Exchange-traded-funds have continued to evolve rapidly, especially since the introduction of fixed-income ETFs, which we covered in this space almost a decade ago.
Most ETFs track various assets or sectors of the capital markets. Fewer have sought to combine those assets into ready-made, off-the-shelf strategies, allowing investors to focus not only on what stocks to buy, but what approaches to use. It's the equivalent of having Thai food delivered rather than spending the time researching how to make it yourself.
With scant attention and little fanfare, last year upstart ETF provider QuantShares became the first firm to offer factor-based, market-neutral ETFs, opening up institutional-grade and often difficult-to-implement strategies to any investor in one simple transaction.
These funds are unique: rather than focus on the specific stocks that are likely to rise or fall for various fundamental reasons, the funds take a market and sector neutral approach, investing an equal dollar amount long and short within various US stocks based on quantitative macroeconomic factors like momentum, size and quality.
Because each fund is simultaneously long and short the same dollar amount of stocks, the idea is for asset managers to benefit not from whether the market is rising or falling, but which types of stocks are outperforming or underperforming at any given time.
Within the firm's U.S. Market Neutral Momentum Fund, for example, those stocks ranked highest for total return are bought, while those with the lowest total return are sold short. If momentum stocks are outperforming, so should this fund. (U.S. Market Neutral Anti-Momentum Fund employs the inverse strategy).
Beyond Directional Bets
- U.S. Market Neutral Value Fund (CHEP)
- U.S. Market Neutral Quality Fund (QLT)
- U.S. Market Neutral Size Fund (SIZ)
- U.S. Market Neutral High Beta Fund (BTAH)
- U.S. Market Neutral Anti-Beta Fund (BTAL)
- U.S. Market Neutral Momentum Fund (MOM)
- U.S. Market Neutral Anti-Momentum Fund (NOMO)
The funds also balance long and short exposure within each sector, meaning that no one particular industry should dictate a fund's return, only the specific performance of the "spread" it seeks to track.
Among the most interesting is U.S. Market Neutral Size Fund, which buys the smallest stocks and goes long the largest stocks, equal-weighted within each sector and rebalanced monthly. Theoretically, the fund should benefit from small-stocks' tendency to outperform over time.
The U.S. Market Neutral Quality Fund takes a similar approach, but focuses on buying "quality" stocks with the highest return on equity and the lowest debt-to-equity ratio, while shorting an equal amount with a lower return on equity and a higher debt-to-equity ratio. Demonstrating that there's no one panacea to profit, the fund actually dropped in recent months as lower-quality stocks outperformed.
Like all free market prices, the funds could even assist investors who don't buy them by providing a real-time indicator of what quantitative factors are working. If you happened to notice value stocks were outperforming, for example, it could lead you to outweigh those types of stocks in your portfolio even if you didn't buy the U.S. Market Neutral Value Fund, which buys undervalued stocks and shorts overvalued stocks, itself.
Bill Gross' bond ETF Pimco Total Return (BOND)
But just as the investing community learned about the importance of asset class diversification after the 2000 tech bubble burst or opportunities in foreign currencies over the past decade, allocating assets to speculate on market spreads using these types of innovative products will require education.
What's unquestionably the most difficult thing to understand about these cutting edge products is that they're stock market funds but not stock market exposure. Instead, the products offer market neutral, qualitative exposure to specific market factors that, like any market trend, come in and out of fashion over time.
That this sort of product would be available to retail traders would have been unthinkable even a few years ago, and as the investment community becomes more sophisticated and astute, expect interest in innovative products like these to grow.—Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC