Introducing Our Innovative ETPs Series

The total expense ratio (TER) for the Man GLG Europe Plus Source ETF is 0.75%. But there are additional costs to consider that are embedded within the index calculation itself. Given that the index turns over about six times a year, the costs associated with this high level of churn are substantial. While the TER is explicitly broken out, these turnover costs, which amount to an additional 72 basis points per annum, are embedded in the index calculation. Each successful broker idea is remunerated to the tune of 6bps, where 3bps will go directly to the broker and the remaining 3bps goes into a shared commission pool which is paid out once a year in the form of a “bonus”. By way of comparison, an institutional investor would typically pay around 10-20bps for a comparable broker idea.

The past performance of the equity fund makes the ETF appear to be an attractive investment that has delivered on its promise to be a consistent source of alpha. However, investors should keep in mind that past performance is not a guarantee of future results.

Fund Construction
Source uses synthetic replication to track the performance of the Man GLG Europe Plus TR Index. The fund engages multiple swap counterparties, including some of the largest investment banks in the world, such as Bank of America-Merrill Lynch, Goldman Sachs, Morgan Stanley, JP Morgan and Nomura, all of whom are also shareholders in Source. Source caps exposure to all swap counterparties by resetting swaps to zero if exposure reaches 4.5% of the fund’s net asset value (NAV) in any of its ETFs. This is less than half of the UCITS prescribed limit of 10% for exposure to any single counterparty. The swaps are also reset whenever there is a creation or redemption in the fund. Each counterparty delivers a collateral basket composed of European, U.S. and Japanese equities to be held at Northern Trust and marked to market daily. In exchange for delivering the index's performance, the swap provider receives the performance of this collateral basket, plus a fee. Currently, Source does not engage in securities lending in its ETFs, but will notify investors in advance if that policy changes. Any dividends paid by the fund’s constituents are continuously reinvested.

Index Construction
The index is constructed through a step-by-step process to sort through over 1,000 broker ideas to come up with the 200 – 250 securities that will ultimately be component stocks of the index. Generally, the ideas tend to have an investment horizon of 60 to 90 days to make sure they are based more on fundamentals rather than on technical short-term momentum. However, one might question whether any investment thesis rooted in fundamentals can really pan out over a two-to-three month period. Brokers have to reason their submitted stock ideas which are more often than not based on fundamentals. However, once a buy recommendation from a leading broker is published, the respective stock often moves accordingly. Whether this effect is caused by the “broadcast” effect or is fundamentally driven is difficult to discern. As Man GLG’s own research has shown, those effects will be smoothed out after 60-90 days, hence the relatively short investment horizon.

The first step in the process underlying this index is to filter the broker ideas. The remaining stocks that pass a series of screens are used to construct the portfolio and ultimately build the index.

The first filter screens the brokers. There are around 65 eligible brokers, selected based on the strength of the individual and organisation, their overall relationship with Man GLG, performance metrics, and risk management practices. The qualitative screen includes recommendations from the discretionary investment manager of Man GLG and their relationship with the brokers, amongst other things. Successful brokers will be put on a 6 month trial before being included on the list of eligible brokers. As for risk management, Man GLG examines whether the brokers have a robust selling discipline in place as panic selling during down markets can lead to undesirable outcomes. The performance of the brokers is reviewed quarterly and they are ranked based on their trailing 12 month performance. If the performance of a broker begins to suffer, Man GLG will contact the respective broker to discuss the source of underperformance. The next step in the filtering process is to remove ideas for shares domiciled outside the 17 eligible European countries. Before all duplicates are removed, the index screens the broker ideas for liquidity and removes ideas for shares that would lead to establishing positions representing more than 20% of the average daily trading volume of a given stock.

The first step in constructing the portfolio is to normalise the position size based on expected success (risk and conviction). Hereby, Man GLG looks at how many buy recommendations are received for a certain stock. Positions are increased with each consecutive buy recommendation. However, as soon as the index receives the sixth consecutive buy recommendation for a stock, the respective position will be reduced again and ultimately be closed out. If a stock idea receives a sell recommendation after a buy recommendation from any eligible broker, the position will be closed straight away. Afterwards, a return optimiser is implemented. The optimiser adjusts the positions based on known patterns of success, like contribution factors (e.g. is the broker a sector leader) and contextual factors (non-consensus view). Man GLG has a statistical process in place to measure if a broker is a “leader” or a “follower”. The process looks at past recommendations and determines whether a broker’s recommendations were the first on a given security or whether the broker issued their recommendation only subsequent to similar calls made by other brokers. More specifically, the index looks for patterns that have previously outperformed and enhances positions that fit these patterns. Only 20% of the ideas received by Man GLG have a similar analyst recommendation in public databases within ten days. The final step is a market-capitalisation adjustment to neutralise the market-cap versus European equity markets. Man GLG is not interested in “size bets” and therefore adjusts their small-, mid, and large-cap weightings to bring it in line with the MSCI Europe TR Index. The final index usually consists of around 200 – 250 stocks with a maximum 5% exposure per holding. Furthermore, stock ideas from leading brokers in a specific sector will experience a higher weighting than ideas from following brokers.

The index is rebalanced daily to accommodate new ideas and changes in recommendations.

Conclusion
So how does this ETF compares 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. 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 actively managed and employs a number of qualitative selection criteria, making the ETF less transparent and more expensive compared to traditional long-only equity ETFs. Due to the exclusive and market-sensitive nature of the ideas received by Man GLG, the index’s constituents are only disclosed once per week with a two-week lag. Even though there is a valid reason for doing so, the vast majority of index calculations and hence constituents are made very visible as mentioned previously. Meaning, investors in this ETF do not know what they hold until two weeks after they bought it. Furthermore, as the index is rebalanced daily, investors will only receive a snapshot of what the index constituents were on that specific day.

When it comes to whether or not broker ideas add value, opinions diverge widely. Brokers are supposedly experts in one area, e.g. healthcare sector or large caps. They are thought to have superior knowledge in their area of expertise and their recommendations are relied upon by many investors in an attempt to add alpha to their portfolios. Man GLG’s Index is backed by a research paper done by GLG Partners in conjunction with Duke University and the National Bureau of Economic Research, analysing whether brokers in Europe do indeed add value. As the existence of this ETF proofs, their findings were positive. However, Man GLG has privileged access to sales persons which helps to outperform the market. In fact, the index includes stocks from leading brokers, probably in the hope the broader market will follow.

That’s been said, mutual funds and retail investors would have a hard time to access the same information in a timely manner for the same price. Due to the total assets under management of Man GLG, the index receives the best ideas from the respective brokers. A senior sales person screens all the ideas and presents the best one with his own interpretation to Man GLG. Hence other investors would have to conduct their own research on published recommendations and would probably come up with other investment ideas. Therefore, this ETF offers a relatively cheap and easy access to those “exclusive” ideas.

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, 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 January 2011 and as such still lacks a suitable track record.

New regulations that were put into place in 2003 changed the landscape for brokers in the US and Europe. The aim was to make research departments/brokers and their investment banks more independent from each other. As a result, brokers had to start publishing and widely disseminating their recommendations. As mentioned previously, Man GLG still gets exclusive access to broker ideas, as an appointed sales person within each broker house screens all its analysts’ ideas and presents the best to Man GLG. However, further regulatory changes vying for greater transparency could impact the success of the underlying strategy. In fact, in recent discussions regulators have been demanding greater transparency for ETPs. One potential risk facing the underlying strategy could therefore be the potential for a regulatory requirement stipulating daily publication of the index’s constituents.

So, how might this ETF work for you? The ETF offers European equity exposure, adjusted to mimic the MSCI Europe Index market-capitalisation exposure in order to avoid “size bets”. Hence the ETF could be deployed as core equity holding. The ETF is perhaps most suitable for investors seeking to tap the potential alpha-generating stream of brokerage recommendations in an accessible, diversified, and liquid vehicle. Of course, investors have to pay for this potential alpha in the form of a 0.75% TER and an additional 0.72% in embedded turnover costs. This is far more expensive—as measured strictly by TER—as compared to a passive pan-European equity ETF, which can have a TER of as little as 0.15% per annum--alpha has a price.