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Overcoming Hurdles in ETFs

Andrew Gogerty

Andrew Gogerty: Think of the ETF wrapper as a technology, not an investment, when considering ETF managed portfolios. Hi. I'm Andrew Gogerty, ETF managed portfolio strategist for Morningstar. The ETF, when viewed as a technology, allows for quantitative analysis across multiple asset classes, sectors, and even geographies, in a very cost-effective manner. Joining me today for insight into how this is being done in practice inside a strategy is Dr. Gerald Buetow, portfolio manager of the sector, opportunistic, and country rotation strategies at Innealta Capital.

Dr. Buetow, thank you for joining me today.

Gerald Buetow: Thanks for having me.

Gogerty: So, quantitative analysis allows for great scalability. A firm builds an investment model, they could very easily apply it to sectors, geographies, fixed income, almost any gamut of asset-class combinations. How should advisors be looking at firms to make sure that they are not trying to be everything to anyone? How do you stay inside your circle of confidence when you have that leverage from quantitative analysis?

Buetow: Well, I think, foremost you must realize what the underlying theory and the concepts are that we use to develop the model. I think as quants and Ph.D.s and physicists, we have a tendency to decouple from the underlying theory and get caught up in the statistics and any kind of metrics and move away from what our overall objective is in trying to find a discriminator between risk and return across asset classes. So, I think just a reality check and reminder. You can't be everything to everyone.

I mean, what we do is fairly simple in theory, and it's a very basic hypothesis, and that is, when we look at individual equity exposure, not at the corporate level, at some sort of aggregate level--because we don't feel that if you get to a level of too much granularity, you're starting to pick stocks and you're starting to look at unsystematic risk, we don't think anybody can do that consistency for a terribly long time. What we look at is our beta duration decision, that is, does the beta exposure look more attractive than the duration exposure in any particular point in time.

So, our hypothesis is when we feel that beta exposure, beta being equity, looks more attractive on a risk-adjusted basis, and a particular fixed-income exposure that we feel is optimal at that point in time, then we will put that beta on. We do not in any way, shape, or form pretend to be experts in commodities. We get questions all the time, "Why don't you just apply it there and apply it there?" Well, because the underlying theory has always been a beta-versus-duration hypothesis. So, we could develop models in theory that would look at commodities and look at other risky exposures. The difficulty with that, of course, is that you need a valuation metric or framework, or supposed framework, right.

I don't think valuing equities is a particularly easy task. But I do think looking at beta and looking at aggregate equity exposure and determining whether or not that is a worthwhile investment at any particular time--not that it's easy--I do think tactical calls are far more important, first of all, than determining what particular equity pieces you want. I think most literature would agree with that.

The commodities space, and these other alternative spaces, there is no underlying valuation metric. There is no perpetuity of cash flows. There is no discount rate. It's a supply and demand. There is short-term and there is long-term types of effects. If you look at even interest rates or currencies, there is equilibrium effects, and then there is transitionary effects. Those are extraordinarily complicated and I think impossible to model consistently. But when you have a valuation metric, a way to look at beta in terms of how much did you spend and what are you paying for, and you compare that to what you can get in the fixed-income market, intuitively it makes sense. So we built a very sophisticated model really in an effort to try to look at that hypothesis in many dimensions, looking at the macroeconomic backdrop, the fundamentals, and so on.

I don't think you can do that consistently looking at other asset classes. Not to say that other people don't do it well, it's just not what we do. I think sometimes hubris seeps in and you say, "Well, heck, there is demand for a product, we think we can get that client if we are able to do this." That's where you start moving off the reservation, and I think we’ve been very careful to make sure that our product development matches what we are good at.

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Gogerty: Sure. Well, let's get into that sector and that country rotation product. Obviously, Innealta’s process evaluates the different sectors or the countries individually, and kind of makes a binary decision, should those sectors or those countries be in and out, kind of judging them on their own merits. Obviously, if it's not the beta, then you said it's the duration, which the out position is fixed income. How is that discussion evolving with advisors, where it's not necessarily a Morningstar Style Box investment, it's more a returns-based analysis investment? Because, I could see country rotation or sector rotation, half the portfolio could be in fixed income at any specific discrete point in time. So, how is that discussion evolving with advisors building portfolios, looking past the style-box holding and more towards a returns-based analysis framework.

Buetow: The style-box framework and perspective has been a tremendous hurdle for us. I think classically up to a few years ago, everybody wanted to put you in one of the nine boxes, thanks to you guys. I think that there is a place for the style box and its evolution, the genesis of it was very important. With the evolution of the ETF market, I think the ability to alter styles in real time has made that style box a little bit arcane. In the sense that, you can find one manager now who can move across all those styles with great fluidity. That's taken the market, I think--the market being the inventors and the advisors space, and on the institutional side as well--a little bit of time to get used to, if you will. And it's been a tough sell.

I mean, we started this in 2004 coming up with the multiasset product in our risk-based products. And then we have the country rotators, and the sector rotator, as well. It's been a problem. Now, it really is not an issue whatsoever. I think people accept the ETF market as a very effective and efficient way to get exposure to asset classes with great accuracy, efficiency, and transparency.

So it has not been an issue in the last couple of years, I think, particularly if you go back and look at the performance when times were bad and the market tanks and so on, the ability to move in and out of styles, if you will, really I think came to the fore, and risk management came back into the lingo. When market goes like it has been the last couple of years, it goes on a trajectory, people have a tendency to forget about risk. We take risk very carefully. So, I think the idea of migrating across the styles and migrating across the exposures quickly with transparency is not something that folks look at now as it used to be walk into an office and say, what box are you in, and a lot of the online programs will be "which box are you in" to get clients.

Now, I think they put you in multiple boxes, if you will, because they realize that you can migrate across the risk spectrum with great ease. So it’s not a hurdle anymore. It was absolutely a hurdle, and it's still a hurdle to some degree on the institutional side because you have a mandate, which is a particular box, and if you don’t fit in that box by the way they defined it--and some people define those boxes differently. Return-based style analysis, as you know, is a statistical process that can have high standard errors from time to time. Holdings-based analysis is dated, so it's a little bit backward-looking. So I’ve always had difficulty with wanting to be categorized as a certain style manager, and I think that's become really a problem of the past quite frankly.

Gogerty: You had talked about risk and institutions, and maybe taking a step back and looking at a portfolio holistically instead of the boxes. One of the things that your opportunistic strategies use is leveraged ETFs, and they have gotten, for lack of the better term, their fair share of press in recent years. How is that discussion with advisors? So maybe the start off, why use leveraged ETFs in your risk-based strategies? Because you have the strategies available without the leveraged ETFs and with them. So the first question would be, why use them?

Buetow: Well, plainly, it offers up a wide spectrum of alternative exposures that we wouldn't normally have collateral to deploy to. For example, we use the tripled equity ETFs Direxion products throughout our risk-based opportunity funds, and we can deploy that excess collateral where we think we can add value. We do it in a risk-adjusted matter. We don't take these unconstrained bets across the alternatives space or anything. For example, back in '08 and '09 when these products started to come out, there was tremendous opportunity in the fixed-income space. We were underweight and we were overweight fixed income, and that was fantastic. We had an overweight to high-yield when the spreads were just crazy, and we rode that train all the way till very recently.

As these products started to become more liquid--and I come from a derivatives background, I understood them and I understood their strengths and their weaknesses--I said, this is an opportunity to build what I think would a really cutting edge product and fortunate enough to be part of a group that would say this is a great idea, we should do it. And it allowed us to overweight high yield, it allowed us to overweight the credit space, where it paid off tremendous dividends for us, both literally and figuratively.

Now, we have the opportunity to deploy that collateral in a way where we can go into the commodities space if we think, like the sell-off in gold, for example, offers opportunities. Gold miners offers us an opportunity. We think risk is being mispriced, so we can go in and buy volatility in the ETF space. So, it does two things. It offers us to better create or better produce a product that offers a fantastic risk/return trade-off for the investor inside what they would normally expect in a multi-asset-class portfolio. And as importantly, it allows us to leverage the growth of the ETF space and take advantage of opportunities that I think are there. I think we would be doing the client a disservice by not having at least one product, or series of products in this case, that allows us the facility to exploit all the opportunities that are out there.

Now, of course, you want to do it smartly. In the ETF space you get lots of exchange traded funds that folks are just throwing ideas against the wall and seeing what's going to stick. And there is a fair amount of attrition from year-to-year that either they are poorly managed or they were just a bad idea and or nobody understood the underlying index. People are now creating indexes and then creating ETFs on them, so you have a double unknown. We are pretty plain-vanilla; we want to make sure we understand what the underlying is doing. We want to make sure that the ETF has sufficient liquidity and meets our standards of the ability to get in and out.

So we do quite a bit of due diligence, and these are just simply derivative-based products. They’re swaps, totally-return equity swaps, and we realized that they are not going to track the index on a total-return basis through time, but they will on a day-to-day basis. So we just have to manage that rebalancing process little bit more carefully, which we think is pretty simple to do. But it opens up the playbook for phenomenal opportunities. Again, you have to be smart about risk. You don't want to be taking silly bets. For example, we have been in and out of volatility this year. We have been in and out of short positions in Europe. We have been in and out of the gold miners, because they have been taking a beating and coming back up and going back down. We just do it smartly, and we dollar-cost-average in when they really go down, and they are so liquid, getting in and out, and even in large positions like we have, we have a good trader. It's just a win-win for everybody.

We're looking quite frankly to be able to add a little bit more of that in our rotators as opposed to just having fixed income, is the possibility to be put on small exposures across either risk or maybe the gold miners or small short positions when we think things have gone up far too quickly. So it’s just really taking advantage of the ETF market fully, and also allowing us to develop a product that meets our investment objective and does it in a smart way, but offers us the opportunity to add a little more alpha to the product. So far, knock on Formica that it will continue, but I think it will. I think that we have a very good investment committee. The ETF space is exploding in areas where I think it needs to explode. I think it needs to spend a little more time on the credit side, on the fixed-income side. We don’t need seven equity ETFs to do exactly the same thing.

Gogerty: Right. Going into the equity, let's talk about your equity and country-rotation strategies a little bit. Those exposures have actually been out. You had mentioned fixed income. They have actually been out and have actually been dominated by fixed income or duration exposure, as opposed to beta exposure in the equity market for some time now. What are one of the two factors in your models that have kept, I don’t want to say kept them on the sidelines, but kept them out of their primary beta driver, whether that be sector exposure or country exposure? What if the models from a quantitative basis said, these are the reasons why those portfolios have been dominated by your fixed-income exposure recently?

Buetow: Sure. Over the last couple of years you've seen the fixed-income markets have done extraordinarily well. You've gone from nominal levels and nominal spreads to very low nominal levels and tight spreads, and that's offered a lot of capital appreciation in the portfolio. So, as I said earlier, our hypothesis is always a beta-versus-duration hypothesis. If we think we can get a very good expected return per unit of duration, that's a higher bogey to beat for the equity markets. So when we're in an environment where we think spreads are 10%, 12%, 14% in high yield, 5%, 6% on investment grade, that's a pretty steady return to give up in order to get into equities, particularly given the macroeconomic backdrop at that time.

So part of our dynamic has been that the fixed income has been relatively attractive. That has degraded over the last two years. We're at a point now where we're not that bullish on fixed income. Actually, we think that the possibility of a bear steepener, a significant bear steepener, is a scenario that has a very high probability, in our minds, in the next year or so. We’ve made those adjustments to our fixed-income portfolio. At the same time, we have seen, in our view, a very suspect underlying organic support for equities. We think it's primarily a monetary policy phenomenon, and we would like to see better fundamentals, better top-line growth, better dynamics of those earnings yields and dividend yields. There's nothing secret about the metrics that we look at. We look at them in an econometrically proprietary manner. But the intuition is the same, and any of the analysts here would say that makes perfect sense. They've been relatively flat to deteriorating over the past few years. So we would have to see those materially change in an upswing.

We're looking at a concave sort of phenomena, where the fundamentals are declining, and in a world where fixed-income had looked OK to actually very attractive, clearly those trade-offs were pretty easy to make. Now the fixed income is not looking terribly good. So we're actually much closer to getting beta exposure than we have been in the past couple of years, and everybody asks that question. The beta dynamic has been fairly active in the last couple of years. We've gone from zero to 30, back down to zero, back to 30, that kind of thing, and they've become short term, because we've timed it well. We've seen a general flattening, say, of the fundamentals. The technicals have become extraordinarily strong. With macroeconomics, there's been a lot of oscillation in the macroeconomic backdrop. So we got to the point where we became momentum traders for short periods of time because we were sort of neutral across the secular metrics that we look at, which is, of course, we look at fundamentals, we look at risk, and we look at the macroeconomic backdrop.

When those are sort of break-even, technicals become the decision-maker. So we're in a situation where we see this tremendous trade-off and a little bit of an uptick, technicals sort of turn around and we're neutral. So this might be a buying opportunity that we get in. What happened last time we did that, we went in pretty significantly, we ended up getting out in less than a month, because they all appreciated double-digits in 30 days and said, this is a pretty good profit. Let's book it and put it back into fixed income. So we're closer now to adding beta. Particularly in emerging and some of the Asian countries, you're seeing a flattening. Some of the dynamics are either sort of neutral to turning positive, and again we have this numeraire now on the fixed-income side, which is not nearly as attractive as it has been historically. So, beta is not as far, far away as it might have been a year ago, if you ask me that question. I'd say I wouldn't be surprised in the next year or so particularly if there is valuation adjustment in any of these markets that you could see us going anywhere from 30%, 40%, 50% in equity pretty quick. At the end of the day, that's the beauty of what we do, of the ETF market is. Literally, we are going to have an investment call in the morning, have talked about it all week, trader on the phone pre-market and say, "Look, this is what we are doing today, and by the end of the day, we have a 40% equity exposure."

Gogerty: That goes back to the ETF as a technology allowing you to gain that access…

Buetow: Absolutely.

Gogerty: In a very cost-efficient way…

Buetow: Absolutely.

Gogerty: Then historically you would have had to move hundreds or even thousands of securities in a country portfolio to get that type of exposure.

Buetow: That's right, and think about the leverage. We just published a number of pieces in the leveraged and the cash create ETFs, and the tracking error is not as clean as it is in the in-kind ETFs. But at the end of the day we say, well, what's the alternative. I remember 1995 where we wanted to get emerging-markets exposure when I ran institutional money, it took us literally weeks to get that exposure. Now, there might be a little bump. We might have to pay a little bit of a premium to get it, but you can get it in the span of an hour, right, and that tracking error may not be perfect because of market timing, currencies issues, and things like that, and the ability for the market maker to be able to hedge their position. But a tracking error of 50 basis points for the ease to get in and out tens of millions of dollars in an hour is--I think, the ETF market is the single most important development in the investment universe since the mutual fund, and interestingly, I think the ETF is going to wipe out a lot of mutual funds.

Gogerty: Good. Well, thank you for that perspective today. Always insightful, especially around the quantitatives. I appreciate your insights.

Buetow: My pleasure.

Gogerty: This has been Andrew Gogerty with Morningstar along with Dr. Gerald Beutow from Innealta Capital. For more information on ETF managed portfolio strategies, please visit Thank you for joining us.