This article is part of our Innovative ETF series, where we will discuss exchange-traded products (ETPs) that are seen as innovative—either they use a newly-invented strategy or process to track their index, or they attempt to improve upon existing strategies. Conventional investing wisdom states that you shouldn’t invest in anything you don’t understand. In fact, many say that if you can’t understand it within 5 minutes then it’s probably not for you. Our intention here is to break down the specifics of these innovative ETFs, leaving you with a better understanding of their potential benefits and risks. If at the end of this article you’re still not clear on how this ETF works or whether it’s suitable for your portfolio, then it’s probably not.
Last time, we examined the RBS CTA ETF.
C-QUADRAT iQ European Equity ETF
The C-QUADRAT iQ European Equity ETF is the first rules-based strategy ETF using the EURO STOXX 50 TR Index as a benchmark. The underlying strategy, the C-QUADRAT European Indicators Model, is a rules-based quantitative process aiming to forecast the future price movement and market phase of the EURO STOXX 50 Index. The multi-step model comprises seven different indicators based on macroeconomic, fundamental and technical variables. The ETF aims to deliver absolute returns and relative outperformance versus the EURO STOXX 50 TR Index with downside protection. Essentially, the strategy goes long the EURO SOTXX 50 Index Future in positive market environments, short if the model is convinced of the potential for declining prices and neutral during periods of market uncertainty. In certain circumstances, the strategy can also go 1.5X or 2X long the EURO STOXX 50 Index Future and will be reset once the indicator of the underlying strategy changes.
Since inception (23/08/2010), the ETF has outperformed the EURO STOXX 50 TR Index, whilst exhibiting lower volatility, as seen in the table below.
The following graph illustrates the live performance of the C-QUADRAT iQ European Equity ETF relative to the EURO STOXX 50 TR Index.
Like most trend following models, the C-QUADRAT iQ European Equity ETF struggled during the non-trending year that was 2011. Only by avoiding the sharp market downturn in August and September 2011, was the ETF able to outperform the EURO STOXX 50 TR Index since its inception as it rebounded strongly after markets bottomed out.
Diving deeper into the fund’s performance, we find that the strategy outperformed the EURO STOXX 50 Index in 85% of the weeks with negative market returns and 22% of the weeks with positive returns. Moreover, if we exclude the most volatile period (August and September 2011) from our performance analysis, the C-QUADRAT Indicators Model would have underperformed the EURO STOXX 50 Index by an accumulated 22% since inception.
Based on its performance over its fairly brief live track record of nearly 2 years, it appears as though this ETF could perhaps best be used as a portfolio hedge rather than a source of alpha. The correlation between the EURO STOXX 50 Index and the strategy was a meagre 9% during this period and therefore the ETF could offer substantial diversification benefits within an existing equity portfolio.
Moreover, leveraged ETFs usually don’t guarantee the investor double the index's return for any holding period longer than one day, because of the daily rebalancing and the compounding arithmetic involved. This issue is generally amplified in periods of high market volatility and can lead to greater losses than anticipated. The same holds true for inverse ETFs. However, the C-QUADRAT iQ European Equity ETF doesn’t “reset” its leverage during those periods when leverage is employed and therefore doesn’t suffer from similar issues. When leverage is utilised, a leverage factor of 1.5 or 2 will be embedded daily in the index calculation at the volume-weighted average futures price between 9:05am-9:15am CET. As the price of EURO STOXX 50 futures changes during the daily trading session, the leverage will be reset to either 1.5 or 2 at the volume-weighted average future prices between 5:20pm–5:30pm CET. This ensures that the investor gets exactly the leveraged performance of the underlying index over the long-run. However, intraday variations between the reference index and the C-QUADRAT iQ European Equity ETF can occur. As the leverage is set at the beginning of the trading day, the leverage can deviate only from the simple 1.5X or 2X when bought intraday. Because the product is not intended for intraday trading, but rather as a medium-to long-term investment, this should not cause any issues for investors. Investors interested in a more detailed analysis on issues surrounding daily/monthly leveraged ETFs can read an article covering this topic here.
It’s also important to note that strategies like this are developed based on back-tested models. Through back-testing it is fairly easy to develop strategies that deliver absolute and relative returns--on a back-tested/non-live basis. More interesting is therefore the question about the live performance. Simply because a strategy was successfully back-tested doesn’t guarantee it will be a future winner once it has gone live.
Based on the back-tested results, the C-QUADRAT European Equity TR Index delivered on its promises of absolute and relative returns. As we mentioned previously, since the product has gone live, it can be argued that the ETF was perhaps better suited as a portfolio hedge rather than a source of alpha. Given the fund’s short track record of 20 months and the difficult market environment that has prevailed during its lifespan, its true colours remain to be seen.
The total expense ratio (TER) of the C-QUADRAT iQ European Equity ETF is 0.63%. But there are additional adjustments to consider that are embedded within the index calculation. The index only uses index futures and the money market to achieve the desired investment objective. The index can be, theoretically, rebalanced daily. For each index adjustment, the index-provider charges 1.5bps of the rebalanced futures’ nominal value. On average, the strategy rebalanced 20 times p.a. during the back-tested time period, adding up to 30bps p.a. in additional expenses. Moreover, the index incorporates a 1% p.a. distribution fee in its calculation. On the other side the EONIA is included in the index calculation which partly offset the rebalancing adjustments and distribution fees. These embedded index adjustments increase the fund’s headline expense ratio accordingly.
Investors interested in a detailed analysis of the underlying index strategy and the fund construction can read more here.
Conclusion
So how does this ETF compare to traditional long-only ETFs?
Traditional long-only equity ETFs are generally purely passive investments following widely recognised benchmarks. These products’ benchmark indices are usually free float market capitalisation weighted, like the EURO STOXX 50 Index. The composition and calculation of these indices is generally very transparent and often free from any qualitative selection criteria. Moreover, ETFs tracking long-only pan-European benchmarks are available with TERs as low as 15bps.
In contrast, the index underlying the ETF discussed in this article is essentially a rules-based long/short strategy. As a result, the ETF is less transparent and more expensive compared to traditional long-only equity ETFs. However, the ETF-sponsor publishes the position relative to the EURO STOXX 50 Index Future daily on their website. The ETF-issuer publishes the iNAV on Bloomberg and Reuters between 10:00am and 17:15pm CET. The index calculation agent of the C-QUADRAT European Equity TR Index is STOXX Ltd. The index calculation agent later calculates and publishes the official index level intraday on Bloomberg and Reuters. Therefore the investor knows every day as well as intraday what his position relative to the EURO STOXX 50 Index Future is, e.g. short, neutral, long or leveraged.
At the end of the day, investors’ foremost concern is a product’s performance--net of fees. In that regard, this strategy has added value to date, as the performance figures above show, despite the associated fees and embedded turnover costs. Nevertheless, this ETF has only been live since the end of August 2010 and as such still needs to build a sufficient track record. Until now, the live performance of this ETF indicates the product could be a better hedging tool than it is a source of alpha. However, given the short time period and the prevailing non-trending market environment it is too early to say if the product will continue over the long-term to deliver on its promises, e.g. absolute returns and relative outperformance versus the EURO STOXX 50 TR Index.
