Passive investments are set to encroach further onto the turf of active managers as exchange traded fund issuers mull the development of new products that take long and short positions.
ETFs offering exposure to individual risk premia are viewed as a likely starting point for the development as existing long-only funds tracking strategies such as value, momentum and low volatility, typically carry a higher market beta than the long/short strategies that underlie 30 years of academic research.
“Most academic literature to isolate risk factors has been done with a long/short methodology and even though it still makes sense in a long-only structure, performance tends to be a bit diluted,” said Ben Seager Scott, director of investment strategy and research at Tilney Group.
“There’s a lot of focus on absolute return strategies and it wouldn’t be surprising to see a passive equity long/short product in the next year or so.”
While UCITS rules permit short positions, the development would require a shift towards swap-based replication that has been largely eschewed in favour of funds backed by physical shares. Following a long-running industry debate spearheaded by large physical ETF providers such as BlackRock’s iShares, much of the synthetic ETF market has already transferred to physical replication.
“Creating a long/short ETF structure presents challenges as there’s still a clear investor preference for physical funds and that has a knock-on effect for IFAs, which are reluctant to buy synthetic products,” said Seager Scott.
A synthetic structure may not be an insurmountable hurdle for the largely sophisticated investors that are eyeing long/short exposure, however. Swap-based replication is becoming more common in new ETFs tracking more esoteric markets where counterparty risk may be preferable to liquidity risk.
“For long/short ETFs, you have to be synthetic and more sophisticated investors are comfortable with that as they understand UCITS rules that require collateral to back the swap,” said Howie Li, executive director of ETF Securities. “They also realise that stock lending happens in physical ETFs, which can create the same counterparty profile as a synthetic product.”
HEDGE FUNDS
For investors keen to reduce the market beta of their long-only factor exposures, typical strategies would be to enter into a long-only ETF and short the wider market through listed futures. It is a method that sophisticated investors find efficient and some ETF issuers believe the strategy is preferable to additional complexities that may created by the creation of long/short products.
“A long/short strategy on factors is a sensible proposal and makes sense if you trust the long-term outperformance of the factor, but it’s a very different risk profile compared to long only portfolios,” said Vincent Denoiseux, head of quantitative strategy for passive at Deutsche Asset Management.
He said the behaviour of a long/short value factor strategy, for example, will dramatically differ from that of a long-only value strategy.
“Long-only factors make sense as part of an equity portfolio, whilst long/short is really more of a hedge fund building block and should be considered as an alternative asset,” said Denoiseux. “If you buy something that is essentially a hedge fund, you may not get the full upside benefit when the market goes up.”
The emergence of long/short factor premia has been touted for more than two years. Analysts at Nomura said in 2015 that expected 7.5% returns for US corporate pension plans would require an industrial scale emergence of long-short passive strategies.
The analysts said hedge funds were unlikely to capture a large part of that flow after CalPERS opted to divest from hedge funds and a review of 89 UK local authority pension schemes highlighted the large portion of fees being paid to hedge funds despite low allocations.
“Hedge funds have had a tough time and in a low rate environment investors have got to look at other sources of return,” said Li.
“There’s certainly a place to be long undervalued stocks and short overvalued stocks, but the issue is the increased risk. Long/short strategies can be risky if the long and the short call is based on the same reasoning. If that reasoning turns out to be incorrect, the risk is leveraged compared to a long-only trade.”