The first generation of Exchange Traded Funds (ETFs) arrived in the US some fifteen years ago. While their debut on the UK market is comparatively recent, there are now more than 100 ETFs launched on the London Stock Exchange, and there are already at least half that many planning to launch this year.

The removal of the UK Exchequer’s stamp duty on foreign ETFs has been a key driver of this growth. The range of ETFs has also dramatically increased, opening up more opportunities for hedge funds to optimise their investment strategies with the use of ETFs. In this article, we look at the increase in popularity of ETFs that aim to outperform the main market cap-based indices, by tracking indices that select stocks using one or more fundamental measures.

The ETF landscape

Exchange Traded Funds are essentially Index Funds that trade like a single stock. They have come a long way since they were first introduced in the US. The range of indices and markets that ETFs provide access to, has expanded at a rapid pace. ETFs tracking broad-based indices like the S&P 500 and FTSE 100 have been joined by ETFs offering exposure to specific market segments, investment styles and global industries, regions including emerging markets as well as various fixed income markets and alternative asset classes, such as property, infrastructure, commodities and listed private equity.

Why ETFs?

ETFs can be traded in real-time on a stock exchange and investors can buy and sell intraday at live prices rather than limiting themselves to the end-of-day price points. Investors also benefit from improved transparency as information on the securities’ underlying assets is published daily. Hedge fund managers, attracted to ETFs unique qualities of transparency, convenience and flexibility are increasingly using these funds as part of their short term cash management and asset-allocation strategies. ETFs also enable investment into specific sectors of the stock market, or into certain geographical areas, through just one trade.

Alternative weighting strategies prove increasingly popular

Traditional stock market indices, including the S&P 500 and Russell 1000 are weighted according to the value of the current share price and the number of shares outstanding – otherwise known as a company’s market capitalisation. This can cause the index to overweight overvalued stocks and underweight undervalued stocks.

Recently, new weighting methodologies, such as those based on one or more fundamental factors have been developed to address some of these issues and to enhance investors’ risk-return ratios. California-based company Research Affiliates was the first to introduce this approach using four specific metrics in itsFundamental Index Portfolio: book equity value, cash flow, sales and gross dividends.

Academic research indicates that fundamentals-based indices outperform cap-weighted ones. For example, when Arnott, Hsu and Moore (2005) constructed a 1,000 stock portfolio based on cash flow, sales dividends and book value parameters, and the portfolio’s performance was back-tested from 1962-2004 against the S&P 500, the results showed an excess in performance of 2%, a superior Sharpe Ratio (0.452 vs 0.306 for S&P500).

The MarketGrader system

MarketGrader, a US-based equities research company, is another index provider using a fundamental screening methodology. It has created indices which focus on US equities and are designed to outperform the major US indices. The MarketGrader methodology selects stocks from a universe of around 5,700 US-listed equities, based on a company’s fundamental attractiveness, combined with sensible diversification in terms of sector distribution and market capitalisation.

In September, six US equities-focused MarketGrader indices became available to European investors as ETFs on the London Stock Exchange through Spa ETF Plc, a sister company to asset management firm, London and Capital.

The MarketGrader methodology has a proven track record of consistently outperforming major US market indices. For example, in the past three years, the MG 100 Index has achieved a cumulative return of 43.54%, compared to the S&P 500, which has returned 21.16% over the same period (to 31 December 2007). It is innovative approaches like MarketGrader’s that provide today’s hedge funds with an alternative to the benchmark huggers indexes, and have opened up brand new arbitrage opportunities for this alpha-seeking investment group.

Potential hedge fund strategies using fundamental ETFs

* Long/short hedging strategies
New ETFs that are outperforming the traditional benchmarks offer hedge fund managers the opportunity to operate next-generation long/short trading strategies.

One strategy would be to buy an ETF that tracks a distinct fundamental such as via the SPA MarketGrader ETFs, and simultaneously short-sell an ETF or Future that relates to a benchmark index like the S&P 500. This allows a shrewd investor to isolate and amplify any out-performance created by the fundamental strategy over the market capitalisation weighted benchmark index.

Many commentators currently believe that large-cap stocks will continue to outperform in the US and a more aggressive long/short strategy would be to take a long position in a fund such as the MarketGrader Large Cap and take a short position in the S&P Small Cap index. A less risky, size neutral strategy would be to short the S&P 500.

In the US, ETF providers like ProShares now offer short ETFs that cover many major indices and US sectors, allowing investors a convenient way to take short positions. It is only a matter of time before these types of ETFs arrive in the UK.

* Index Pairs trading strategies
In the same way as pairs trading can work with individual stocks, there are opportunities to look for high correlation between two separate ETFs. In this example, the investor would look for two ETFs where the underlying indices have a close correlation over the long term, but the short term correlation has diverged, buying when you believe the gap is at its largest and selling when this relationship reverts to the mean. This example is illustrated in Figure 1 using the MG40 and MG Small Cap Indices.

ETFs are clearly a rapidly growing asset class and the year ahead looks busy for the ETF market. In 2008, as the market witnesses a continued increase in the range and styles of ETFs on offer, hedge fund managers will be able to use these funds in more and more innovative ways.