This creates a negative drag on short ETP positions because exposures that don’t pay out relatively quickly can depreciate in value. For example, an investment of £100 which didn’t immediately pay out, could be worth £95 a few months later as a result of the negative carry. If the view then comes good with the underlying index falling 20%, the short position will only gain 20% of £95, rather than the full 20%, creating a drag of £1.
Risk-efficient transitions
Where investors require short-term access to markets, however, short and leveraged ETPs can offer investors of all sizes the ability to speedily and cost effectively augment the exposure of a portfolio. This is particularly pertinent for asset allocation changes, which necessitate portfolio transitions.
Once an investor has decided to change their portfolio allocation, the faster that change can be actioned, the better. The portfolio is inherently sub-optimally positioned as soon as that decision is made.
According to Martin Mannion, head of trustee services at the John Lewis Partnership pension fund and chairman of the committee responsible for the T-Charter, the code of best practise for transition management: “From the perspective of the TStandard, from the point of making a decision, an investor is at risk from not being positioned accordingly.”
An investor wishing, for example, to reduce or divest from a long physical gold holding, which can take time to execute, can use a short gold ETP to create an immediate portfolio effect, minimising out-of-market risk and the opportunity cost of not being allocated according to the desired allocation. Where portfolio changes are relatively simple, reducing the need for a specialist transition manager, or where investors are moving out of illiquid investments, short and leveraged ETPs can offer the flexibility to implement risk-efficient transitions.
According to Ben Shaw, development director at the Occupational Pensions Trust: “Where the market turned against, for example, a direct physical property allocation, which would take a while to sell, using a short ETP could help protect the capital value of the portfolio. The challenge would be to find an ETP with an exposure sufficiently close to that of the portfolio.”
Longer-term role
Their use is not confined to tactical exposures however. Despite the drag associated with path dependency, providers report investors willing to manage this risk can use short and leveraged ETPs to protect portfolios more efficiently over the longer-term than long-only diversification in a world were crossand intra-asset class correlations remain elevated.
“Alternative product demand is increasing as traditional asset classes don’t offer the diversification they used to,” according to Boost’s Nossek. “Rebalancing a fund by selling equities and buying bonds or making a defensive move into cash can be expensive and involve significant transition costs. Using a short equity ETP is more cost efficient, even considering the need to manage the path dependency, and offers a negative correlation with the underlying index of effectively -1.
“Gearing through leveraged ETPs also allows for more efficient capital deployment. If the underlying stocks are looking increasingly similar, why take a big position in a single stock? Lever the index rather than guessing the market.”
As the range of short and leveraged ETPs continues to expand and liquidity improves, institutions of all sizes will find the door of opportunity opened by this market increasingly attractive for implementing cost effective and flexible tactical and strategic allocations to take advantage of short-term opportunities and manage both short and longer term risks.
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