The Benefits of DiversificationFor an institutional investor, such as Beaumont Capital Management (BCM), the ability to conduct in-kind asset transactions is one of the more important differences between ETFs and mutual funds. Using SPY as an example, an institutional investor can purchase the component stocks of the S&P 500 and exchange them with the fund sponsor for newly created shares of SPY. This process works in reverse as well, where outstanding shares are redeemed in exchange for the underlying component stocks. The ability to create new shares and redeem existing ones means that even if the ETF itself doesn’t trade very often, it is still as liquid as its underlying securities. This is called “implied liquidity”, and it allows institutional investors to acquire and dispose of large ETF positions without the need to buy or sell ETF shares in the market.
The Benefits of Diversification
While we covered the ease with which one can diversify using ETFs above, it also makes sense to touch upon the benefits of diversification and investing in a diversified vehicle. Single stocks and bonds are both perfectly viable means of investment, but investing in them requires considerable expertise as it invites single company risk. A diversified vehicle will allow an investor to take advantage of what they believe to be a favorable industry trend or asset allocation without having to bear the additional risks present in the securities of a single company.
ETFs for a Quantitative Strategy
According to the Capital Asset Pricing Model (CAPM), there are two primary sources of risk: systematic and unsystematic. Systematic risks affect broad asset classes making them generally unavoidable for securities within that group. On the other hand, unsystematic risk, which could be an earnings report, a new product launch, or a lawsuit, is company-specific and can be significantly reduced by holding a well-diversified portfolio. In a traditional “bottom-up” portfolio, the stock picker is selectively bearing unsystematic risk as a potential source of active return. The problem is that it is incredibly difficult to adequately quantify unsystematic risk without inviting undue complexity. When it comes to quantitative investing, simplicity is key. Going back to the chart above, the single stock was more volatile over the time period displayed due to company specific events while the technology sector as a whole was relatively calm. Since our models attempt to take advantage of systematic inefficiencies, they require the use of a diversified vehicle in order to reduce unsystematic risk; ETFs are without a doubt the most convenient, efficient and transparent means of accomplishing this. As a result, they are the vehicle of choice for all of the BCM strategies.
Brendan Ryan and Deniz J. Rezendes are Research Analysts at Beaumont Capital Management, a participant in the ETF Strategist Channel.
Sources:
Copyright © 2015 Beaumont Financial Partners, LLC. All rights reserved.
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Kelley, T., Hwang, I., & Roche Kelly, L. (2015, May 13). ETF Assets Set to Overtake Hedge Funds This Year. Retrieved August 4, 2015, from http://www.bloomberg.com/news/articles/2015-05-13/etf-assets-set-to-overtake-hedge-funds-this-year
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Fees presented do not include advisory fees or trading costs: SPDR® S&P 500® ETF. (2015, July 31). Retrieved August 4, 2015, from https://www.spdrs.com/product/fund.seam?ticker=spy
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How to Choose an Exchange-Traded Fund (ETF). (n.d.). Retrieved August 4, 2015, from http:// guides.wsj.com/personal-finance/investing/how-to-choose-an-exchange-traded-fund-etf/
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The S&P 500 proxy portfolio was created using the State Street SPDR® S&P 500® ETF (SPY) holdings as of July 31, 2015. The security with the lowest weight in the ETF, Diamond Offshore Drilling (DO), was assigned 1 share and the remainder of the portfolio holdings were scaled up to their respective weights using the dollar value of one share of DO as a reference. Share counts were rounded up or down so that no fractional shares were held in the portfolio. At least one share of each individual holding was required in the resulting proxy portfolio.
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Roughly two hundred dollar increments is derived from the average closing price of the State Street SPDR® S&P 500® ETF (SPY) over the last twenty days ending September 9th, 2015. State Street SPDR® S&P 500® ETF (SPY) closing prices sourced from Bloomberg.
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Egan, Matt. (2015, March 12). 86% of Investment Managers Stunk in 2014. Retrieved August 4, 2015, from http://money.cnn.com/2015/03/12/investing/investing-active-versus-passive-funds/
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Bernicke, Ty. (2011, April 4). Retrieved August 4, 2015, http://www.forbes.com/2011/04/04/real-cost-mutual-fund-taxes-fees-retirement-bernicke.html