The Danger in Bespoke Funds: Many offer lots of leverage on the way up, but also on the way down

SATURDAY, JANUARY 25, 2014

The Danger in Bespoke Funds

By BRENDAN CONWAY | MORE ARTICLES BY AUTHOR

Many offer lots of leverage on the way up, but also on the way down.

Call it the rise of the bespoke exchange-traded fund. These days, in a shift from general-interest ETFs, a large institutional investor can identify a hole in its portfolio, and presto, the investing public gets a brand-new specialized fund. But while these custom-crafted strategies might be a perfect fit for one investor, they could be a lousy fit for you.

A single buyer showed up for the lion’s share of several of last year’s biggest ETF launches: Ken Fisher’s Fisher Asset Management owns 97% of two recently christened Barclays exchange-traded notes. Similarly, the Arizona State Retirement System invested $100 million in each of four iShares “factor” ETFs—funds focused on one factor, such as value or momentum. Big, professional investors are more comfortable than ever owning ETFs, and fund makers love this because it helps them rake in the money, notes S&P Capital IQ analyst Todd Rosenbluth.

Complexity is one hallmark of these funds. Take Barclays’ $1.4 billion ETN+FI Enhanced Global High Yield ETN (ticker: FIGY), majority-owned by Fisher. It uses a complex formula for leveraged returns on 24 countries’ stocks. But the leverage varies over time, and there’s a screen to remove undesired stocks. “Our size and scope allow us to do this,” says a Fisher spokesman, citing the firm’s thesis on growth stocks and benefits like strong liquidity. If investors chase the ETN’s recent returns–the three-month rise is ahead of the MSCI EAFE index’s—they risk getting crushed by leverage in a selloff. But what hurts you might not hurt Fisher nearly as badly. The ETN is less than 3% of the firm’s assets under management. Individuals’ bets would probably be bigger, because their portfolios get unwieldy when allocations are too small. A Fisher spokesman cautions against comparisons, but adds that “there are certainly economic benefits to size in this area.”

The best-known custom-ETF craze followed a revamp of an existing strategy: the yen-hedged Japan fund. In 2012, firms including RiverFront Investment Group hatched the idea of tweaking the WisdomTree Japan Hedged Equity ETF (DXJ) in favor of yen-sensitive stocks, on the theory that they’d fare best in a monetary-policy shift. The plan was well timed: Exporters were enviably positioned for Abenomics. The yen plunged, Japanese stocks soared, and the ETF surged 42% in 2013. Assets under management ballooned to $13 billion.

Were there suddenly so many investors with nuanced views of Japan—or were they just jumping on the bandwagon? “Make sure you’re doing your homework,” cautions Chris Konstantinos, a RiverFront manager. Any selloff would be a double whammy for the ETF because investors would sell stocks and crowd into yen.

Are you more eager on Japan than RiverFront? The firm’s most aggressive strategy, a global growth portfolio, has a 12% Japan weighting. A more conservative strategy has 5.5%. If your exposure is bigger, you’re outbulling the bulls. “Japan is my highest-conviction idea,” says Konstantinos, “but we’re not putting all our eggs in that basket.” Also, RiverFront’s aggressive strategy uses 32 ETFs; its annual portfolio turnover is 75%. Most individual investors can’t be so tactical.

You might win for a while chasing the big guys’ returns, but it’s more likely you’ll churn—and you may well get burned. Chances are these highly specialized ETFs are a better, safer fit for someone else’s portfolio.