In my FT column at the weekend I floated how one specialised part of the investment spectrum – structured products – is trying to come up with new solutions to the absolute returns conundrum. Why do I choose the word conundrum? Largely because I think the single greatest challenge to getting more ordinary folk engaged with investing isn’t the potential for upside opportunity – the greed instinct takes care of that impulse. No, the problem is risk. In effect most people are hard wired to fear
- What they don’t know much about (investing) and
- Anything that might destroy their hard-earnt wealth.
I think that we investment commentators are rather dismissive of these fears. We’ve seen the long term studies and tend to think that the ‘risk’ of investing is one ‘worth taking’. Tell that to a young investor in their twenties who’s just managed to scrape together a few thousand spare pounds and wants to maybe boost the size of that pot by investing in stocks and shares. I can shout until I am blue in the face about their long term horizons a as relative youngster but if shares start jumping about, all they see is their home deposit vanishing down an investment black hole. Which is exactly why behaviourally inclined outfits such as Nest – the government auto enrolment pensions provider – have portfolios for young people that are way more conservative than economic theory suggests. Nest’s view is that they don’t want to scare off young investors with a bout of market volatility, and thus a judicious investment in low risk bonds might more sense.
Regardless of your age, the core issue for me, is that the great majority of people regard investment with suspicion. They think it is risky, despite the upside potential, and are unwilling to take the plunge. And even many of those wealthier – and older – investors who do have large amounts of capital, are also risk averse. Again, people like me can scream about volatility being your friend until we are blue in the face and these investors will opt for a smart hedgie with the latest long short strategy.
Which brings us nicely to absolute returns funds. I am no fan of this form of active investing. It strikes me as expensive and in many instances a dangerous form of blackbox thinking. For the last few decades I’ve hunted high and low for any sensible alternatives – which is why I think structured products serve a function.
ETFs by contrast, until recently, have tended to avoid the challenge of designing a fund that can make money in any market. But at an Inside ETFs panel I moderated last month I was struck by one comment from a major issuer – if everyone is so enthusiastic about smart beta, why not include long short in the mix. Much as I wanted to protest that market neutral or long/short is not a factor as such, my panellist was right. Surely going market neutral is just one form of active exploitation of market factors and inefficiencies designed to extract a superior return, but with less risk.
If ETF issuers are going to break new ground, they need to move away from thinking about which new amazing new upside investment opportunity to embrace and think long and hard about investor outcomes – of which controlling downside risk is the real biggie. Already many big houses are deep into the minimum/low volatility maze, coming up with cunning new plans to buy the ‘right’ kind of stocks. But more is needed. Many investors don’t really care about some clever new take on low vol – they want lower risk with upside potential. Which is where absolute returns funds come in, with their expensive promise – with the key innovation being the ability to go long and short. If the passive fund managers are going to really make a dent on the retail market they need to be thinking about not only multi asset class funds but also long/short AR strategies.
There are in fact some long/short and market neutral ETFs but only in the US market. In all I counted about a dozen from various issuers including First Trust which has the biggest issue. But all bar the First Trust fund have AuMs of less than $100m, which makes them dead men walking i.e below economic fund sizes. Also, again bar First Trust, performance has been very sketchy with more than a few providers notching up losses over the last year despite returns of 20% or more from mainstream indices such as the S&P 500.
In sum, some thought needs to be given as to how to develop a proper market neutral strategy for an ETF format. I’m not entirely convinced a ‘straight forward’ long/short of a major equity index will actually work, if only because of the operational issues of going short a long list of stocks.
Perhaps a better way is to run a market neutral strategy using smart beta ideas. i.e go long and short different types, factors and styles of stocks. That’s certainly the idea behind a new ETF out in France called the Amundi European Equity Multi Factor Market Neutral ETF (MKTN). This new fund is tracking an index with six different ‘factors’ or styles of share, with a separate long/short overlay. In practical terms the ETF is using two iStoxx indexes: the iStoxx Europe Multi-Factor Index, which it longs and draws its factor exposure from; and the STOXX® Europe 600 Futures Roll index, which it shorts and gets its market neutral position from, this rebalances on a weekly basis with input from the Sunguard APT model.
So why buy a market neutral fund like this? In a raging bull market, a market neutral fund misses out on huge gains but it also means that during a flash crash or financial crisis, a market neutral fund can avoid huge losses. For MKTN to produce a positive return, one of two things must happen. In an upward-trending market, the multi-factor index must make more money than the money (presumably) lost by shorting Europe 600 futures. Or, in a downward-trending market, the money made shorting Europe 600 futures must exceed what would likely be lost by longing the multi-factor index.
Now, this is a complex creature, no doubt, but looking at data from Stoxx on the underlying index, returns have been fine so far but with much lower volatility – though this data is from an index back test and no substitute for an actual fund. Another key stat stands out – the overall cost of the fund is a reasonable 0.55% which is very low compared to most absolute returns funds. I’m fairly certain that Amundi will have no interest in marketing this to retail investors but it has the makings of an excellent idea – a practicable strategy to implement at low cost relative to other mainstream options. For many defensive investor’s it could end up being a core product, especially in robo adviser land where arguably this kind of innovation is most needed. Expect more to emerge over the next few years as market neutral funds become the next big battleground in retail investing.