundred funds offering exposure to “plain vanilla” stock and bond benchmarks has quickly grown to an ever-growing line of exchange-traded products covering nearly every nook and cranny of the investable universe. This proliferation of ETFs has given investors more precise tools for accessing traditional asset classes, but it has also opened up investment strategies and asset classes that were previously either out-of-reach or that required considerable time and/or expenses to implement properly
Many investors have some misconceptions about the hedge fund asset class; stories of outrageous returns generated in the 1990s and early 2000s have led them to believe that hedge funds seek to generate massive absolute returns by taking on significant risk. But in reality, hedge funds aren’t always out to generate eye-popping absolute returns. As the very name of these vehicles suggests, most hedge funds are designed to hedge, dampening volatility and providing diversification benefits to traditional stock-and-bond portfolios.
In this special report, we highlight all of the different investment strategies and products offered in the Alternative ETFs space. We cover important factors that should be considered when searching for an alternatives ETF, as well as highlighting noteworthy benefits and drawbacks of certain strategies.
When analyzing the of the ETF industry, most investors highlight the cheap, liquid exposure to traditional asset classes as the main reason for the popularity of the exchange-traded structure. While ETFs have indeed provided a low-cost alternative to the traditional asset classes, they have also made it easier than ever to achieve exposure to “exotic” asset classes, geographies, and investment strategies. One of the more unique innovations in the ETF industry is 130/30 investing, a strategy implemented by the ProShares Credit Suisse 130/30 (CSM) and the First Trust KEYnotes Exchange Traded Notes (JFT).
Just as ETFs have democratized commodities, so too have they brought another previously hard-to-access asset class within reach. As evidenced by huge inflows and a surge in the number of product offerings, more and more investors are embracing volatility exposure as an effective tool. Perhaps the most popular volatility index is the VIX, or the Chicago Board Options Exchange Market Volatility Index, which measures the implied volatility of S&P 500 index options. The VIX was introduced in 1993 by Duke University’s Professor Robert Whaley, and is a hypothetical measure of volatility based on metrics involving options trades and expectations of stock market volatility over the next 30 day period. As such, investors obviously cannot invest directly in a volatility index such as the VIX. But financial innovations of recent years have created opportunities for tapping into this asset class; futures on the VIX began trading back in 2004, and the first VIX-linked options debuted in 2006. More recently, ETNs linked to VIX-related indexes popped up, and have multiplied in recent weeks and months.
As correlations between international markets have steadily increased over the years, identifying non-correlated assets has become both increasingly important and difficult. Against this backdrop, long/short investment strategies may be an intriguing opportunity, as they maintain the potential to generate positive returns even in the most challenging of economic environments. The idea behind such an investment is relatively simple: establish a long position in an asset that is undervalued relative to a comparable security and a corresponding short position in the relatively overvalued counterpart. Because the net exposure is zero these strategies are often described as “market neutral,” meaning that performance is not correlated to the general movement of the markets but rather to the relative performances of the opposite asset classes.
Alternative weightings are a popular way for investors to gain unique exposure through exchange traded vehicles. Weighting options like equal, RAFI, dividedn, and others have become increasingly popular, and so too have the funds that utilize these strategies. The ProShares RAFI Long/Short (RALS) was the first ETF of its kind. The fund seeks to replicate the RAFI U.S. Equity Long/Short Index, a benchmark that utilizes the fundamental weighting methodologies developed by Research Affiliates that have gained impressive traction with investors in recent years.
ProShares‘ Hedge Replication ETF (HDG), is an ETF that seeks to provide returns characteristic of the hedge fund asset class. HDG is designed to maintain a high correlation to the HFRI Weighted Composite Index, an equal-weighted composite of more than 2,000 funds. “Many portfolios could benefit from the risk/return characteristics of hedge funds, but investors often either can’t or don’t invest in hedge funds because of a variety of challenges,” said Michael L. Sapir, Chairman and CEO of ProShare Advisors LLC, ProShares’ investment advisor. “We are pleased to offer an ETF that addresses challenges of hedge fund investing and may be, for many investors, an attractive alternative to hedge funds.”
Most traders move in and out of leveraged ETF positions within a single trading session, as the objectives that they use these funds to accomplish are short-term in nature. But an increasing number of advisors have begun using leveraged ETFs over extended time periods to generate amplified returns on trends that may not play out in a single trading session. Since leveraged ETFs compound daily returns, returns over multiple trading sessions can often result in unpredictable returns, particularly in seesawing markets. But by using a relatively simple rebalancing plan, advisors can increase the likelihood that returns on leveraged ETFs will closely correspond to an intended multiple of the related index.
Since their introduction in 2006, leveraged ETFs have attracted tens of billions of dollars in cash inflows and become immensely popular among investors looking to accomplish a variety of objectives. As scrutiny of these products has intensified, the conception that leveraged ETFs are overly-complex products beyond the grasp of most investors has spread. While many of the intricacies surrounding leveraged ETFs are far from simple, the underpinnings and mechanics of these products are actually quite simple.
Much of the controversy surrounding leveraged ETFs has focused on the performance results delivered by these products over extended periods of time. A common criticism has been that leveraged ETFs don’t perform as they should or as they are advertised to. In reality, however, most leveraged ETFs actually do a very good job of accomplishing their stated objective. The disconnect that has stirred debate, investigations, and ultimately regulations issue that arises is not between actual performance and stated objectives, but rather between investor expectations and a disconnect between investor expectations and the goals outlined in the prospectus.
Leveraged ETFs have become tremendously popular tools for investors looking to accomplish a wide variety of objectives, including hedging existing positions or amplifying exposure to market movements. In this working paper, Raymund Wong and Kara Hargadon analyze some conceptions surrounding leveraged ETFs and the returns exhibited by these products over certain historical periods.
Much of the confusion over leveraged ETFs has focused on the performance of these funds when held for multiple trading sessions. After the unprecedented volatility of 2008, many investors were left with the impression that leveraged ETFs are bound to erode returns over extended periods of time, resulting in returns that vary in magnitude and perhaps even direction from a simple multiple on the return generated by the underlying index.
These risks are very real, and necessitate the frequent monitoring (and perhaps rebalancing) of any leveraged investment. But there’s a good chance of compounding working for investors as well. In certain environments — such as the impressive rally of 2009 — the compounding effect of leveraged ETFs can work for investors (or at least for those who made the correct directional call).
Leveraged ETFs In The News
- It’s A Wonderful Rally (Wall Street Journal, December 2009): In a follow-up to a previous article, James Stewart reports on his experiences with leveraged and inverse ETFs. “Indeed, there’s such an array of innovative products now available that even small investors can mimic strategies once reserved for professionals,” writes Stewart.
- Trading Leveraged ETFs: No One’s Complaining In A Bull Market (Seeking Alpha, January 2010): David Fry reflects on the his use of leveraged ETFs to accomplish investment objectives. “We’ve been able in a short period of time to capture 5-7% returns and more over short time periods as previously described,” writes Fry. “Naturally, not all trades are successful and losses of a similar amount have also been experienced. Nevertheless, all things considered, when winners exceed losers by a significant amount, then this is a suitable methodology for the most aggressive investors”
- See all news stories from ETF Database on leveraged ETFs here.
More Leveraged ETF Resources
A collection of resources from around the Web providing further education on leveraged ETFs:
- Today’s Best-Performing Leveraged ETFs
- Today’s Worst-Performing Leveraged ETFs
- Understanding The Returns Of Leveraged And Inverse Funds in the Journal Of Indexes
- The Universal Effects Of Compounding and Leveraged ETFs at ProShares.com
- Components of Leveraged and Inverse Funds from ProShares.com (pdf)
- Geared Investing: An Introduction to Leveraged and Inverse Funds from ProShares.com (pdf)
- Geared Fund Performance: Understanding Leveraged and Inverse Funds from ProShares.com (pdf)
- Volatility In Perspective from ProShares.com (pdf)
- Alternative Investments: Understanding Their Role in a Portfolio from ProShares.com (pdf)
- Understanding Taxable Distributions from Direxion.com (pdf)
- Understanding the Impact of Changing Market Exposure on Leveraged ETFs from Direxion.com (pdf)