Innovation in the ETF Industry: Tales from Quant 2017 Venice


In 1993 in the New York stock exchange the first Exchange Traded Fund was established. Since then, the number of ETFs has exponentially increased, and now accounts for about 4000 funds.

This instrument tries to replicate an already existing benchmark with a typically small tracking error and lower cost than mutual funds. Authorized participants act as market makers exchanging creational units (i.e. units of the underlying) with shares of the ETF. Redemption of shares is not settled in cash but in the underlying. Arbitrage keeps the secondary price aligned with the underlying and the fund is not obliged to hold a huge quantity of cash, causing underperformance in a rising market. They can be negotiated through the day allowing a quick reaction to changed market conditions.

Our portfolios can benefit from the use of ETFs’ strategies because of the traditionally high liquidity of these instruments and the achievement of high diversification with low transactional cost. The costs of ETFs are usually very low if confronted with mutual funds with a variable TER that can go from 0.09% to 0.6%.

In this article we are going to present 4 different ETFs issued by 4 different companies, each one of them can be used to enhance a quality of the portfolio and is based on a different strategy.

First of all, we are going to start observing the outstanding results of the SPDR S&P500. This is maybe the most famous Exchange Traded Fund tracking the S&P500 with a TER (Total Expense Ratio) of 0.09% and a tracking error of 0.04%. Last week as we have seen the best results in the S&P500 in almost 4 months, investors channelled $8.2 billion in the $250 billion fund, one of the biggest inflow in the fund history.

The second ETF we analyze is the Lyxor US$ 10y Inflation[1]. This is an option if you want to hedge your portfolio for expected inflation. The strategy trades expectations by buying TIPS and shorting nominal US bonds with the same maturity, the difference in the cash flow has a modified duration of 8.7 years (but that can vary over time).   In order to find the number of shares to cover the inflation risk of your portfolio you have to balance the equation with the durations:

DUR (portfolio) / DUR (ETF) = proportion of shares in the portfolio

The cost of this strategy is the annual TER of 0.25 % which is not low at all considering that inflation is about 2%. We suggest to use this strategy for an active management of the portfolio and not for a passive long term hedging; we believe that in that case a hedge on actual inflation would be more cost effective.


The third ETF is the iBoxx EUR Corporate Yield Plus[2]. This is another way to approach the European corporate market. It invests as underlying in corporate bonds using a smart beta methodology. By buying corporate bonds with the highest credit spread and the lower volatility it seeks to deliver returns in a very difficult market, where the ECB keeps loosening criteria to buy corporate bonds and investors strive to find good investments. In the current macroeconomic situation adding risk in our portfolio is almost inevitable, generally it can pass from an increase in duration or from shifting away from AAA bonds to cheaper ones. The problem with this kind of ETF is that it provides unwanted exposure to downgrade risk; the companies with the higher credit spread are also the most likely to become non-investment grade bonds. Historical series seem to show that markets discount this uncertainty before the downgrade really happens, and, when it does, the asset could start a process of recovery in value. The rationale behind it seems to be that uncertainty is overly penalizing the bond, but further digging and research will be made analysing this phenomenon. This ETF is a physical one, distributes dividends (underlying bonds coupon) and has a TER of 0.25%.


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[1] ISIN LU1390062831