ETF Solutions For Today’s Market

September 01, 2021

Inflation is running at an annual 5.4% clip. The real yield on the 10-year U.S. Treasury note is negative and the Cboe Volatility Index is rising, even as the S&P 500 Index made new highs in late July.

With so much uncertainty in the markets, financial advisors can have a tough time convincing clients to stay the course with their investments. A spate of new exchange-traded funds are trying to address these concerns, some with twists on classic ideas and others mixing a few types of strategies.

ETF Rule Creates Opportunities
Todd Rosenbluth, director of ETF research at CFRA, observes that regulatory changes, specifically the ETF Rule, encouraged firms to launch new actively managed products.

In the first six months of 2021, 200 new exchange-traded products launched, including 51 in June alone, he points out. Two-thirds of these offerings were actively managed products.

Among these new actively managed launches is the Horizon Kinetics Inflation Beneficiaries ETF (INFL). Debuting in January, the ETF is a first for the firm, and has already gathered over $620 million in assets under management (AUM). Rosenbluth notes that the fund has exposure to global companies that investors may not automatically assume will benefit from higher inflation, such as materials firms, financial exchanges and health care companies.

Another actively managed product launch in 2021 was the American Century Low Volatility ETF (LVOL), which seeks to deliver a lower volatility portfolio than the S&P 500, with enhanced risk-adjusted returns.

“What’s interesting to me about [the American Century fund] is that it’s taking what’s primarily been an index-based approach to reducing volatility and choosing companies based on historical volatility, but without taking fundamentals or valuation into “account,” Rosenbluth said.

LVOL’s strategy is more multidimensional than most index methodologies. The fund has a heavier technology weighting, around 31%, but no exposure to utilities, which Rosenbluth considers a novel approach.

Concerns about rising inflation eating away at fixed income yields prompted David Miller, chief investment officer of Strategy Shares ETFs, to launch in May the Strategy Shares Gold-Hedged Bond ETF (GLDB), which tracks a corporate bond index with a gold overlay. The concept is similar to India’s sovereign gold bonds, where the bonds are denominated in grams of gold to maintain purchasing power, he explains.

The fund’s index comprises bonds from blue chip U.S. companies, with a 10% gold overlay through a total return swap. Combining bonds and gold in a single fund offsets the disadvantages the two have singularly, which is that bond yields are reduced by inflation, while gold has no coupon but offers inflation protection.

“You clip a nice yield from the bonds, and your purchasing power is preserved because it’s effectively denominated in gold rather than in U.S. dollars,” Miller added.

Option Strategies Increase
A number of defined outcome ETFs launched this year, too, following on the success of Innovator’s original strategy. These ETFs cap both the upside potential and downside risk of an investor’s portfolio using options for a more predictable return.

Ben Johnson, director of global ETF research at Morningstar, calls these defined outcome ETFs a “kinder, gentler structured note.” He recalls seeing an uptick in sales of these ETFs in response to the volatile market conditions.

These ETFs that use options to cap gains and losses are not unlike “bumper bowling,” where inflatable bumpers prevent bowlers from throwing gutter balls. “It’s a strategy for people who are just worried about seeing the value of their portfolio go down quite a bit over quite a short period of time,” Johnson said.

Rosenbluth says that other fund families are launching other option-based equity strategies too.

The Swan Hedged Equity US Large Cap ETF (HEGD) is an actively managed fund that uses passive ETFs with exposure to the U.S. large cap market, and hedges that risk with put options dated two years out. It also uses an actively managed options strategy to lower volatility and capture additional return. Launched in December 2020, it currently has $82 million in AUM.

Randy Swan, founder and lead portfolio manager of Swan Global Investments, says that with the traditional 60/40 stock/bond portfolio no longer offering consistent income, investors need to rethink income and market risk. Hedges allow both of these actions.

“We’re able to invest about 90% of the portfolio [in equity by holding a] low cost, tax efficient ETF, and roughly 10% toward the hedge,” he explained. “So we think it’s much more efficient and cost-effective, and actually more reliable.”

Mike Green, portfolio manager and chief strategist at Simplify ETFs, says the firm used the derivative rule changes to create a suite of products that modify traditional market exposures using derivatives to create different revenue streams. They are building on their actively managed convexity suite first released last year.

One example is the Simplify Interest Rate Hedge ETF (PFIX), which has already gathered $75 million since its May launch. The ETF is an attempt to hedge against interest rate volatility and a sharp rise in rates. It holds a large position in over-the-counter interest rate options and is designed to mimic holding a long-dated put position on the 20-year U.S. Treasury bond.

Not all new ETF launches are hedge products. Some are responses to investor interest in new asset classes, such as the Simplify U.S. Equity PLUS GBTC ETF (SPBC), an actively managed ETF investing in U.S. equities and the Grayscale Bitcoin Trust.

The fund targets 100% exposure to U.S. equities using ETFs and futures, and puts 10% of its total assets in the Grayscale Bitcoin Trust—currently the only legal way for a publicly traded fund to get access to bitcoin. Green says the fund will have a maximum allocation of 15% to the trust, and will actively rebalance the bitcoin exposure to 10% of the portfolio’s assets.

“It’s an effective way for somebody to have some exposure to the crypto space, but not necessarily have it explode relative to their overall portfolio,” he said. “By doing it inside the ETF, we’re actually able to do an exchange-in-kind, and therefore it has much more favorable tax treatment.”

Will Active Management Perform?
Both Johnson and Rosenbluth say that while a new regulatory regime helped active management become more popular in ETFs, the outsized performance by ARK Invest and star manager Cathie Wood likely encouraged issuers to pursue the framework.

The rise of active ETFs—whether by investor demand or ETF issuers launching in this format—may also stem from ideas that indexes may not stand up to the current unusual market conditions, even though history shows that actively managed funds rarely beat indexes, Rosenbluth suggests.

He contends that investors may believe active is a better option after seeing ARK’s 2020 performance, or they could be comparing actively managed fixed income ETFs that are benchmarked to the Bloomberg Barclays Aggregate. Most of the money that’s outperformed an index is in active ultra-short fixed income ETFs, he notes.

“I think investors are using recency bias,” Rosenbluth said.

The rise in actively managed ETFs also demonstrates that ETFs are the investment vehicle of choice for more investors.

“If a lot of asset managers want to remain relevant to advisors in particular, they have to move to this format,” explained Johnson. “Because it’s a format that just works better for today’s advisor who isn’t tied to a big broker-dealer.”

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