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Bolstering Diversification with Uncorrelated ETFs

January 12, 2018

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This week, the SEC halted industry efforts to deliver 12 bitcoin ETFs and two cryptocurrency mutual funds. This news came in the wake of last month’s release of two bitcoin futures contracts, the first trading on the Cboe (XBT) and the second on the CME (BTC).

Regulator’s hesitation on an ETF offering is the result of concern surrounding investor safety. They feel the risks of lack of liquidity as well as volatility on the underlying bitcoin asset could put investors in danger.

 

This news got me thinking about ETFs again and how powerful and advantageous they are. I’ve always liked how ETFs are one of the portals that connects the traditional and alternative investment worlds. After working for a managed ETF quantitative trading firm, I had the opportunity to learn a lot about this asset class first hand, which I’m very grateful for. Prior, I was most familiar with FX and commodity futures, so learning about a more mainstream retail investment product was good exposure.

 

Though I am all for less constrained investment freedom in the alternative space, I do agree with protection of retail investors when a riskier asset permeates mainstream investment channels. This will begin to happen once a bitcoin ETF is available and retail investors unfamiliar with the risks of volatile fiat currencies no longer need a separate bitcoin or futures account to participate in trading the currency.

 

Because I’ve always been more into alternatives, I find this asset class particularly interesting. I see ETFs as more alternative because they can give investors access to alternative assets in a way that could (potentially) be safer as a fund is, by nature, more diversified than investing in any one of their underlying assets alone. This has the ability to provide some protection against idiosyncratic risk through a bit more shock absorption during times of volatility amongst the individual included assets. ETFs are a great way for retail traders and investors to increase diversification by gaining exposure to alternatives.

 

 

Adding Diversification Now

 

So why is diversification important right now? Many technical analysts are predicting a 2018 bull equity market top, followed by a period of decline near 2019. This current eight year bull market primary trend is exceptionally long, being the second longest in history. The longest ran from 1987 to 2000, roughly 13 years and the previous five (including our current) have run five, five, five, eight, and eight years (also all Fibonacci numbers, non sequential, of course). Increasing exposure to uncorrelated alternative asset classes through ETFs can help to mitigate a degree of systematic risk.

 

 

Additional benefits of ETFs

 

Diversification isn’t the only benefit of investing in ETFs. They also encompass the appeal of low expense fees, stock-like trading abilities, tax efficiency, a high level of transparency, and strong liquidity.

 

  • Cost efficiency: In comparison to the mutual fund, ETFs sit lower in terms of fees incurred. This is because unlike mutual funds, which are actively managed, most ETFs available to retail investors are passively managed (there are actively managed ETF funds, as well). However, broker and other fees must still be considered with passively managed ETFs.

 

  • Flexibility: ETFs are also more flexible than professionally managed funds. Most of professionally managed funds attempt to mitigate risk by actively maintaining a tracking error within a certain range above or below the benchmark it’s designed to follow. This is a positive for lessening severe losses, but it also goes the same way with returns. If an actively managed fund outperforms its benchmark too much, it’s still deemed risky. The benefit of this tracking error flexibility does depend on an investor’s individual risk threshold.

    • Since ETFs trade on exchanges similar to stocks, retail investors have a lot more flexibility entering and exiting positions quickly throughout the day, unlike the flexibility they would see in a professionally managed fund. They can also be shorted like stocks as well.

 

  • Volume and liquidity: An ETF’s liquidity is dependent on that of its underlying securities. An ETF comprised of highly liquid securities with substantial traded volume will have a high degree of intra-day liquidity as well. Higher liquidity will generally provide a smaller bid/ask spread, which is a benefit for day traders putting in market orders looking to execute at a certain price. It will be a negative for scalpers trading the spread and operating on limit orders, who benefit more from thinly traded assets with a wider bid/ask spread.

 

 

Gaining currency exposure through FX ETFs

 

 

 

An example of an alternatives based ETF uncorrelated with the stock market would be currency ETFs. FX basket ETFs denominated by a variety of currencies can be a better option for less experienced or more risk averse investors as ETFs tracking any long single foreign currency can be more volatile. An example would be the WisdomTree Bloomberg Dollar Bullish Fund (USDU), which contains a fairly balanced range of currencies such as the euro, Mexican peso, Aussie dollar, as well as emerging market currencies like KRW, BRL, and CNY.

 

Be sure to check the distributions into any one underlying currency in a basket FX ETF as sometimes they will be disproportionately allocated into a single currency, such as the PowerShares DB US Dollar ETF Index bullish Fund, which has a 50%+ EUR allocation.

 

Currency ETFs are most beneficial for buy and hold investors looking for diversification and gaining some longer term controlled FX exposure, since the ETFs are easier to trade through their brokerage account. However, for FX day trading, they’re not ideal due to imprecision that can only be attained in the actual spot FX market. They would also be less appealing to non-carry or swing traders that unwind all positions at the end of their trading day to avoid rollover interest on spot positions held overnight.

 

 

 

 

 

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