PRMIA on ETFs #1 – Index-Based Approaches for Risk Management in Wealth Management
April 23, 2013
It seems to be ETF week for events in New York this week, one of which was hosted by PRMIA, Credit Suisse and MSCI last night called "Risk Management of and with ETFs/Indices". The event was chaired by Seddik Meziani of Montclair State University, who opened with thanks for the sponsors and the speakers for coming along, and described the great variety of asset exposures now available in Exchange Traded Products (ETPs) and the growth in ETF assets since their formation in 1993. He also mentioned that this was the first PRMIA event in NYC specifically on ETFs.
Index-Based Approaches for Risk Management in Wealth Management – Shaun Weuzbach of S&P Dow Jones Indices started with his proesentation. Shaun's initial point was to consider whether "Buy & Hold" works given the bad press it received over the crisis. Shaun said that the peak to trough US equity loss during the recent crisis was 57%, but when he hears of investors that made losses of this order he thinks that this was more down to a lack of diversification and poor risk management rather than inherent failures in buy and hold. To justify this, he sited an example simple portfolio constructed of 60% equity and 40% fixed income, which only lost 13% peak to trough during the crisis. He also illustrated that equity market losses of 5% or more were far more frequent during the period 1945-2012 than many people imagine, and that investors should be aware of this in portfolio construction.
Shaun suggested that we are in the third innings of indexing:
- Broad-based benchmark indices
- Precise sector-and thematic-based indices
- Factor-based indices (involving active strategies)
Where the factor-based indices might include ETF strategies based on/correlated with things such as dividend payments, equity weightings, fundamentals, revenues, GDP weights and volatility.
He then described how a simple strategy index based around lowering volatility could work. Shaun suggested that low volatility was easier to explain than minimizing variance to retail investors. The process for his example low volatility index was take the 100 lowest volatility stocks out of the the S&P500 and weight by the inverse of volatility, with rebalancing every quarter.
He illustrated how this index exhibited lower volatility with higher returns over the past 13 years or so (this looked like a practical example illustrating some of the advantages of having a less volatile geometric mean of returns from what I could see). He also said that this index had worked across both developed and emerging markets.
Apparently this index has been available for only 2 years, so 11 years of the performance figures were generated from back-testing (the figures looked good, but a strategy theoretically backtested over historic markets when the strategy was not used and did not exist should always be examined sceptically).
Looking at the sector composition of this low volatility index, then one of the very interesting points that Shaun made was that the index got of the financials sector some two quarters before Lehman's went down (maybe the index was less influenced by groupthink or the fear of realising losses?)
Shaun then progressed to look a short look at VIX-based strategies, describing the VIX as the "investor fear guage". In particular he considered the S&P VIX Short-Term Future Index, which he said exhibits a high negative correlation with the S&P500 (around -0.8) and a high positive correlation with the VIX spot (approx +0.8). He said that explaining these products as portfolio insurance products was sometimes hard for financial advisors to do, and features such as the "roll cost" (moving from one set of futures contracts to others as some expire) was also harder to explain to non-institutional investors.
A few audience questions followed, one concerned concerned with whether one could capture principal retention in fixed income ETFs. Shaun briefly mentioned that the audience member should look at "maturity series" products in the ETP market. One audience member had concerns over the liquidity of ETF underlyings, to which Shaun said that S&P have very strict criteria for their indices ensuring that the free float of underlyings is high and that the ETF does not dominate liquidity in the underlying market.
Overall a very good presentation from a knowledgeable speaker.