Monetary policy, volatility and interest rate regimes, among other factors, have caught the attention of money managers offering exchange-traded products. With institutional investors now willing to expand their ETP holdings beyond market-weighted index funds to fundamental and factor-based strategies, fund sponsors have introduced more products with embedded, programmatic hedges.
The most prominent — currency-hedged ETPs — now hold $12.9 billion in assets across 15 funds and three issuers, according to research firm XTF Inc. The funds track indexes that are fully hedged against short-term exchange rate spikes in specific non-dollar assets, most prominently the $11.1 billion WisdomTree Japan Hedged Equity Fund and the $698 million Vanguard Total International Bond ETF, a share class of an $18.1 billion fund launched on May 31.
Yet, as investment offerings wander from the liquid market for currency futures and forwards for their hedges toward swaps and exchange-traded notes, the newer products have been slow in catching on.
For institutional investors, recent ETPs factoring in volatility or interest rate hedges are still low in both assets and liquidity. And to incorporate them requires either an adjustment of an overlay or shifting assets from both a long portfolio as well as an absolute-return allocation.
ETPs explicitly targeting exposure to CBOE Volatility Index futures offer a variety of terms — daily resetting and total return, long, short, leveraged and inverse leveraged — but remain niche products with just $2.7 billion in assets across 17 offerings from Barclays, VelocityShares and ProShares. Fund and notes layering a volatility hedge on top of a standard stock index have found even less acceptance. Some products even have complex rebalancing formulas.
The $598 million ETN+ S&P VEQTOR ETN from Barclays Bank PLC, for example, tracks an index that is long the S&P 500 total return but dynamically adjusts an allocation to VIX futures and cash. The ETN, which has 4.1 million notes outstanding, has a 0.95% annualized fee. Offerings with similar goals, but different strategies to achieve their results — include the Horizons S&P 500 Covered Call ETF and the VelocityShares Volatility Hedged Large Cap ETF.
Dave Shore, partner at Marin Financial Advisors and a trustee of the Marin County Employees' Retirement Association in San Rafael, Calif., said that including a hedged ETP can amount to “smart risk control” but requires a thorough analysis of what asset classes — bonds, equity or absolute return — using the hedged ETP might require a manager to adjust.
Packaged strategies such as these often blur the lines between specific mandates, blending long exposure and aspects of absolute-return or market-neutral strategies. Similarly, some of the products will use VIX ETNs and swaps interchangeably to achieve long or short volatility exposure.
Mr. Shore, whose firm advises on more than $300 million for defined benefit plans and retail investors, believes the hedged ETPs are attractively priced relative to funds of funds and more complicated absolute-return strategies. Still, institutional investors tend to wait for a fund to reach at least $1 billion in assets before allocating to a new product except in cases where they participated in the genesis of the fund or note (Pensions & Investments, Aug. 19).
On the credit side, ETPs from Van Eck Global and ProShares feature interest rate “hedges” — shorting Treasuries or selling futures — to isolate exposures in high yield and investment-grade corporate bonds, thereby eliminating duration and isolating only credit. (Credit spread ETFs looking to use swaps in the strategy have been in registration for several years, but have not yet launched.)
“Hedged strategies make sense when the cost of the hedge is manageable and investors are left with a potential return that is attractive,” said Fran Rodilosso, fixed-income manager for MarketVectors ETFs, a unit of New York-based Van Eck Global.
In 2013, however, investors have opted to simply reduce duration by moving money into shorter duration products and floating-rate note funds rather than hedge out the risk-free aspect of higher yielding longer-term credits.
Through September, fixed-income funds ETPs with duration less than 3.5 have seen $29.5 billion in net flows according to San Francisco-based research firm IndexUniverse, whereas longer duration funds have seen a net $19 billion exit the funds. n