ETFs with no fund managers – just logic

The hedge fund industry faces strong headwinds in the coming year or so. For one thing, 2006 was the fourth straight year that it underperformed the markets.

Fortunately for hedge funds, it is all about spin, so here’s what managers can say in their defence: “It’s not about outperformance of the markets, it’s about low volatility.”

Or, “Let’s not forget that in 2001-02 we outperformed the markets each year and by 30 per cent in 2002.”

And they are right. Nobody wants to put all their money in the S&P 500 index funds and watch it go down 20 per cent while their hedge fund brethren are cruising to a mediocre 8 per cent gain.

But the world is a cruel place and underperformance is weak and will be punished by investors. Particularly when you are charging a 2 per cent management fee and 20 per cent performance fee. At some point investors say (and I know because I am one of them): “I want that money back.”

Combine with this the increasing institutionalisation of hedge funds (more and more are being acquired by banks and wobbling along at an obese $5bn in assets or more) and the fact that the bar of assets for investors is being raised to $2.5m from $1m. You’re going to have a hard time staying in business if you are a middling and underperforming $100m hedge fund.

But where will people put their money? No problem. There is a new crop of exchange-traded funds that are very exciting for the retail investor. And these are not your grandfather’s ETFs. They aren’t Spy, which simply tracks the performance of the S&P 500, or QQQQ, which does the same for the Nasdaq 100. Those have their role but they are not interesting to us as investors.

These are ETFs that are fundamentally oriented, focusing on building baskets of stocks that Wall Street has incorrectly priced according to academic research, backtesting and experience.

The jury is still out on how these ETFs will perform over time but I, for one, think they are at the very least great alternatives to the standard fare. In the best case, they will significantly outperform.

Here are some of the ETFs that bear further watching:

The Ocean Tomo Patent index. This is a major market index that tracks the portfolio of diversified companies that the creators believe own valuable patents. According to Ocean Tomo, the index has outperformed the S&P 500 by 310 annualised basis points over the 10-year period ending September 2006.

The basic idea is that Wall Street knows how to value cash in the bank and real estate holdings and other tangible, semi-liquid assets. But it has no idea how to value a patent and usually ignores a company’s patent portfolio completely when assessing a value for a company.

But the patents do have value, so an arbitrage exists between the perception (by Wall Street analysts) and the reality (the eventual value of the patent in question).

“Intellectual property today is an inefficient market, and the index leads to greater opportunities to unlock value for investors,” says Keith Cardoza, chief investment officer of Ocean Tomo.

“Diversified across all sectors, styles and capitalisations, the index presents a unique and powerful way for sophisticated investors to enhance their portfolio.”

The Clear Spin-off Index. This is an index designed to track stocks that are spin-offs from other companies. It is based on the idea that these companies can now better focus on their own specific strategy and unlock value.

When a stock is spun off from a publicly traded company there is often artificial selling pressure created by the standard fare index ETFs. The latter are obliged to hold the parent stock but also must not to own the spin-off (if the spin-off is not yet included in an index). This creates opportunities that Clear takes advantage of.

The PowerShares Buyback Achievers Portfolio contains companies that have repurchased 5 per cent or more of their outstanding shares for the preceding 12 months.

The Sabrient Defender Index comprises companies that had positive returns the prior quarter and performed well on down days. The index is rebalanced quarterly.

So, in contrast to making a random statement such as “tobacco stocks are defensive”, this ETF bases its selections on solid evidence: here are the stocks that went up on down days and went up overall for the quarter.

The Sabrient Insider Sentiment Index identifies 100 stocks that reflect favourable corporate insider buying trends and recent earnings estimate increases by Wall Street analysts. Stocks come from a broad universe of US-traded stocks and American Depositary Receipts (ADRs). The earnings estimate increases are determined via the public filings of such corporate insiders.

Perhaps the thing I like best about these ETFs is the lack of ego. They are all based on good academic research and follow passive indices that have outperformed the market for years.

In addition, there are very logical reasons for the strategies that underlie each ETF to work. And there’s no hedge fund manager behind them. Bliss.

james@formulacapital.com