A couple weeks ago when I wrote about my evolution on asset allocation I said that I’ve learned a lot on the topic from Wes Gray and Jack Vogel at Alpha Architect. I’m in the middle of handling a new set of twins, but last week I had a chance to chat with these two to discuss their new Value Trend Momentum Index and the associated ETF that seeks to track that index. Their new ETF already has over $17mm and was launched on May 3, 2017.
I like checking in with Wes and Jack every once and a while because I always learn something from our conversations. The discussion that follows lends some interesting insights into the liquid alternatives space, innovation in the ETF space, and the mechanics of implementing trend-following strategies inside an ETF investment wrapper.
Why do you think so many liquid alts have struggled? Is it because we’re in a bull market or are there other problems in this space?
Ben, first off, we want to congratulate you on the birth of you new twins. You literally will have your hands full from here on out. We also want to say thanks for giving us this opportunity to help investors better understand what we are doing with our new strategy. Anything we can do to help empower investors through education is a welcome opportunity.
So on to your question…
One key problem with liquid alternatives is they are often too expensive, have poor tax-efficiency, and/or are too complex. These are solvable issues and can be addressed by the ETF industry.
The other big issue is the “bull market” problem you mentioned, and this has to do with a lack of investor education and discipline. For instance, in conversations outside of our fellow finance geeks and PhD-types, we notice that some investors who dip their toe into alternative investments don’t really understand the expected return profiles of the alts. Initially they love the idea — add diversifying risks to a portfolio and smooth the ride associated with buy-and-hold equity. But they quickly forget these concepts throughout a long bull market, and expect their alt investments to beat the S&P 500 Index every year, when, by construction, these alternatives are not even designed to “beat” the Index.
Consider a value-focused long/short equity liquid alt strategy: the expected return on this strategy should be roughly equal to the equity market return multiplied by the beta of the long/short portfolio, plus/minus the “alpha.” For argument’s sake, “alpha” simply reflects the unexplained, which could be attributable to unique risks, systematic mispricing, or noise. (Note: alpha is often in the eyes of the beholder and depends on the factor model chosen).
Let’s assume this L/S alt has an expected 1% alpha and the beta of the portfolio is 0.30, in other words, the long/short strategy has roughly a 30% market exposure. Over a certain time period, let’s assume the market earns 10%—the long/short strategy should be up around 10%*0.3 = 3% plus an assumed 1% in alpha—ending in a grand total average return of around 4%. This strategy has arguably been successful, given risks incurred. However, this strategy still underperformed the market by over 6%!
In theory, investors should be sophisticated enough to identify that the liquid alternative product was effective, given the risk exposures. Financial advisors usually understand this element of alternative investing. However, the reality is that investors in a bull market (or the clients of financial advisors) naively compare everything to the best performing long-only benchmark (e.g., S&P 500 Index Fund) and often get frustrated when the “expensive alt” doesn’t beat the Vangaurd S&P 500 Fund that they can purchase for almost nothing. So while investors may be looking to add uncorrelated or “alternative” exposures to their portfolio, they need to fully appreciate the role that alternatives play in a portfolio. And the role of alternatives is not to beat the S&P 500 Index every year. In fact, on an absolute basis, most alternatives should underperform generic equity indexes over the long-haul because they have less market exposure.
Why did Alpha Architect make the leap into the liquid alts space?
We’ve been in the alternative space since the beginning. In fact, before Alpha Architect existed, Wes launched a long/short equity hedge fund in September 2008 (good timing!). Alpha Architect has also been researching and implementing various alternative strategies for the past several years. This is really our first public leap into the liquid alternative space. We made the leap because we were interested in creating a tax-efficient liquid alternative product that combines the three factors we believe in: (1) Value, (2) Momentum, and (3) Trend. We use Value and Momentum for the security selection portion of the portfolio—the idea here is to purchase what we consider to be the top ~50 US Value stocks, the top ~50 US Momentum stocks, the top ~50 Developed International Value stocks, and the top ~50 Developed International Momentum stocks. So in total, the underlying equity portfolio is usually around 200 stocks, and accessed by holding our four underlying ETFs (QVAL, IVAL, QMOM, and IMOM).
The final ingredient for our Value Momentum Trend ETF is a trend-following layer. We use long-term trend-rules to hedge the portfolio’s beta. The two rules are a 12-month moving average rule and a 12-month time-series momentum rule (the two are related but not the same). The rules are assessed separately to the US and International portions of the portfolio. (Here are some details on our trend-following concept).
If the trends are positive, the beta is ~ 1; when the trends turn negative, we can hedge the portfolio and can bring the beta down to ~ 0. This dynamic switching of the portfolio (assessed monthly), from having a beta of ~ 1 in trending markets, to having a beta of ~ 0 in bearish markets, is somewhat unique in the liquid alternatives space (Cambria, Pacer, and Alpha Clone are a few others). Compared to other long/short equity strategies where the beta is static (normally 0.5 or below), our beta is dynamic—this is a point of differentiation for this strategy compared to other products in the space.
Where do you see a fund like this fitting into a broadly diversified portfolio?
It depends on the investor’s goals and beliefs. We also feel it is important that investors spend a substantial amount of timing understanding the research behind our approach to value, momentum, and trend, before jumping into this product. Our strategy is totally transparent, but it is simultaneously fairly sophisticated and built for long-horizon investors with a high-level of discipline.
There are two primary audiences. First, for those investors who are fans of the ardent believers in the three factors — Value, Momentum, and Trend — this vehicle can be a core part of the equity portfolio, since the program is meant to deliver global value and momentum equity premiums, but with a trend-following system that can help minimize tail risk. However, the portfolio is expected to deliver a lot tracking error, especially compared to the S&P 500. The tracking error relative to the S&P 500 comes from 3 part of the portfolio: (1) the portfolio is roughly 50% US and 50% foreign developed stocks, (2) the portfolio invests heavily in Value and Momentum stocks, and (3) the portfolio uses trend rules which can make the portfolio have a beta of 0 at times. Advisors and investors need to understand this tracking error. Most investors should consider this strategy as either their (1) “alternative” bucket within the portfolio or (2) the “satellite” portion of the equity portfolio (in conjunction with low-cost core beta holdings — see here for an explanation).
Can you explain why you chose to allocate to your underlying funds using a risk parity-type of approach? What are the pros and cons of this method?
We use a simple risk parity approach (see risk parity for dummies) to balance the risk exposures across value and momentum. We do this because our focused momentum strategies can be substantially more volatile than our value strategies. Equal-weighting is also a fine approach, but one ends up overweighting momentum versus value. We’d prefer to keep the two exposures roughly balanced. The downside of volatility-weighting the positions is an added layer of complexity, but our approach is 1) simple, and 2) annually rebalanced to minimize the noise/frictional costs of complex allocation strategies. In general, investors can expect to see a small dollar-weighted tilt towards value. For example, the value exposure might be 55% and the momentum exposure might be 45%, whereas an equal-weight approach would sit at 50/50.
How much does the fund wrapper (ETF vs. mutual fund) matter with a strategy like this?
The wrapper is important for the investors we serve, which are typically tax-sensitive long-horizon investors. As many investors know, ETFs have tax advantages over other investment vehicles (e.g., mutual funds, hedge funds, or SMAs). We are able to minimize taxable distributions inside the ETF structure, which allows long-term investors an opportunity to compound their capital on a tax-deferred basis. For those who consider taxes as a real cost of their investment approach, there are compelling reasons to deploy active strategies inside an ETF vehicle.
How does the use of shorting index ETFs impact the fund from an operational perspective? Is there anything investors need to know about the use of shorting other ETFs in an ETF?
From an operational perspective, the fund will always be long underlying securities (in our case, long 4 ETFs) and has the potential to be short index ETFs (for the US and developed markets) if the VMOT index trend-signals are triggered. For those who follow the hedge fund lingo, we can essentially shift between a long-only stance, a long/short stance (e.g. partially hedged), and a market neutral stance (fully hedged). When we are in a hedged stance the fund needs to post a portion of the underlying assets as collateral in order to open the short position (for example, short SPY). The details of how this works are fairly complex, but we encourage anyone interested in understanding the details to read what follows.
A trend rule triggers and we now need a short position to hedge our long book. What happens next? Let’s say that the fund owns four ETFs that are fully paid, and the value of the fund is $100. If the fund wants to short $100 of an index ETF, the fund can use the long ETF positions ($100) as collateral to open a short index ETF position. In this case, assume the fund has (essentially) $0 in cash.
How does this work, and what are the costs?
To open the short position, the Prime Broker will assess the collateral and decide the margin requirement. We access what is referred to as portfolio margin (as opposed to Reg-T margin), which accounts for portfolio characteristics when assessing margin requirements. This is important in our context because the margin requirements to enter a short position, which is negatively correlated with our long positions, means that our margin requirements will often be much less than 50% (Reg-T requirement). Let’s say the prime broker determines that the margin requirement to hold the short position is 20%. In this case, the fund would need to borrow $20 ($100*20%) from the prime Broker, and will pay an interest rate on this borrowed amount. The interest rate is typically, Borrow Rate = Fed Funds + markup, where the markup ranges across brokers.
Once the prime broker determines there is the necessary collateral in place, the fund can initiate the short ETF position, and will receive $100 in cash from the short sell. The fund will pay a cost to borrow the position (often called the short rebate) to maintain the position (SPY is around 30-35bps/year), but the fund will also receive interest on the $100 in short proceeds. The interest rate received on the short position is typically the fed funds rate minus some haircut.
So in total, the carry cost to the fund to initiate the short position is given below:
Cost = (Margin Requirement %)*($100)*(Fed Fund Rate + Markup) + (Short Rebate Cost) – ($100)*(Fed Funds Rate – haircut).
Let’s say the margin requirement is 20%, Fed Funds is 1%, the markup/haircut are 50bps, and the rebate is 30bps. The overall carry cost of the short position will be as follows:
Annual Costs = 20%*$100*(1.5%) + $100*0.30% – $100*(0.50%) ~ 0.10% or 10bps.
In other words, there is a 10bps negative carry for holding the short position. In general, with higher interest rates the carry becomes more positive and with lower interest rates, holding a short position will have negative carry.
Last, it should be pointed out that the fund, like any other fund that engages in short-selling or other derivative transactions, does take on some counterparty risk by employing such a strategy.
What are some of the misconceptions about the use of trend-following rules?
We think there are two main misconceptions.
The first misconception is that trend-following is a voodoo science and “doesn’t work.” This is the main conclusion when statistically analyzing a buy-and-hold portfolio relative to a trend-followed portfolio. For example, the t-stats for differences on monthly average returns are unlikely to be different and may even favor B&H in many samples. The Sharpe ratios may also be worse than those of B&H. These facts often lead many researchers to suggest trend-following is futile and this is without considering transaction costs and taxes.
There is a lot of truth to the arguments above, however, the goal of trend-following is to minimize large drawdowns, not necessarily maximize returns. In our post here, we examine the historical returns associated with a variety of asset classes and sample periods using either B&H or trend-following techniques (Time Series Momentum and Meb’s piece are great papers on the subject). While in some instances the investor would have achieved a lower return from the trend-following portfolio compared to the buy-and-hold portfolio, for all asset classes and samples examined, the drawdown was greatly reduced—which is the goal of trend-following. Will these rules continue to provide tail protection in the future? Nobody really knows. However we believe investor psychology will likely provide chart patterns that slowly grind to the upside during bull markets, but crater at a rapid rate during bear markets. Long-term trend-following rules will likely be successful in these environments.
The second misconception is that trend-following is a perfect solution. Many who read articles highlighting the benefit of trend-following (in the past they helped reduce drawdowns for five asset classes) fall in love with the idea without fully understanding how the rules work. There are at least three negatives to using such rules, which get highlighted by those who claim trend rules are heresy.
- First, there can be negative tax consequences by using such rules (ETF wrappers can help minimize the burden, but can’t eliminate it).
- Second, the rules can’t prevent “flash crashes,” such as the October 1987 market.
- Third, there can be negative whip-saw events caused by using trend-following rules. This occurs when a trend-rule signals to get “out” of an asset class, and the prices subsequently turn positive. Recent examples of this were experienced in the U.S. equity market. At the end of both September 2015 and January 2016, both of our trend rules signaled to get out of U.S. stocks due to price declines. The subsequent month returns to the SP500 were as follows (1) October 2015: +8.44%, (2) February 2016: -0.13%, (3) March 2016: +6.78%. Being out of the market for those three months caused an investor using trend-following to miss out on 15.09% of returns!
So for an investor contemplating the use of trend-rules, we recommend that they study the potential negative consequences of these rules.
How important is global diversification when implementing factor-based strategies?
When using factor-based funds in a portfolio context, an investor should always look to diversify the portfolio across the different factors. We believe the combination of Value and Momentum factors can generate the highest level of expected portfolio benefits with the least amount of complexity. We talk about the why and how on our website. There are also multi-factor funds that combine the factors within a portfolio (Corey has some cool research/thoughts on this, as does AQR).
As for international diversification, this is generally done to access a broader opportunity set that isn’t entirely dependent on the US. As we’ve discussed in the past, the US stock market is arguably an anomaly. Moreover, the US market is more expensive (on a P/E or CAPE comparison) than international stocks. So to the extent that current P/E or CAPE levels are predictive or long-term returns, holding a large international exposure alongside a US exposure seems like a prudent approach.
Do you think the ETF-of-ETFs or fund-of-funds are the next big growth segment in the ETF world?
There are certainly a lot of compelling reasons to deploy the ETF of ETFs strategy. The biggest reason is that an advisor / sponsor can make an asset allocation portfolio more tax efficient and simple to access by using the ETF wrapper to deliver the exposure. We’ve seen Meb do that with a few of his strategies (see GAA). You also have the ETF strategists looking at the ETF wrapper as an operationally efficient way to deliver their value proposition to the market without having to manage individual managed accounts. Of course, there are a lot of structural incentive problems and indirect conflicts of issue reasons why financial intermediaries may choose to bypass the ETF of ETF wrapper and stick with traditional managed accounts. Nonetheless, to the extent consumers become aware of the benefits of the ETF structures versus traditional managed account structures, and entrepreneurs decide to disrupt the industry, we could see substantial growth in the ETF-of-ETFs space. Only time will tell.