Hard Lessons from an ETF Entrepreneur

by Maz Jadallah

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Over the past few months I’ve been talking to potential strategic partners about launching a new family of sentiment-weighted indices.  After a decade and a half at this, I’ve got a lot of useful scar tissue around product design, market fit and go-to-market strategy. I’ve never been more certain that 13F intelligence can help investors make better decisions.  There’s never been a better time than now to build tools and services for the individual investor.

I’m proud of our accomplishments. In 2008 we were amongst the first to offer a cloud based research service for 13F analysis. In 2012 we were the first to launch an ETF that utilized 13F data. By 2015, the fund had earned a five star rating from Morningstar and accumulated over $200 million in assets before performance stumbled badly due to a dynamic hedge feature.  The fund never recovered.

I’ve learned some very hard lessons about building a business around ETFs.  I’m sharing them here so that they can help other ETF innovators. Here we go.


ETF buyers hate black boxes

Despite the recent uptick in new active ETFs, my experience has been that most ETF buyers will avoid ETFs with an opaque investment methodology.  Here’s why. Without radical transparency around your process, it will be very hard to retain your investors at times when your strategy underperforms – and it will underperform at some point.  Transparency helps you minimize the turnover in your fund which is a critical component of asset growth (that is often overlooked). A good rule of thumb is that you should ask yourself whether you can explain your index design to your mother in a way that she could describe it back to you.  

The methodology to construct our new sentiment-weighted indices will be fully transparent.  I’ll share more in the future but for now, Figure 1 summarizes the theoretical performance of high sentiment strategies organized by market capitalization.  

Figure 1

In the above analysis, sentiment is defined as the number of times a stock appears within the largest ten holdings amongst funds in our universe. Portfolios are rebalanced quarterly and constituents weighted by sentiment. Market caps are recalculated quarterly and the effects of delisted securities are included.  

How funds are rated should inform your design

Most advisors/investors use a “style box” approach when building portfolios for their clients.  The style box framework gives them a way to categorize the “tools” they used to build a portfolio.  Morningstar and others has developed rating methodologies that give investors a way to compare funds in the same category.  Like it or not, an ETFs “rating” is one of the first things investors look at to evaluate a fund, so it matters a great deal.

Figure 2

Here’s the thing, you don’t get to choose the category to which your ETF is assigned.  Instead, regardless of what your investment mandate may be, your ETF will be assigned a category based on the characteristics of its current portfolio.  If your mandate is all-cap but your current portfolio is 60% by weight invested in large cap growth stocks, then that’s the category to which your fund will be assigned.  

This is important because if your fund’s holdings are “partially mismatched” relative to other funds in your category it will usually work against you, not for you.  For example, if you happen to be assigned to a category that is outperforming other categories (e.g., large growth) – then you’re being compared against funds and a benchmark who’s portfolio holdings are often 100% exposed to that “factor” while your portfolio is only 60% exposed.  On the other hand, if you’re assigned to a category that is underperforming relative to other categories (e.g., value) you might be doing better than the average fund in that category but often you won’t get the credit as most allocators will tell you that the reason you’re doing better is because your portfolio is “underweight” the underperforming factor while the other funds and the reference benchmark in that category are 100% exposed.  

The important take away is that if you’re going to bring a product to market you need to be intimately aware of how its quality will be evaluated.  Hope and novelty are not product strategies.

Know when to quit

If your horse breaks a leg after leading the race, it’s time to find a new horse.  I can not tell you how difficult a decision that is for a startup business.  Like in any startup, your initial product is your “baby” to which there is is a lot of emotional attachment.  It’s incredibly difficult to decide to liquidate a fund.  Deciding to liquidate your only fund is excruciating.  

I should have liquidated our fund back in 2016/17.  The fund’s dynamic hedge kicked in for the first time in Q4 2015 and hurt performance badly.  The hedge triggered again in Q1 2016 and in both quarters the market rallied hard while the fund was hedged neutral, causing the fund to miss both rallies.  In months, we went from +20 percentage points of outperformance (total return) and a five star rating to dramatically underperforming with one star.  The funds assets went from over $200 million to $50 million.  Ouch. Had the fund achieved $500 million or more prior to its stumble I believe it would have been survivable.

Instead of liquidating, I stuck it out, changed the fund’s underlying index with one that was not hedged so that we avoid another “whipsaw” event.  Performance recovered some but assets never did.  

You can’t control the markets. Sometimes that means you need to liquidate a fund.  Build that thinking into your product plan.


The ETF business is hit-driven

I worked in the entertainment industry for a decade.  Like the movie or music businesses, ETFs are hit-driven. That means that success is directly proportionate to the number of bets.  ETF issuers look to their hits to pay for their flops.  On average, for every three new funds launched, one fund is liquidated/merged.   From 2013 to 2022, 2763 new ETFs were launched while 946 were liquidated/merged (Investment Company Institute).  Keep the winners, shoot the losers.  Rinse-repeat.

For smaller “startup” issuers that poses quite a challenge as launching multiple funds requires much more investment capital than launching one fund.  Yet, the business risk of running a one horse race is much higher than the risk of running a multi-horse race.  That’s why large asset managers entering the ETF segment always deploy a “family” of funds.  Any horse can stumble in any given market environment but it’s unlikely that all of them will.  

Ignore retail investors at your peril

Retail investors are often ignored as a segment by most ETF issuers, especially new entrants. You can’t blame them – unlike a mutual fund or a private fund, where the fund knows the identity of the shareholder when they buy/sell shares, ETF managers are often blind to who their individual shareholders are because individual investors buy/sell shares through their brokers instead of directly through the fund.  Imagine, trying to market to an audience without the ability to know your customers!  It’s crazy.

No wonder most ETF issuers focus mainly on advisors as their target audience. There are way fewer of them, they are easier to reach/track, and they can “write bigger checks”!  Right?  Wrong. 

To my knowledge, in the entire history of ETFs, there has never been an advisor that has been fired for NOT putting their client into your ETF.   Think about it; advisors have a ton of choice for any given portfolio exposure.  They view their skill at asset allocation as the “alpha” they are delivering to clients.  So, the cheaper the ingredients they use to deliver that “alpha”, the better for them and their clients.  Like sushi chefs at the fish market, most advisors are looking for good quality fish (beta/theme) at low prices, they’re not looking for the latest sushi roll.

The reality is that for ETFs at the higher end of the fee spectrum (most new funds are), retail investors tend to make up a majority of their shareholder base, not advisors.  Figure 3 below highlights a few ETFs across different expense ratios showing how total shares outstanding is split between  “asset owners” and “asset allocators” investors.  Note how for higher fee funds, “asset owners” make up a majority of shareholders, while cheap beta funds are mostly owned by “asset allocators”.

Figure 3

The lesson here is that a retail-minded marketing/distribution strategy is absolutely key.  Don’t get me wrong, advisors are great but their participation in your fund will lag its market adoption (the first $25-50m in AUM).  Not only that, and perhaps more importantly, advisor allocated assets tend to be a lot less sticky.  

Scaling up 

Build digital platforms (not brochures)

Luckily, in today’s digital world, building a retail-minded distribution strategy is possible for even small entrants.  Unfortunately, most issuers still tend to build “brochure-like” websites and then run digital ad campaigns to drive traffic. 

A better approach is to build a digital platform from the ground up that is designed to connect with and build relationships with your target audience. A platform that adds real value.  For example, if your funds are ESG focused, you should build tools that allow users to leverage your expertise (e.g. rubric/tool for ESG assessment, ability to customize emphasis for specific “E” or “S” or “G” attributes, ways to “live” and “apply” ESG values, automatic donations to ESG causes, ESG for kids, the only limit is your imagination). 

Our initial cloud-based 13F research platform would have been perfect to build direct relationships with investors interested in 13F investing.  Instead, shortly after I deployed our first fund, we stopped offering our research service. I mistakenly believed that the advisor was the main target audience for our funds and that the research service would have been a distraction.  I’m still kicking myself!

The good news is that our platform is very much still operational (I use it daily) and in a re-launch – we’ll make it the center of our marketing/distribution strategy.  It doesn’t take much to imagine how, in a M/L-AI world, our platform would evolve to become an indispensable tool for retail investors.

The biggest win in pursuing this kind of “platform strategy” is that it allows you to build direct, real time relationships with your target audience and customers … that is marketing gold.

The people you meet

While lessons are important, what you remember the most are the people you meet along the way. Even as the journey continues, I wanted to take the time to recognize the people that helped me come this far.

The support I’ve received from my parents, my sisters/brother and my kids can only be described as heroic. Their support was and is unconditional and I assure you I would not be here were it not for their love and strength. Make sure you have people around you that love you.

I’m extremely indebted to all my clients and the people that invested in me and my vision early; Mike Buchanan, Tad Buchanan, Jim Chiddix, Glenn Duval, Richard Fullerton, Cesare Alessandrini, Jeffrey Parker, Roy Block, Michael Carrier, John Rigsby and Operative Capital all of whom have been amazing.

Advisors/Partners: Brad Bredemann (awesome as head of sales but even better when he’s got your back in a foxhole), Peter Spinelli and Fernando Sepulveda (for being believers), Meb Faber and Jason Jones (for support during the early days).

Developers: Gary Blessington and Robby Russell at Planet Argon (hiring them early was one of my best decisions).

ETF service provider: Garrett Stevens at Exchange Traded Concepts (straightest shooter in the business, entrepreneur at heart), Mike Castino, Michael Barolsky and all the folks at U.S. Bank Fund Services (for finding ways to help even when it was hard); Tom Lydon at ETF Trends (for being an early innovator in ETF marketing); Joe Anthony at Gregory FCA (for owning the PR game and always being generous in sharing his talent); Kris Monaco, Molly McGregor, Mark Abssy, Corey Villani and Lauren Latuso at International Securities Exchange (for helping me launch our first fund).

Legal/Tax: David J. Morandi (for being terrific as company counsel and for being a dear friend), Paul Bleeg and Hiren Modi (for tax counsel and support).

New sentiment-weighted indices 

We’re actively talking to potential strategic partners about deploying a new family of sentiment-weighted strategies. We have all the ingredients:

  • proven methodology and a strong track record
  • redesigned indices to avoid key pitfalls
  • go-to-market strategy leveraging our existing research platform as a lead generation engine to lower customer acquisition costs
  • ability to evolve and enhance features (e.g. mobile app, ML/AI-powered investing/trading, etc)

If you think you’re a good fit, please reach out. 

The Fast Money Takes It Slow

by Maz Jadallah

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It’s a virtual certainty. You can bet your bottom dollar on it. Whenever we discuss our methodology with prospective investors, the first question ALWAYS relates to the delayed nature of Form 13F filings. The implication is that a hedge fund manager is likely to have already exited their position by the time the manager’s quarterly filing is published 45 days after quarter end, rendering the form useless.

After nearly six years, our response is also now very predictable. The truth is hedge funds hold their positions on average for at least a year and for high conviction holdings it can be much longer than that, therefore disclosing positions quarterly can yield valuable information about a security.

In this research note we take a definitive look at hedge fund holding periods. We analyze holding periods for all Form 13F disclosed securities as well as for those held with high conviction. We also look at whether the length of a manager’s holding period is predictive in any way to the efficacy of following their holdings.

Exhibit 1 summarizes the distribution of funds in AlphaClone’s universe by holding periods. The analysis includes every holding for every fund in our universe. Holdings that appear, disappear and then appear again later are treated as separate trades. Holding periods are presented in months.

Ex 1 Fast Money

It turns out the fast money isn’t that fast after all. The average holding period across all positions is over 17 months. It makes intuitive sense then that if managers are waiting on average a year and a half to realize their investment thesis, the fact they must file quarterly means that following them based on their disclosures can make sense …. assuming the manager has skill in selecting holdings.

Conviction matters.

Let’s dig a little deeper. When it comes to active management, conviction matters. Positions that rank among the manager’s largest will drive performance, for better or worse. Therefore, high conviction positions are where the manager must have the most confidence. High conviction holdings also tend to do better when followed than the average holding overall so it’s worth taking a look at holding periods for high conviction holdings only. 

Exhibit 2, summarizes the distribution of funds in AlphaClone’s universe by holding period, for high conviction positions. For the purposes of this analysis we define high conviction positions, as any position who’s size has attained a rank of 10 or lower (a rank of 1 is the highest conviction position and the largest position) in a manager’s portfolio at any time over the course of the manager’s holding period. Like in the previous analysis, holding periods are presented in months.

Ex2 Fast Money

Surprisingly perhaps for many, the average holding period for high conviction positions is a staggering 4 years! Perhaps the most remarkable outcome from Exhibit 2 is the contrast between reality and conventional belief around how hedge funds invest. Fed by the financial media, investor perception is that hedge funds are charlatans getting rich off of high fees, playing a game that the average investor could not hope to understand let alone profit from. Hedge funds are hot money, fast money, smarter than you money when the market is up, and the money we love to hate when the market is down. The reality of course is the opposite, hedge funds don’t play by a different set of investing rules; they buy and hold, they are patient, and yes, on average they are indeed more skilled than most investors, but that’s because they are more experienced and better equipped, not be because the laws of investing physics are somehow different for them.

Too much of a good thing.

Using 13Fs to follow experienced investors can be deceptively easy. Many investors fall in love with a manager’s stellar returns, with the manager’s brand or their cult of personality. A novice 13F follower figures they can “roll their own” and be wildly successful. Again reality does not match perception. Like any investment approach, success using 13Fs takes doing your homework, it takes discipline and it takes patience.

For example, many 13F followers, including some of our competitors, believe low turnover is a key determinant for success when selecting which managers to follow. The idea is that low turnover managers hold their positions for very long periods of time and therefore following their disclosed holdings makes the most sense, especially when they also have a great historical performance record.

Exhibit 3 correlates manager holding period with the efficacy of cloning their holdings. For the purpose of this analysis we define cloning efficacy by summing the monthly excess returns (2010-2015) of a composite made up of several “follow simulations” or “clones” (e.g. follow top 5 holdings, follow top 10 holdings, etc.) over a US market factor. All simulations account for the delay inherent in 13F disclosures and include the effects of “dead” or delisted securities, thereby avoiding survivorship bias.

Ex3 Fast Money

The scatter plot above couldn’t more clear. There is absolutely zero correlation between a manager’s holding period and the desirability of cloning their positions. Longer holding periods are necessary to make a manager’s disclosures usable but not sufficient to determine which manager to follow.  Like many of the best investment disciplines, utilizing Form 13F successfully is simple but not easy.

tortoise and hare

Active v Passive – A False Choice

by Maz Jadallah

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The active vs passive debate continues unabated in the financial media.  Passive strategies continue to accumulate assets while active strategies lose them causing many to proclaim that active investing is dead.  Let’s take a step back and try to separate reality from hype.

Despite passive’s impressive gains, the amount of assets being managed actively is still greater.  According to the Investment Company Factbook, at the end of 2017 there was approximately $12 trillion in actively managed mutual funds vs $7 trillion in index mutual funds and ETFs combined.  Add $3 trillion in hedge fund assets and you get about a 2 to 1 ratio of active over passive.  So at least historically, investors have had a real need for active strategies.  What was that need? Why has it changed? Will it change again in the future?  The answer to all of these questions can best be explained looking through the lens of one of the most enduring traits exhibited by investors – the fact they chase performance.

Passive strategy performance has been by far better than active performance since the financial crisis (see table below).  Believe it or not, investors over the past 10 years have enjoyed 4 in 5 odds that the S&P 500 returns 10% or more annually – the historical average (since 1949) is only 1 in 3, and the average during periods of increasing interest rates (like now!) is even worse at 1 in 5.  So when the S&P 500 is at its historical return average (6-8%/year) or less, investors apparently want to try and do better.  Conversely when returns are 10%/year or greater investors don’t see as much of a need for active.  The key question then becomes – will 10%+/year US market index fund returns continue for the foreseeable future?

Perhaps recognizing the ominous signs of lower future market returns, #Vanguard (the kings of passive investing) and #Morningstar have weighted in on the need for balance between active and passive strategies in a portfolio.  The prevailing wisdom is that investors should seek some exposure to active strategies making sure to select lower fee funds since low fees are a strong predictor of future performance.

But which low fee active fund should investors select?  At the end of 2017 there were almost 19,000 mutual funds, 3,400 ETFs and at least 5,383 hedge funds. Screening for funds in the lowest fee quartile still leaves you with 5000 funds!  Manager/fund selection is perhaps the most difficult aspects of active investing – that’s exactly where AlphaClone can help.

AlphaClone’s investment approach seeks to solve the active manager selection dilemma.  Using mandated quarterly holdings disclosures by institutional investors (Form 13F-HR), we assess the stock selection skill of each manager in our universe every six months.  We then select the manager’s with the highest score and build portfolios based on their disclosed high conviction holdings.  Read “Clone Score – How We Pick Managers” for a deep dive into AlphaClone’s methodology.

While technically our strategies are characterized as passive because they are rules based, they can also be seen as quasi-active because we seek to identify and follow the high conviction investment holdings of the world’s most established active managers.  That’s why we like to characterize our strategies as “active indexes”.

We thought it would be instructional to look at performance results for five investment regimes that span the passive/active continuum.  Each approach seeks to gain exposure to US equities but in very different ways.  We define the five investment approaches as follows:

  1. Extremely passive: this approach will allocate to a single market cap weighted index that seeks to represent all US equities.  We use the Fidelity Total Market Index Fund (FFSMX).
  1. Passive: this approach divides US equities into two categories; large cap and small cap.  Our analysis assumes a 50/50 allocation between the iShares S&P 500 Index ETF (IVV) and the iShares Russell 2000 ETF (IWM).
  1. Active Index:  Our analysis assumes a 100% allocation to the AlphaClone Hedge Fund Master Index (ALFMIX) which can be accessed via our ETF.
  1. Active:  taking one step further towards active management we simply take the Morningstar US Large Blend category returns which represents the average return of all active mutual funds in that category.
  1. Extremely active:  finally, for the high octane set, we include an “extremely active” category represented by the HFRI Equity Hedge Index. The index represents the average returns for hedge funds that espouse and equity investment approach.

We calculate annualized returns through August 2018 and compare each investment approach across several time horizons.  The results are presented in the Exhibit 1 below – extremely passive is the left most bar (light grey), extremely active is the right most bar (dark grey).

A few things jump out from the exhibit above:

  1. Passive strategies have performed very well, especially over the three year horizon.
  2. Despite achieving returns that are double their historical average, the active index approach still managed to outperform the more passive approaches over the five year horizon.
  3. No investment strategy outperforms all the time – active indexing returns lagged over the 3 year period and passive strategies are beginning to lag more recently.

Active or passive represents a false choice to investors and their advisors.  A thoughtful combination of both passive and relatively low cost and efficient active investment regimes has proven itself over time to be superior to either passive or active strategies on a stand alone basis.



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