Welcome to CanadianHedgeWatch.com
Friday, October 22, 2021

Investors using ETPs more for risk management


Date: Monday, August 22, 2011
Author: Thao Hua, investmentNews

Stomach-turning global volatility has bolstered demand for certain alternative exchange-traded products used by institutions to hedge their portfolios or make directional bets quickly in order to profit from market instability.

“We've seen pretty significant year-to-date increases on inverse” ETPs, said Russ Koesterich, managing director and global chief investment strategist for BlackRock Inc.'s iShares business. “In general, investors are using these products to position against what they think might be a dour movement of assets, and they want to hedge part of that exposure.”

When major market indexes plunged Aug. 4, portfolio managers at Roosevelt Investment Group Inc. used ultrashort exchange-traded funds to help shave about 100 basis points off losses on a day the Russell 3000 Index declined by 5.07%.

The short ETFs are used along with a broader array of risk management tools that include increasing cash, Treasuries and gold holdings, said Nainesh Shah, senior securities analyst and portfolio specialist at Roosevelt Investment Group.

“We want to have diversification within the risk management bucket” as well as the stocks portfolio, said Mr. Shah, whose equity boutique has about $5.2 billion in assets under management and advisement on behalf of pension funds, endowments and high-net-worth clients.

$2.1 BILLION IN JUNE

Net new inflows for leveraged, inverse and leveraged inverse ETPs totaled $2.1 billion in June alone, according to the latest figures available. In the first half of this year, investors put $6.1 billion in new assets into ETPs, almost as much as the $6.4 billion for all of 2010, according to BlackRock Inc's ETF industry report published last month.

“What we're seeing now is an evolution of the [ETP] industry,” said Scott Burns, director of ETF research at Morningstar Inc.

“A lot of people think ETFs are primarily used by retail investors,” he said. “That is increasingly not the case; they're tools for pension managers when building strategies, for tweaking risks inside of the investment portfolios.”

The group of ETPs that includes leveraged, inverse and volatility-trading instruments is a relatively new breed, specifically designed to appeal to institutions.

“They're much more tools for trading or hedging, rather than buy-and-hold securities,” said Edward McRedmond, senior vice president and head of institutional and portfolio strategies at Invesco PowerShares Capital Management LLC.

PowerShares markets leveraged ETPs through a partnership with Deutsche Bank AG.

Worldwide, $49.9 billion was invested in leveraged and inverse ETPs as of June 30, a hefty sum considering that they were first introduced in the United States just five years ago.

Overall, a total of 577 leveraged, inverse and leveraged inverse ETPs traded on stock exchanges globally as of June 30, according to BlackRock data. Such ETPs account for about 3.5% of total ETP assets, but they claim 11% of the trading volume — evidence that these securities are primarily used to gain short-term exposures.

Also dubbed “geared” ETPs, leveraged and inverse products aim to deliver two to three times the return of the correlating assets, or the inverse of a particular index in a trading day, respectively. There are also ETPs that aim to do both.

The ways that they are constructed vary widely, but it often is done using assets and derivatives in order to mimic the stated return objectives, sources said.

One of the newest types of ETPs used by institutions to control volatility within investment portfolios is based on short-term and medium-term futures contracts on the Chicago Board Options Exchange Volatility Index, or VIX — often referred to as the “fear index.”

First introduced in 2009, these securities already had garnered a total of $2.3 billion in assets as of June 30. On Aug. 4 alone, the VIX jumped 35.41%, and $3 billion in VIX ETPs were traded in the biggest volume day for the securities.

“Large institutional investors are rethinking their portfolios, and [leveraged and inverse ETPs] allow them flexibility to manage exposures,” said Mr. Koesterich of iShares, which doesn't offer leveraged and inverse ETPs.

However, its parent company BlackRock does distribute iPath products, which include geared ETPs sponsored by Barclays Bank PLC.

“What the [ETP] industry is doing is looking at what institutional investors are investing in today and going to the product development laboratory to come up with a formula to deliver that asset class or strategy” through an ETP, said Michael L. Sapir, chairman and chief executive of ProShares Advisors LLC.

The firm is the largest provider of geared ETFs with about $26 billion in assets under management.

Leveraged and inverse ETPs can be structured as an ETF or an exchange-traded note, which is a debt security. Hedge funds are most likely to use geared ETPs because they need to be more tactical and nimble, Mr. Koesterich said.

“Some pension funds and en-dowments are trying to manage their investment portfolios more tactically, but they're at different stages in getting to that point,” he said.

JUST GETTING STARTED

Just a few of the largest pension funds and endowments are using these ETPs so far, sources said.

One is the $66 billion Ohio State Teachers' Retirement System, which reported owning 325,000 shares of ProShares UltraShort S&P 500 ETFs, according to 13F filings as of June 30. Fund spokesman Nick Treneff didn't return telephone and e-mail requests for further information.

“There's a slow but growing trend toward broader global equity mandates,” Mr. Koesterich said. “One thing that implies is a loss of flexibility, and here, ETPs might come in handy.”

Banks and money managers including hedge funds and mutual funds are the most prevalent users of some of the biggest leveraged and inverse ETPs.

For example, hedge fund firms Harbinger Holdings LLC, Iridian Asset Management, Two Sigma Investments and Wolverine Asset Management all were among the top shareholders of ProShares UltraShort S&P 500 ETFs, according to 13F filings as of March 31. Officials at these firms and other hedge funds contacted either didn't return calls or declined to comment about how they use geared ETPs.

William Lloyd, managing director and head of index products at ETP provider VelocityShares, said that his firm launched six VIX ETPs in November and already has attracted $550 million in assets.

Institutions are using ETPs in combination “with different instruments to help protect [their portfolios] against a spike in volatility,” he said.

FUNDS BEHAVE STRANGELY

Some managers remain skeptical.

“They don't necessarily do what you want them to do” over longer periods of time, compared with the actual performance or inverse of the performance during the same period, said Francois Buclez, chief executive of Cube Capital, a fund of hedge funds with about $1.2 billion under management that also invests directly as an overlay to boost returns.

“Some of our underlying hedge funds do use short and leveraged ETPs, but we don't,” he said.

Most leveraged, inverse, long/ short and VIX-based ETPs reset daily, meaning that the securities are designed to achieve their investment objectives for the trading day only. Due to the effect of compounding, long-term performance depends on the path that the security moved from point A to point B, sources said.

For example, the Russell 1000 Financial Services index gained 8% between Dec. 1, 2008, and April 30, 2009, according to a regulatory notice issued by the Financial Industry Regulatory Authority Inc. During that period, an ETF seeking to deliver three times the daily return of the index fell 53%.

Another difficulty is the implicit cost of the structure because of the borrowing complexities linked to shorting and leverage, Mr. Buclez and others said.

Mr. Sapir said that his firm has a rigorous process by which it pursues favorable terms for getting exposure to certain parts of the markets, including the cost of margin financing and the cost of borrowing.

“Another thing to keep in mind is that geared ETPs are convenient tools to implement investment strategies, and investors may even be willing to give up a few basis points in order to gain convenience” and speed of execution, he said.

Thao Hua is a reporter at sister publication Pensions & Investments. Data editor Timothy Pollard contributed to this story.