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					                                                                   Trading                                                               K E Y P O I N TS
                                                                          TACTICS                                                        • In 2004, roughly 70 percent of ETFs
                                                                                                                                           outperformed the S&P 500.

                                                                                                                                         • Some pioneering investors use ETFs
                                                                                                                                           not only as trading vehicles but to
                                                                                                                                           actively manage money.
                                        Passively Active                                                                                 • A handful of hedge funds tailor their
                                        Exchange-traded funds are a growing phenomenon                                                     strategies to focus on trading ETFs.

                                        BY ZOË VAN SCHYNDEL, CFA                     lios based solely on ETFs. The Philadel-            • Investing in an index through an
                                                                                     phia money manager has about US$50                    ETF gives money managers the broad

                                                   he NASDAQ-100 Index Track-        million in assets and 125 clients, most               market exposure they need.
                                                   ing Stock (QQQQ) is the most      of whom use ETFs. Kelly claims to be
                                                   actively traded security in the   the first money manager to come to the
                                                   world, with about 100 million     market with a managed ETF product.                       Hedge Funds’ Use of ETFs
                                        shares traded daily. That’s impressive            Kelly uses a proprietary quantita-             Hedge funds, one of the early adopters
                                        trading activity for a passive investment    tive process to determine the asset mix             of ETFs, quickly realized that they
                                        product. In addition to the QQQQ,            of his portfolios, which are bench-                 could move in and out of these vehicles
                                        approximately 350 exchange-traded            marked to the S&P 500, and seeks to                 to equitize their cash or to go long or

                                        funds (ETFs) trade on 31 global              provide returns above the benchmark.                short particular sectors. Now, a handful
                                        exchanges. A few investing pioneers,         Kelly is proud of his performance record            of hedge funds are tailoring their strate-
                                        ranging from financial planners to hedge      and says, “through March 2005, in the               gies to focus on trading ETFs.
                                        funds, are using ETFs not only as trad-      22 quarters since inception, the ETF                     Saddle River Capital Management,
                                        ing vehicles but to actively manage          strategy has beaten the S&P 500 64 per-             of Ridgewood, N.J., manages US$10
                                        money. Sometimes called trackers, ETFs       cent of the time. On a rolling quarterly            million in ETF strategies. In July 2004,
                                        are index-tracking mutual funds that         basis, the strategy has beaten the bench-           the manager opened up The Saddle
                                        trade on exchanges just like stocks. As      mark more than half the time.”                      River ETF Strategy Fund. The fund is
                                        an index-based product, these funds               C. Michael Carty, the founder of               SEC registered and invests in the entire
                                        have become popular vehicles for             New Millennium Advisors, LLC, a New                 spectrum of ETFs. Dick Wolfe, manag-
                                        investors who seek immediate exposure        York City-based investment adviser, uses            ing director, says that “currently the
                                        to the broad market as well as to specific    proprietary quantitative, fundamental,              fund has a core/satellite portfolio whose
                                        sectors. The ETFs available to investors     and technical disciplines to manage insti-
                                        now range from the Deutsche Bank DAX         tutional and individual accounts. Carty
                                        DVG (FGQ1) and the iShares FTSE/             manages an ETF-only long/short strategy                     “When you are
                                        Xinhua China 25 Index Fund (FXI) to          that seeks absolute returns. He says that                 considering an ETF,
                                        the Vanguard REIT VIPERs (VNQ).              “the strategy is conservative and designed
                                             US ETFs represent approximately         to preserve principal. The strategy is                      liquidity has to
                                        $225 billion in assets, while globally       designed to build a more efficient portfo-                   be factored in.”
                                        the total is more than US$300 billion.       lio and may trade the ETFs on a daily
                                        ETF asset growth has brought such            basis or hold them for several months if                             DICK WOLFE
                                        fund powerhouses as Fidelity and Van-        they are following a trend.” Carty expects                        Managing Director
                                        guard into the market. ETFs, however,        the strategy to have a lower standard                      Saddle River Capital Management
                                        are relative newcomers to the mutual         deviation and higher returns than the
                                        fund scene. Of the approximately 150         S&P 500.
                                        US ETFs on the market, the oldest and             Carty says that “ETFs are flexible              core is 50 percent invested in the S&P
                                        largest is the S&P 500 SPDR (SPY),           enough that they can meet most clients’             500 and satellites are invested 50 per-
                                        launched in January 1993; SPY has            needs.” He believes that “the worst                 cent pro rata in the 10 sector SPDRs.”
                                        grown to over US$50 billion in assets.       thing about ETFs is that due to their                     To avoid liquidity issues, Wolfe
                                        Next in popularity is the QQQQ, with         complexity, specifically their unique                “focuses on ETFs that have at least
                                        close to US$20 billion in assets.            share creation/redemption process, they             100,000 shares traded on a 30-day aver-
                                                                                     need more client education than tradi-              age and in some cases may go as low
                                             Money Managers and Active ETFs          tional funds. Also, commission-based                as 50,000 shares traded.” Once trading
                                        Over the past six years Jim Kelly, the       professionals do not want to deal with              volume goes below this level, Wolfe
                                        founder of Kelly Capital Management,         them because ETFs do not provide the                feels that “the liquidity is just not ade-
                                        has been actively using ETFs and now         compensation available with traditional             quate. When you are considering an
                                        specializes in creating individual portfo-   mutual funds.”                                          ,
                                                                                                                                         ETF liquidity has to be factored in.”

48                                                                                   CFA   MAGAZINE        J U LY- A U G U S T 2 0 0 5
     Gary Gastineau is a portfolio man-                                                                      Vaidas Uzgiris, vice president of
ager in the Dickerson Division of H.G.                                                                  trading for Greenwich, Conn.-based
Wellington & Co., Inc., as well as the
                                                     “Using ETFs frees up                               Timberhill, LLC (the market-maker
managing director of ETF Consultants.                the managers so that                               unit of Interactive Brokers), makes a
Gastineau, with his partner Michael                                                                     market in all US ETFs and most others
Dickerson, has put together a valuation
                                                       they can use their                               traded around the world. Uzgiris says
model that “values indexes or stock                    brainpower to add                                that “there is a perception that money
baskets based upon their aggregated                                                                     managers who invest in ETFs are cheat-
fundamentals and appropriately weights
                                                     value by finding good                              ing somehow.” Because they are being
the fundamentals so that the indexes                 stocks to invest in or                             compensated to research stocks, not a
can be valued as if they were individual                                                                stock basket, the analysts are uncom-
stocks. The model ranks indexes based
                                                     bad stocks to short.”                              fortable when their level of analysis and
on their relative value and identifies                                                                   due diligence is not down to the indi-
                                                                VAIDAS UZGIRIS
buy and sell candidates.” Since January                          Vice President                         vidual company level.
2003, the partners have managed                                  Timberhill, LLC                             Uzgiris argues that investing in
money using iShares ETFs based on the                                                                   ETFs “is a sensible thing to do in order
S&P BARRA Growth and Value Index-                                                                       to get generic exposure at a low cost.
es, primarily for the high-net-worth              individual security exposes me to. I can              Money managers’ performance is usually
market. The Skyhawk Market Neutral                even sell short without waiting for an                measured against a benchmark, and for
Hedge Fund, which the partners plan               uptick, unlike with stocks.”                          them to invest in the index through an
to launch in the first quarter of 2006,                 From a behavioral perspective,                   ETF gives them the exposure that they
uses this same model, as will other               Kares notes that “for many fund man-                  need. Using ETFs frees up the managers
hedge funds that they intend to launch.           agers selling is one of the most difficult             so that they can use their brainpower
                                                  things they have to do because they                   to add value by finding good stocks to
     Integrity and Other Advantages               become emotionally invested in a par-                 invest in or bad stocks to short.”
Robert Kares, a Boynton Beach, Fla.,              ticular stock. When you use an ETF it’s,                   In 2004, roughly 70 percent of
fee-only financial planner, says that              just a basket of stocks, so selling is                ETFs outperformed the S&P 500,
“with all of the recent problems and              more logical and unemotional.”                        according to data from Lipper and
scandals, ETFs are one of the most                                                                      Financial Research Corp. On the active
transparent investments that you can                    Active Managers’ Bias                           side, there will always be managers
make, and the arbitragers help to keep            When Kelly is asked why he doesn’t                    who can add value through their man-
ETFs fairly priced.”                              have much competition for his active                  agement and analysis skills. In the end,
      In addition to their transparency,          ETF strategies, he says that “it’s the                though, the focus should be on what’s
Kares favors ETFs for a number of other           psychology of portfolio managers and                  best for clients. As Kelly says, “a lot of
reasons and needs no prodding to provide          analysts that biases them against a ‘pas-             ego needs to be put aside on Wall
a list of their top features. “It’s very diffi-    sive’ product.” As Kelly tells it, “most              Street, and when ETFs are appropriate
cult to explain to clients in January why         of the research and money management                  for a client they should be used.”
they have phantom income from capital             community don’t see ETFs as a security
                                                                                                        Zoë Van Schyndel, CFA, is a lecturer at
gains trades on their mutual funds, espe-         to research.”
                                                                                                        the University of Miami and a freelance
cially when the funds have declined in                 Kelly maintains that ETFs are worth
                                                                                                        financial journalist.
value. With ETFs, I don’t have that prob-         researching, saying that “in one ETF
lem as the ETF in-kind creation/redemp-           share I can capture the return of several
tion process effectively reduces capital          thousand securities. I don’t have to ana-
gains taxes to zero or close to it. I also like   lyze how each individual security is
the low expenses. With the average mutu-          impacted on a daily basis, but I do active-
                                                                                                        RECOMMENDED RESOURCES
al fund’s expenses running above 1.25             ly manage the portfolio of ETFs and
percent and ETFs at 10–30 basis points,           need to determine whether or not these                “Traditional Indexing Is Passé”
there’s just no comparison.”                      ETFs are a good value for my clients.”                Points of Inflection: New Directions for Portfolio
      On the subject of ETF trading, Kares        For example, if you want exposure to                  2004 CFA Institute Conference Proceedings
says, “I like the fact that I can trade all day   the oil industry, there are about seven               (cfapubs.org)
and have the luxury of being able to get          ETFs globally from which to select.
                                                                                                        “Index Mutual Funds and Exchange-Traded Funds”
out of a position immediately if I want.          Whether to use one fund or another                    Abstracted in the CFA Digest (February 2004)
With most ETFs you can trade options,             would depend upon your preference for                 (cfapubs.org)
such as with the QQQQs I can trade puts           the individual stocks that the funds are
                                                                                                        “European Exchange-Traded Funds: An Overview”
and calls. By betting on an index like the        composed of, dividend collection pro-                 Abstracted in the CFA Digest (May 2003)
QQQQ, I avoid the risk that buying an             cedures, weightings, and so forth.                    (cfapubs.org)

                                                  CFA    MAGAZINE         J U LY- A U G U S T 2 0 0 5                                                        49

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