Competition to Launch the Most Complicated ETF Heats Up

I’m not opposed to some level of sophistication in the ETF market and I’m cool with innovation. But have we gotten really far away from the original appeal of these products?

A few years ago, the blogosphere mocked the launches of such nonsensical products as the “global aquaculture ETF” – literally an index of publicly traded fish hatcheries. Then the triple-leveraged gold mining ETFs and the triple biotech ETFs came along and we barely sniffed at them. By the time they were rolling out such absurdities as the “Risk-On” and “Risk-Off” products (ticker symbols were ONN and OFF, natch), the bloggers couldn’t even get up the dander to spit in the issuer’s general direction. Both were eventually killed in May of last year, with very few investor tears shed at the announcement.

The new phase involves currency-hedging every asset class in sight as well as 800 different ways to do smart beta. Again, I don’t hate them all as a category, I suppose I just question whether or not most of this stuff is even necessary. All of the behavioral studies conclude that, when presented with too many choices, the consumer will end up making worse decisions or even decline to make any decision at all. I’d hate to see that happen in the ETF marketplace.

Factset makes an important point about the rise of multi-factor smart beta products:

Overall, these smart and kind-of-smart ETFs have become a driving force in the ETF industry. We count some 811 funds out of the 1,796 ETFs currently on the market as Smart Beta, with nearly 25% of total assets ($526 Billion) falling into this category.

But do they actually deliver? As you can imagine, the answer varies wildly. Value and Growth rarely work at the same time, but both are considered the simplest of Smart Beta. For that reason, the ETF industry has put a lot of effort into developing multi-factor Smart Beta ETFs that use more than single factors to pick their stocks. As of the end of May, there were 42 such funds with five-year track records. Only eight showed any statistically significant alpha—and three of those eight were negative alphas!

Ditto for currency-hedging, which is a great idea that may already be going too far:

A few years ago, there were essentially no assets in currency-hedged ETFs, whereas today there’s some $62 billion. More than half of that has arrived in just the last five months.

WisdomTree, which essentially invented the currency-hedged ETF market a few years ago with its groundbreaking Japan product, DXJ, is out with another two products for the suite. From their release this morning:

WisdomTree (NASDAQ: WETF), an exchange-traded product (“ETP”) sponsor and asset manager, today announced the launch of the WisdomTree International Hedged SmallCap Dividend Fund (HDLS), and the WisdomTree Global ex-U.S. Hedged Dividend Fund (DXUS) on the NYSE Arca. HDLS seeks to provide exposure to the small-capitalization segment of the dividend-paying market in the developed world outside the U.S. and Canada, while neutralizing exposure to fluctuations of foreign currency relative to the U.S. dollar. DXUS seeks to provide exposure to the dividend paying companies in the developed and emerging markets outside of the U.S. while neutralizing exposure to fluctuations of foreign currency movements relative to the U.S. dollar.

I have no doubt that Jeremy Schwartz & Co see a real need in the marketplace for products like this – WisdomTree doesn’t do fly-by-night stuff and they put a lot of time and effort into product construction, from what I’ve witnessed over the years. The real question is whether or not these would be appropriate for all investors – or whether the advisors who pick up on these products will know how best to employ them and explain them to their end clients.

Which brings us to the latest latest craze – the ETF mashup. This is exactly what it sounds like: smushing together two investing strategies into a single product with a catchy story. Here’s Eric Balchunas, the ETF axe at Bloomberg:

Last month, PowerShares mashed together two popular strategies—currency hedging and low volatility—with the PowerShares Europe Currency Hedged Low Volatility Portfolio (FXEU). FXEU tracks the 80 least-volatile stocks in the euro zone and uses derivatives to hedge out the currency.

The question here: Do investors need really need less volatility when hedging their currency exposure? Currency hedging already lowers volatility.

and:

Last week a suite of new ETFs were launched by Highland Capital Management that attempt to tie together the theme of tracking stocks held by hedge funds with actual hedge fund strategies used by funds in real life.

What?

Oh, also:

BlackRock has also gotten into the mashup trend. It launched the iShares Commodities Select Strategies (COMT) late last year. Doesn’t sound like a mashup from the name, but it is combining two entirely different asset classes: commodity futures and equities. Besides the commodity-producing stocks, it holds a wide spectrum of commodity futures, ranging from energy to livestock.

 

Who the f*** was asking for that?

I read recently that roughly a quarter of all ETFs that have been launched since the 1990’s have already been put to sleep – that’s 500 funds or so. The products were never mainstream enough to build sufficient AUM or trading volume in order to keep them going. Or they’ve been outright disasters, like some of the more notorious Vix-related products that have crunched investors who thought they were actually obtaining a hedge (LOL when the hedge itself turns into something you needed a hedge against).

I suppose that so long as ETF makers are willing to be creative, we should encourage it. After all, the marketplace is self-policing to some extent – meaning the bad funds get weeded out as investors vote with their feet. Ron Rowland, who keeps an ETF Death Watch list at his site, Invest With An Edge, says there are more than 300 ETFs and ETNs in his deadpool as of May.

So don’t be surprised if a whole slew of 2015’s bumper crop in sophisticated strategy ETFs end up being euthanized in the coming years as well. Creative destruction.

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.

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