In the rapidly expanding exchange traded fund (ETF) industry, existing and new market participants are trying to capture new money by broadening their product range. Although the large majority of ETFs track traditional, market cap weighted indices, providers have extended their product development to more specialised areas, by using their existing proprietary benchmarks or building new ones in-house or in collaboration with external index providers.
“There is always innovation in the index space and the earlier adopters of that innovation seem to be the ETF providers,” says Manooj Mistry, head of db X-trackers UK. “We have a lot of dialogue and interaction with all the index providers. What drives innovation is client demand, as investors use ETFs as portfolio building blocks, to access different markets and asset classes. Now that all the main markets and asset classes are covered, we are moving into the more niche product territories.”
Launches of actively managed or quantitative based ETF strategies in the hedge fund space are prime examples of the market’s natural evolution.
“There is nothing in the rule book that says ETFs have just to track standard indices. ETFs are very much an access tool, a wrapper through which you can access different types of markets, provided the right fundamentals are in place in terms of structuring a liquid and tradable product,” explains Mr Mistry.
In January, Deutsche Bank’s ETF platform launched an equity strategies hedge fund index ETF. This is a sub-component of the existing db hedge fund index ETF, which is linked to the performance of six core hedge funds strategies and has so far gathered $1.5bn (E1.1bn) in assets.
The recent launch meets investors’ demand for liquidity, as equity long-short and equity market neutral strategies are the most liquid subset of the six strategies, says Mr Mistry. The index, which is linked to the performance of 17 hedge funds from 13 alternative managers, gives exposure to actual, as opposed to replicated, hedge fund performance.
Last year, hedge fund Marshall Wace entered the ETF space with its market neutral ETF, which tracks the proprietary MW Topps global alpha index. Changes in the underlying portfolio are made through the firm’s rule-based proprietary systematic process. This was a clear indication of the interest of the hedge fund community in these passive instruments to enhance their distribution and product offering.
Recently, Europe’s largest hedge fund firm Man GLG followed suit, launching the Man GLG Europe Plus Source ETF on the Source platform. The product provides exposure to a long-only total return index, developed by Man Systematic Strategies, based on the best trading ideas from approximately 60 brokers. GLG, recently acquired by Man, has used a systematic process to select the best quality broker ideas and run a liquid and diversified portfolio since 2005.
Addressing the common industry-led criticism that active-type ETFs often attract for their lack of daily disclosure of their entire portfolio composition to market makers, which would ensure a tight bid-ask spread, Sandy Rattray, head of Man Systematic Strategies, states the product offers full transparency.
Authorised participants will always know the constituents of the ETF and dealers should find it very straightforward to hedge this portfolio, which holds between 200 and 250 names, weighted by market capitalisation, he says. “The returns of the portfolio show characteristics which are ‘index plus’,” says Mr Rattray. “Our own ‘plus’ – when compared with a broad European equity benchmark – has been historically between 200 and 800 basis points, with a tracking error in the range of 200 to 500 basis points.”
Recently, Source, which describes itself as an open architecture provider with a multi-partner approach, agreed to distribute a range of “well engineered and smarter” ETFs with Pimco. This led to the creation of a GDP-weighted ETF, while the partnership with Merrill Lynch last year brought to launch two ETFs tracking the Merrill Lynch Factor Model strategy. The model uses a portfolio of six liquid and well-known market indices to replicate the global performance of hedge funds. The product would appeal to investors who want hedge fund exposure without incurring potential liquidity problems, says Source’s CEO Ted Wood.
In addition to product innovation, the ETF platform’s multi-partner approach answers to the structural innovation needs of the ETF market in Europe, says Michael John Lytle, founding partner at Source. “Fragmentation is one of the key issues of the European ETF market, which has developed in a way that looks more like a structured product market, with each different institution launching products that make sense to them as an institution, as opposed to meeting industry needs.”
Unlike the US, which is a single ETF market, in Europe, where there are multiple currencies and different tax systems, many products track the same indices and trade on multiple exchanges. Many European ETF products never reach a critical mass, with significant liquidity and the trading volumes necessary to make them attractive for secondary trading.
