introduction
In recent years, the traditional financial market has seen rapid development of index products represented by ETFs, showing that the growth rate of capital inflows in the Smart Beta ETF-actively managed ETF market is higher than that of ordinary index ETF products. The asset management industry has gradually shifted its attention from ordinary index products to more innovative index product series, such as ESG ETFs, actively managed ETFs and theme ETFs. Among them, active ETFs in the equity market have made new breakthroughs, attracting over-the-counter products to actively transform and become a hot spot for active product development in recent years. Global index providers continue to innovate and improve the index system to meet new market demands, promote the industry to develop in depth in a refined and diversified manner, and promote continuous innovation in index products. Crypto index-enhanced products are still in a very early stage compared to traditional financial markets. With the growth of the overall crypto market value, the market growth space for index-enhanced structured products should also increase rapidly. We believe that the market size and current status of index funds and index enhancement funds/ETFs in the U.S. stock market are of reference value for the development path of index enhancement funds in the crypto market. We believe that crypto index enhancement funds can obtain excess returns that meet the needs of investors with different risk appetites through these return enhancement methods, whether it is a multi-factor quantitative stock selection model, a subjective timing model, a sector rotation model, or an index futures derivative return enhancement model.
Hong Kong and US stock common index ETFs and index enhancement funds/ETFs scale and development trend
Between 2015 and 2023, the scale of both index funds of U.S. or Hong Kong stocks, as well as index-enhanced funds/ETFs, showed steady growth, while the scale of index-enhanced funds/ETFs, that is, actively managed ETFs, grew even faster, increasing 10 times in 8 years. In 2023, the scale had reached nearly ⅓ of that of ordinary index funds.
Table 1 Comparison of the total size of ordinary index funds and index enhancement funds/ETFs for US and Hong Kong stocks from 2015 to 2023
In the traditional financial market, the scale of index funds for U.S. and Hong Kong stocks even tends to exceed their corresponding market capitalization, while the scale of index funds/ETFs in the crypto market is far from its market capitalization. With the growing interest of traditional investors in crypto asset management products, the development prospects of cryptocurrency index funds and exchange-traded funds (ETFs) are broad.
Table 2 Comparison of the market capitalization of US stocks, Hong Kong stocks, cryptocurrencies and the corresponding index funds/ETFs
Active management characteristics of index-enhanced funds
Index funds can obtain returns (β returns) from following the benchmark market by tracking the characteristics of the index, such as tracking error, market capitalization style, valuation style, industry weight ratio and individual stock weight ratio.
Enhanced index funds, on the other hand, strive to obtain additional returns (alpha returns) that exceed the market through active management by fund managers, so that when the market falls, the decline is less than the benchmark index, and when the market rises, the returns are greater than those of the tracking index, striving to achieve relatively stable compound interest performance in the long term.
In terms of tracking indices, index enhancement funds can track a wide range of indices, including broad-based indices, single industry indices or other thematic indices. From the current market environment of US and Hong Kong stocks, broad-based indices such as S&P500, Nasdaq-100, Russell2000, DJIA, HSI, HSCEI are the mainstream choices for index enhancement funds at the β end.
Ways to Enhance Index Fund Returns
With the continuous innovation of the financial market, index enhancement funds can obtain excess returns in a variety of ways, thereby achieving the effect of "enhanced" returns. The "enhanced" returns of index enhancement funds can be achieved through, for example, multi-factor quantitative stock selection models, subjective timing models, sector rotation models, stock index futures derivatives return enhancement models, etc. These are the more common ways to enhance the returns of index enhancement products.
Quantitative multi-factor enhanced strategy products
The goal of the quantitative multi-factor enhancement strategy is to select stocks by using multiple factors at the same time to obtain better returns. These factors are divided into many dimensions, such as technical factors (market momentum and technical indicators), macro factors, statistical data mining (machine learning, deep learning), fundamental factors, etc. From the fundamental factors, they include company financial stability, dividend yield, valuation, etc.
Table 3 Common multi-factor stock selection enhanced index funds in the U.S. stock market
Take the Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) for example. SPHD tracks the S&P 500 High Dividend Low Volatility Index and uses a multi-factor stock selection strategy that focuses on high dividend yields and low volatility stocks. It selects the 50 securities in the S&P 500 with the highest dividend yields and low volatility. The constituents are weighted by dividend yield, and individual weights are capped at 3% to ensure diversification. To maintain its low volatility target, the fund is rebalanced semi-annually, re-evaluating stock selections based on updated dividend yield and volatility metrics. Due to its low volatility, the ETF generally outperforms the broader S&P 500 index in bear markets, but can lag behind in strong bull markets.
SPHD's earnings enhancement partly comes from overweighting high-dividend and low-volatility stocks. However, SPHD has significantly underperformed the benchmark S&P 500 in the interest rate hike environment in the past year. The main reason may be that high-dividend industries, such as finance, energy, aviation, and tourism, have been greatly negatively affected during the epidemic. High-dividend stocks in these industries may perform poorly during the epidemic. In particular, the financial sector, which accounts for 26% of SPHD's portfolio, was hit hard in the recent banking crisis. The performance below the benchmark has caused its AUM to decline on a large scale.
Strictly speaking, SPHD and QUAL are considered passively managed funds that use some enhancements. These enhancements are designed to optimize specific factors of the portfolio, but the overall investment strategy of the fund is still based on tracking a specific index. In addition to using passive management methods to track the index, QARP also uses some enhancements and active management strategies to select the constituent stocks of the portfolio, so it is a typical actively managed fund.
When implementing a quantitative multi-factor enhancement strategy, it is necessary to consider the weights of different factors and the number of holdings in the portfolio. Depending on the actual situation, different factor weights and holdings can be used to achieve different investment goals. For example, more financial stability and earnings stability factors can be used to invest in stable stocks, or more market momentum and technical indicator factors can be used to invest in growth stocks.
Subjective Timing Enhancement Strategy
As an investment strategy, subjective timing can be divided into multiple methods, including technical timing, fundamental timing, macro timing, sentiment timing and event-driven timing. These methods are based on different analysis and decision factors and aim to identify market trends, value and opportunities in order to make better decisions on buying, selling or adjusting investment portfolios.
1. Technical analysis timing: Technical analysis is a method of identifying potential market trends by studying historical price and volume data. Investors can use technical analysis tools (such as trend lines, moving averages, relative strength index, etc.) to determine the direction, strength and turning points of the market, thereby determining the right time to buy or sell.
2. Fundamental analysis timing: Fundamental analysis focuses on factors such as a company's financial status, competitive advantages, and industry position. Investors can evaluate a company's value and growth potential by conducting in-depth research on the company's fundamentals. When the market price underestimates the company's true value, investors can buy; when the market price overestimates the company's true value, investors can sell.
3. Macroeconomic analysis timing: Macroeconomic timing enhancement strategies are based on the impact of macroeconomic data on market trends to make more precise asset allocations. These strategies usually involve analysis of factors such as interest rates, inflation, and monetary policy. For example, during economic expansions, investors may increase stock investments; during recessions, investors may reduce stock investments or turn to safer assets. Fund managers make strategic decisions to adjust their portfolios based on their outlook and expectations for global macroeconomic conditions. Compared with passive index funds that only track benchmarks, they can bring excess returns from macroeconomic timing.
4. Market sentiment analysis timing: Market sentiment analysis focuses on the impact of investor emotions and psychological factors on market prices. Investors can use market sentiment indicators (such as the Fear/Greed Index, Investor Confidence Index, etc.) to determine whether the market is overly pessimistic or overly optimistic, and choose the timing accordingly. Buying when the market is overly pessimistic and selling when the market is overly optimistic may help investors obtain excess returns. Sentiment strategies are becoming more and more popular. Other sentiment strategy indicators include AAII Sentiment Index, VIX, Market Vane, Put/Call Ratio, etc.
5. Event-driven strategy timing: Event-driven strategies focus on specific events that affect the value of a company (such as mergers and acquisitions, spin-offs, reorganizations, etc.). The timing of buying or selling can be determined based on the anticipation and analysis of these events.
Take Pacer Trendpilot US Large Cap ETF (PTLC) as an example. Pacer Trendpilot US Large Cap ETF (PTLC) is an exchange-traded fund (ETF) based on the US stock market that adopts an active timing strategy. Its goal is to adjust its exposure to US large-cap stocks according to market trends to achieve relatively stable investment returns.
The fund mainly tracks the S&P 500 index and adopts a timing strategy based on moving averages. When the S&P 500 is above the 200-day moving average and the closing price of the last five trading days is above the five-day moving average, the fund will invest all its assets in the S&P 500 index; when the S&P 500 is below the 200-day moving average, the fund will allocate 50% of its assets to the S&P 500 index and the other 50% to short-term U.S. Treasury bonds; when the S&P 500 five-day moving average is below the 200-day moving average for five consecutive trading days, the fund will invest all its assets in short-term U.S. Treasury bonds.
Observe the performance of Pacer Trendpilot US Large Cap ETF (PTLC) in some specific market environments, such as the bull market in 2017, the volatile market in 2018, and the market shock caused by the epidemic in 2020 to explore the characteristics of timing enhancement funds. In 2017, the S&P 500 index achieved a higher annual return of about 21.8%. In this year, the return rate of the PTLC fund was about 20.4%, slightly lower than the benchmark index. Although PTLC captured some gains in the rising market, it performed slightly worse than the S&P 500 index in this market environment due to management fees and transaction costs.
The market environment was volatile in 2018. The S&P 500 index rose sharply at the beginning of the year, but then fell significantly at the end of the year, and finally fell by about 4.4% for the whole year. In contrast, PTLC performed better in 2018, with a full-year return of about -3.7%, achieving a certain degree of reduction relative to the benchmark index.
In early 2020, the COVID-19 epidemic triggered a sharp shock in global stock markets. The S&P 500 index fell by about 34% in a short period of time, but then rebounded strongly, with a full-year increase of about 16%. PTLC's performance was relatively weak during the year, with a full-year return of about 11.5%. Although the fund achieved a certain degree of loss reduction through timing strategies during the market decline, its performance was relatively poor during the subsequent rebound, resulting in a full-year return lower than the benchmark index.
Therefore, in rising markets, PTLCs perform similarly to the benchmark index; in falling markets, the fund's timing strategy may help mitigate losses, but due to tracking error, it will not beat the benchmark in all market conditions.
Sector Rotation Enhancement Strategy
The sector rotation enhancement strategy determines which sector is about to take the lead based on the rotation of the business cycles of different sectors before the market starts. It increases the allocation of upward trending industries or reduces the allocation of sluggish industries (that is, industry "overweight" or "underweight"), and achieves excess returns that are higher than the rise and fall of the tracking index by deviating from the industry allocation of the tracking index.
Table 4 Common industry rotation stock selection enhanced index funds in the US stock market
Take PDP (Invesco DWA Momentum ETF) as an example. PDP aims to track the performance of Dorsey Wright Technical Leaders Index. It adopts a relative strength strategy and selects and weights 30 US stocks with the best relative strength. Assuming that in the market, stocks in the technology industry perform best and have a high relative strength, PDP will select the best performing stocks in the technology industry.
To execute the strategy, PDP will rebalance its holdings regularly to ensure continued investment in technology stocks with the highest relative strength. If the market environment changes and the relative strength of other industries begins to rise, such as the consumer goods industry, in this case, PDP may adjust its holdings and weight its investments in the new best performing industries based on the new relative strength data and market trends.
In general, PDP's strategy execution method is based on relative strength stock selection and is adjusted according to market performance and trends. Stocks are selected based on relative strength, that is, performance relative to other stocks or industries. The holdings are rebalanced regularly. The two funds in the table outperformed the benchmark performance in the one-year time dimension, but the YTD performance was relatively poor.
Derivatives Enhancement Strategy
Derivative enhancement strategies are used to enhance the performance of a portfolio through the use of derivatives such as options, futures, swaps, etc. These strategies usually involve considerations such as leverage, hedging risks and speculation.
Some derivatives enhancement strategies based on US stocks include:
1. If the stock index futures contract has a discount space relative to the spot index, then you can simulate part of the index position by investing in stock index futures, and at the same time obtain the enhanced benefits of negative premium convergence. If the point of the futures contract is lower than the actual point of the spot index, buy the futures contract. Theoretically, when the contract expires, the points of the two must be extremely close, so the long position of the futures contract during this period must earn a little more than the spot index. This method tracks the underlying index by allocating part of the funds to stock index futures, and the remaining idle funds are operated through fixed income or arbitrage strategies to obtain relatively stable returns.
2. Calendar Spread: Use the price difference between futures contracts of the same index with different expiration months to conduct arbitrage. When the forward contract has a higher premium than the near-term contract, a long position can be established in the near-term contract while a short position can be established in the forward contract. Over time, the price difference between the two contracts may converge, bringing excess returns
3. Inter-market Arbitrage: When there is a pricing difference between two highly correlated markets (such as commodities, interest rates, exchange rates, etc.), a long position can be established in one market and a short position can be established in another market at the same time. Over time, the pricing difference between the two markets may converge, thereby bringing enhanced returns.
4. Option strategy: Options are another common derivative. For example, the return on existing stock investments can be increased by selling covered calls. In this strategy, the fund holds a certain number of stocks and sells a corresponding number of call options. This allows the fund to collect option premiums, thereby increasing the overall investment return. However, the risk of this strategy is that if the stock price rises by more than the option exercise price, some potential gains may be missed.
5. Pairs Trading: This strategy involves two stocks in the same industry or with high correlation. When the price difference between the two stocks exceeds the historical normal level, a long position can be established in the relatively undervalued stock, while a short position can be established in the relatively overvalued stock. Over time, the price difference between the two stocks may converge, resulting in excess returns.
Take the ProShares UltraPro Short QQQ ETF (SQQQ), an index enhancement fund based on US stocks using derivatives enhancement strategies, as an example.
The ProShares UltraPro Short QQQ ETF (SQQQ) uses market timing and derivatives-enhanced strategies to provide returns that are -3 times the daily performance of the Nasdaq-100 Index. This inverse leveraged ETF is designed for experienced investors who believe that the technology and large-cap stocks in the Nasdaq-100 will decline in the short term. To achieve its investment objectives, SQQQ uses financial instruments such as swaps, futures contracts, and options to gain short exposure to the Nasdaq-100 Index. As a result, SQQQ can magnify gains when the underlying index declines, but can also magnify losses when the index rises.
Specifically, in the swap strategy, SQQQ obtains short exposure by signing swap contracts with other financial institutions. In the swap contract, SQQQ agrees to exchange the proceeds of the underlying asset (such as the Nasdaq-100 index) at a fixed price within a specific period. This enables SQQQ to obtain short exposure to the Nasdaq-100 index without actually holding the stock.
In the futures contract strategy, SQQQ obtains short exposure by selling Nasdaq-100 index futures contracts. Through this method, SQQQ agrees to sell the underlying asset (Nasdaq-100 index) at a specific price on a specific date in the future. This strategy allows SQQQ to short the Nasdaq-100 index without actually holding the stock.
In the option strategy, SQQQ uses the purchase of put options to achieve short exposure. Put options give SQQQ the right to sell the underlying asset (Nasdaq-100 index) at a specific price on a specific date in the future. Purchasing put options allows SQQQ to gain profits when the underlying asset falls, thereby achieving short exposure to the Nasdaq-100 index. SQQQ executes these transactions on multiple trading platforms and venues to ensure liquidity and the best price. However, this ETF is generally considered a high-risk short-term investment and is not recommended for long-term holding.
Multiple enhanced strategies tracking the same index provide investors with suitable risk exposure
Even if they track the same index, by providing different index tracking strategies and leveraged products, investors can choose index fund investment representatives with appropriate risk exposure according to their risk tolerance, investment goals and expected returns. The following is an introduction to some series of products that track the Nasdaq-100. Most of these products are passively managed and aim to provide investors with different strategies for tracking the Nasdaq-100 Index to obtain corresponding exposure and returns.
QQQ (Invesco QQQ Trust): As Invesco's core product, QQQ is the most popular and well-known ETF tracking the Nasdaq-100 Index (AUM 175780mln). It aims to replicate the performance of the index by investing in the same securities in the same proportions as the index, which includes the 100 largest non-financial companies listed on the Nasdaq stock market. QQQ is a market-cap-weighted ETF, meaning that holdings are weighted according to their market capitalization.
QTR (Global X NASDAQ 100 Tail Risk ETF) seeks to track the performance of the Nasdaq-100 Index while reducing tail risk. This ETF invests in the same securities as QQQ but also holds put options on the Nasdaq-100 Index to hedge against large market declines.
QQQM (Invesco Nasdaq-100 ETF): QQQM is a low-cost alternative to QQQ. It also tracks the Nasdaq-100 index, but with a lower expense ratio. The investment strategy and holdings are similar to QQQ, but with lower expenses, making it more cost-effective for long-term investors.
QQQN (Invesco NASDAQ-100 Triple Q Disruptive Innovators ETF) is an exchange-traded fund (ETF) launched by Invesco. The fund aims to track the Nasdaq Q-50 Index, which includes non-financial companies ranked 101 to 150 by market capitalization on the Nasdaq market. These companies are generally considered to be in the growth stage, with innovative capabilities and breakthrough technologies. QQQN provides investors with exposure to a group of potential companies in the growth stage.
The QQQA (ProShares Nasdaq-100 Dorsey Wright Momentum ETF) strategy seeks to track the performance of the Dorsey Wright NASDAQ OMX CTA Momentum Index, and its enhanced strategy includes a momentum strategy to select stocks based on relative strength signals. Relative strength refers to the performance of an individual stock relative to the market or industry. Based on relative strength signals, Nasdaq-100 index constituents that have performed well in the short term are selected. Based on the momentum investment strategy, stocks are selected based on their relative strength and weights are adjusted accordingly. Stronger performing stocks will receive higher weights, while weaker performing stocks will receive lower weights or be excluded from the portfolio.
TQQQ (ProShares UltraPro QQQ): TQQQ is designed to track the Nasdaq-100 High Beta Index and is a leveraged ETF that seeks to provide three times the performance of the Nasdaq-100 Index. It seeks to track the performance of the entire Nasdaq-100 Index. Due to its leveraged amplification effect, TQQQ will generally exhibit higher volatility and risk than the index.
QQQX (Nuveen NASDAQ 100 Dynamic Overwrite Fund): QQQX is an actively managed fund based on the Nasdaq-100 index. It adopts an overwrite strategy, which is a strategy of holding Nasdaq-100 index constituent stocks and selling call options at the same time. The overwrite strategy is designed to increase the income of the portfolio. In this strategy, the fund holds stocks in the Nasdaq-100 index and sells corresponding call option contracts at the same time. If the price of the Nasdaq-100 index is lower than the exercise price of the call option on the expiration date, the call option will expire without being exercised, and the fund can retain the premium collected. In this way, the fund can obtain additional income by selling call options when the market trend is stable or falling.
The goal of the overwriting strategy is to increase the portfolio's return through this additional income and to protect against market declines to a certain extent. However, the simultaneous sale of call options in the overwriting strategy also limits the portfolio's potential gains in rising markets, because the fund may be limited from the gains when the call options are exercised.
Summarize
Compared with the equity ETF/Index Fund market based on U.S. stocks, the crypto index enhancement product market is still in a very early stage. With the growth of the overall crypto market value, the growth space of the index-enhanced structured product market should also increase rapidly. We believe that the various enhancement strategies of U.S. stock index funds and index enhancement funds/ETFs can be applied to the strategy construction of index enhancement funds in the crypto market. Crypto index enhancement funds can help investors with different risk preferences obtain corresponding risk exposure and excess returns through these return enhancement methods, including multi-factor quantitative stock selection models, subjective timing models, sector rotation models, or stock index futures derivatives return enhancement models.
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