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Here we outline the construction of the C-QUADRAT iQ European Equity ETF and its underlying index in more detail.
Fund Construction
The C-QUADRAT iQ European Equity ETF uses synthetic replication to track the performance of the C-QUADRAT European Equity TR Index which aims to achieve positive medium to long-term returns and to continuously outperform the EURO STOXX 50 TR Index. The manager of the C-QUADRAT iQ European Equity ETF is the Commerzbank AG. Commerzbank AG uses unfunded swaps to deliver the performance of the benchmark index. Under this model, the ETF buys and holds a basket of securities and simultaneously enters into a swap agreement with a single counterparty, Commerzbank AG, which commits to pay the index performance (adjusted for the swap spread) in exchange for the performance of the fund’s holdings. C-QUADRAT iQ European Equity ETF is one of very few ETF providers to hold Index-Certificates, issued by state-backed banks, in its substitute basket. The rationale behind this is to reduce administration costs as no rebalancing for corporate actions are necessary. Such certificates expose investors to credit risk and therefore potentially add an extra layer of counterparty risk. However, the issuing banks are backed by the respective state governments in Germany which should reduce this risk. The swap is uncollateralised and is reset at least once a month or whenever the exposure to Commerzbank reaches the UCITS-mandated maximum limit of 10% of the fund’s NAV.
Index Construction
The underlying strategy, the C-QUADRAT European Indicators Model, is a rules-based multi-step quantitative process. The model comprises seven different indicators based on macroeconomic, fundamental and technical variables and will at any point in time be long, short or neutral relative to the EURO STOXX 50 TR Index. The index only uses a varying combination of EURO STOXX 50 Index Futures and money market instruments (EONIA) to achieve its investment objective. It is important to understand that the index is not physically investing in futures but rather makes use of the official futures prices in calculating the index. Therefore, the initial step in the index calculation is to determine suitable EURO STOXX 50 Index Futures, which are usually the most liquid ones with the shortest maturity.
The index calculation can be divided into three steps. The first step involves selecting the influencing variables for the EURO STOXX 50 Index. The second measures the quality of the selected variables and the final step is a rules-based aggregation of the indicators to compose a signal.
Selecting influencing variables
The influencing variables are macroeconomic, fundamental and technical variables. Macroeconomic factors are seen to be a good indicator for the future behaviour of the overall economy and are not sector specific. The information gained through the macroeconomic analysis will feed into the model as a medium- to long-term price predictor. Fundamental variables are used to analyse the features of the EURO STOXX 50 index and to extract the fundamental drivers for futures market movements. The technical variables analyse market movements using trend, volume and volatility. The aim is to detect trends and reversals in early stages of their development.
Determining the quality of the selected variables
The quality of the selected variables is measured using different well-known statistical models and technical indicators to derive values that can be included in the indicator model. Based on the quality and conviction of the selected variables, the so-called Market Direction Indicators I, II & III will receive values between -8 and +8.
The Market Direction Indicator I indicates signals between +2 and -2 whereby positive values indicate an expected rise in future prices. In contrast, negative values are pointing towards declining markets. This indicator is based on macroeconomic, fundamental and technical variables with the objective to forecast mid-term price expectations of the EURO STOXX 50 Index. The Market Direction Indicator II indicates signals between +8 and -8. A positive value signals future prices may appreciate and a negative signal points towards falling prices. This indicator is also based on macroeconomic, fundamental and technical variables and works best in upward trending markets with the objective to predict mid- to long-term price expectations. The third indicator shows signals between +1 and -1 and is based on technical variables. Again, positive numbers indicate the expectation for rising futures prices and vice versa. The aim of this indicator is to forecast changes in short-term price expectations.
Rule-based aggregation of indicators
The rules-based aggregation of the indicators is again divided into several steps. First, the model tries to identify the market phase, i.e. uptrend, downtrend or sideways. Second, the transition indicator tries to identify a market reversal or pull-back. If this indicator determines a reversal or pull-back in an existing upward or downward trending market, it will show a value of +1 indicating that the market turned from a trending to a sideways market. Third, the market neutral indicator measures market uncertainty based on technical and fundamental variables. This is the most dominant indicator as it can override all the other signals with the aim to control downside risk. This indicator switches to +1 as soon as it detects market uncertainty which will result in an immediate market exit, irrespective of any other signal. Fourth, the model tries to identify which Market Direction Indicator is best suited for the current market environment. Markets tend to be influenced by macroeconomic and fundamental data in upward trending markets. However, if markets are trending downwards or sideways, technical variables tend to be the driving force. If the market phase indicator shows a value of +1, the market is perceived to be upward trending; hence the Market Direction Indicator I & II will be applied. In contrast, if the indicator shows a value of -1, Market Direction Indicator III will be used. In downward trending or sideways trending markets, technical variables will be used. Therefore, if we are in an upward trending market with no market reversal or market uncertainty, the aggregation of Market Direction Indicator I & II will be used to determine the trading signal.
In a next step the degree of leverage will be determined by using a leverage indicator. The leverage indicator can be 1, 1.5 or 2 and indicates the degree of leverage only during up trending markets.
In the final step, the exposure to EURO STOXX 50 Index is calculated using the asset allocation indicator, which is calculated daily. This indicator combines the trading and the market phase signal with the leverage signal. Thereby, the leverage can only be applied if both signals are positive. If the trading signal is -1, the strategy will short the EURO STOXX 50 Index. Therefore, if we are in a positive market phase and have a positive trading signal, the strategy can apply a leverage of 1.5X or 2X relative to the EURO STOXX 50 Index. The next table visualises the different scenarios for the asset allocation.
The index is rebalanced as soon as the trading signal or the leverage indicator changes. As mentioned previously, the index is only (theoretically) invested in EURO STOXX 50 Futures and the money-market (EONIA). The daily rebalancing of the asset allocation is based on the volume weighted average price of the EURO STOXX 50 Future, which was determined at the initial step of the index calculation, between 9:05am and 9:15am CET. The index-provider publishes all C-QUADRAT indicators with an 18-day lag. The rebalancing of leverage is based on the volume weighted average price of the futures between 5:20pm and 5:30pm.
As mentioned earlier, for every index rebalancing a 1.5bps levy is charged based on the value of the rebalanced portfolio. This charge also applies if futures contracts are rolled over which could potentially occur quartarly as the most liquid futures with the shortest maturity are March, June, September and December contracts.
Also, additional downside-protection is embedded in the form of an option for the index-sponsor to readjust the exposure factor should the index drop by more than 25% on an intra-day basis.
