Mike Venuto describes how ETFs democratize leverage

When advisors want to reduce clients’ portfolio risk, selling short involves setting up a margin account.

“Traditional leverage can be very expensive,” said Michael Venuto, co-founder and chief investment officer at Toroso Investments in New York. “Inverse ETFs democratize some hedging strategies, so they’re not only for the ‘big boys.’”

An inverse ETF moves in the opposite direction of a regular long position. A client concerned about a $100,000 holding of an S&P index fund could get a full hedge by buying $100,000 of an inverse S&P 500 ETF.

With inverse ETFs, there is no need to have a margin account.


Nevertheless, advisors should tread carefully before using inverse ETFs, which typically reset daily.

Suppose Jane Client’s $100,000 S&P 500 long position goes to $105,000 on Monday and returns to $100,000 on Tuesday. Jane is back where she started.

However, if Jane had purchased $100,000 of an inverse ETF, it would have fallen to $95,000 after Monday’s 5% S&P 500 gain. Tuesday’s index drop from $105,000 to $100,000 is a 4.76% decline.

With a matching gain in the inverse ETF, the inverse ETF would rise to just over $99,500. A flat two days for the index has generated a loss in the inverse ETF.

Over time, this mismatch can be substantial.

Inverse ETFs are “buy-and-adjust” vehicles, according to Venuto, rather than buy-and-hold investments.


Many inverse ETFs are 2X or 3X, meaning that their daily returns are twice or three times the reverse of the underlying index. With these so-called leveraged inverse ETFs, cash outlays can be reduced.

Jane can hedge her $100,000 long position by buying $50,000 of a 2X inverse ETF, for instance. However, the leverage makes the daily discrepancies even steeper.

Nevertheless, leveraged inverse ETFs might offer pinpoint hedging.

For example, a financial ETF could hold an 18% stake in real estate investment trusts, Venuto said.

If an advisor is skeptical about REITs but upbeat on the broad financial industry, a 6% position in a 3X inverse real estate ETF could help mitigate the perceived real estate risk, he said.


Other ETFs can serve similar purposes.

“In volatile markets, to hedge the downside and not sell core positions, we use ProShares Ultra VIX Short-Term Futures (UVXY),” said Jack F. Reutemann, a CFP, and the founder and chief executive of Research Financial Strategies, a wealth management firm in Rockville, Md.

This ETF tracks VIX futures, a measure of S&P 500 volatility; it usually goes up when stocks go down.

“The math is not perfect, but in round numbers UVXY will move eight to 12 times the opposite direction of an S&P 500 ETF,” Reutemann said. “Thus, you can almost hedge an entire 90% core position with one 10% UVXY position.”

Using UVXY in this manner is dangerous, “but SQQQ and SPXS [inverse ETFs on the Nasdaq 100 and the S&P 500] are only 3X inverse, and to get a 90% position I would have to spend 30% of my cash,” he said.

Donald Jay Korn is a New York-based financial writer who contributes to Financial Planning and On Wall Street.

This story is part of a 30-30 series on smart ETF strategies.

Mike Venuto comments on new Gold Hedged ETFs

By Cinthia Murphy
Toroso Investments
Published in ETF.com

The Rex Shares gold-hedged ETFs—new to market this month—attempt to solve a common asset allocation problem many advisors face: What to do about gold?

Most advisors today feel like they must own gold. Most do so because gold offers diversification and portfolio hedging benefits. It can even prove useful for short-term tactical purposes, such as when the need arises for a safe haven in times of turbulent market action.

But as an asset, gold doesn’t generate any type of earnings yield that compounds, or any type of income. For that reason, many advisors struggle with tying up capital in gold at the expense of other assets. An allocation to gold means a smaller allocation to something else.

Read more on EFT.com

Mike Venuto on the use of Inverse ETFs for precise sector exposure

Investors can use leveraged and inverse exchange traded funds to hedge a long position against sudden turns or capture short-term trends in more volatile market conditions.

On the recent webcast, Tactical Strategies to Combat Market Volatility, Sylvia Jablonski, Managing Director and Co-Head of the Capital Markets & Institutional Strategy Team at Direxion, points out that the markets have exhibited heightened volatility, so securities are experiencing wider swings.

“We are witnessing a volatility regime change,” Jablonski said. “Average intra-year volatility has climbed to new highs.”

Michael Venuto, Co-founder & CIO of Toroso Investments, also argues that we can no longer rely on factors like quantitative easing to support a consistent market rally with limited volatility.

“The market has been irrational the last few years,” Venuto said. “Expect a return to normal volatility.”

Consequently, with the heightened volatility, more investors are beginning to pick up leveraged and inverse ETFs to play the market swings.

Jablonski explained that these leveraged and inverse ETFs try to magnify the returns of their benchmarks on a daily basis. Investors should keep in mind that most leveraged ETFs are designed to produce double or triple the performance of the underlying market on a daily basis. Consequently, when investors look at the long-term performance of a typical leveraged ETF, people may notice that the fund may not perfectly reflect their intended strategies.

A market without long interruptions and relative lack of volatility will help maintain positive gains in a leveraged ETF. Since the ETFs rebalance on a daily basis, compounding effects benefit leveraged ETFs in a consistently trending market. On the other hand, in times of increased volatility, leveraged ETF returns can fall behind their intended 2x or 3x strategies.

“Historically, the best environment for the use of leverage has been low volatility high trend,” Venuto said.

Consequently, leveraged and inverse ETF traders should closely monitor their holdings. Venuto suggests investors should “buy and adjust” and refrain from buying and holding these leveraged and inverse products, especially during volatile conditions.

Investors have utilized leveraged and inverse ETFs in a number of portfolio strategies. For example, Venuto suggests small percentage allocations in inverse leveraged options to hedge mitigate detraction from existing positions, so investors are simultaneously going long and short to hedge risk. Through leveraged and inverse ETFs, investors may help limit portfolio volatility or diminish drawdowns in the event of a steep market correction.

Jablonski also pointed to a number of popular short and long plays that have recently cropped up. For example, the Direxion 2x Daily CSI 300 China A Share ETF (NYSEArca: CHAU), which tracks the leveraged 200% position on China A-shares, and the Direxion Daily CSI 300 China A Share Bear 1x Shares (NYSEArca: CHAD), which takes the inverse or -100% performance of Chinese A-shares, have grown in popularity as U.S. investors gain greater access to the Chinese A-shares market.

The energy sector has also been gyrating after the plunge in oil prices and recent rebound in crude, especially the oil exploration and production sub-sector, which has been hardest hit during the energy sell-off. Consequently, traders have played the sudden turns in the sub-sector through the relatively new  Direxion Daily S&P Oil & Gas Exploration & Production Bear 3x Shares (NYSEArca: DRIP), which takes the -3x or -300% daily performance of the S&P Oil & Gas Exploration & Production Select Industry Index, and Direxion Daily S&P Oil & Gas Exploration & Production Bull 3x Shares (NYSEArca: GUSH), the bullish alternative to DRIP.

After plunging to a 17-year low and somewhat recovering in recent weeks, natural gas has also attracted a lot of attention. The Direxion Daily Natural Gas Related Bear 3X Shares (NSYEArca: GASX) has previously been a popular bet to capitalize on the misfortunes in the natgas market, but the long Direxion Daily Natural Gas Related Bull 3X (NYSEArca: GASL) has quickly gained traction as investors rode the recent rally.

Looking ahead, the Direxion Daily 20-Year Treasury Bear 3X (NYSEArca: TMV), which takes the inverse -3x or -300% daily performance of the NYSE 20 Year Plus Treasury Bond Index, could also be a great way to play a rising interest rate environment as the Federal Reserve contemplates higher rates.

Financial advisors who are interested in learning more about implementing leveraged and inverse ETF strategies can listen to the webcast here on demand.

Tactical Strategies using Leverage ETFs described by Mike Venuto

As investors gear up for a volatile market in the year ahead, more aggressive exchange traded fund investors have utilized leveraged and inverse products to quickly adapt and capitalize on shifting market conditions.

On the upcoming webcast, Tactical Strategies to Combat Market Volatility, Sylvia Jablonski, Managing Director and Co-Head of the Capital Markets & Institutional Strategy Team at Direxion, and Michael Venuto, Co-founder & CIO of Toroso Investments, will help go over tools that ETF investors can use to hedge against sharp turns in a volatile environment or to capture short-term trends.

For instance, three popular contrarian bets that have cropped up this year include theDirexion Daily Gold Miners Bear 3X Shares (NYSEArca: DUST), Direxion Daily Energy Bull 3X Shares (NYSEArca: ERX) and Direxion Daily S&P Biotech Bull Shares (NYSEArca: LABU). [Popular Short-Term Leveraged/Inverse ETF Bets]

DUST shares outstanding have substantially increased during the rally in gold, which suggests that some are calling the surge in bullion and miners overdone. DUST has attracted $446.7 million in net inflows so far this year.

However, the Direxion Daily Junior Gold Miners Index Bull 3x Shares (NYSEArca:JNUG) and the Direxion Daily Gold Miners Bull 3X Shares (NYSEArca: NUGT), which take the 3x or 300% daily performance of a group of junior gold miners and larger gold miners, respectively, continue to outperform as ongoing uncertainty helps prop up gold prices. Over the past week, JNUG rose 25.9% and NUGT increased 22.5%.

ERX shares outstanding have substantially increased during the crude oil sell-off as traders tried to catch a falling knife and timed a market bottom. ERX added $50.1 million in net inflows year-to-date.

The more focused S&P Oil & Gas Exploration & Production Bull Shares (NYSEArca:GUSH) has also been outperforming, rising 16.8% over the past week. Oil and gas explorers and producers have been among the worst performers in the recent energy rout, and they also experienced the strongest rebound on the recent rally in oil prices.

LABU shares outstanding have also substantially increased over the course of the correction in the biotechnology sector. Biotechs have yet to rebound along with the broader market. LABU saw $151.3 million in inflows so far this year.

Guillermo Trias describes the ETF sales and marketing ladder

The journey from developing a compelling investment thesis to launching an ETF can be an arduous one indeed. While the rewards for a truly unique ETF can be substantial, the upfront work and attention to detail that are required to make an ETF concept a reality often appear daunting to new issuers that are just dipping their toes into the ETF industry for the very first time.

With this in mind, we teamed up with ETF Trends and a variety of experienced service providers from around the ETF space to produce an overview of the most important recipes for success for new ETF issuers. The result is “Big Tips for New Issuers,” a free print magazine (available online in pdf), aggregating insights from experts in indexing, research, marketing and PR, trading, legal, listings, sales, and advertising.

What follows are a few brief excerpts from a selection of submissions, highlighting some key points from the publication. To download the full magazine, be sure to visit http://bigtips.co

1.) ETF Sales and Distribution is an awful lot like a ladder: you’ve got to climb it one “rung” at a time

“Getting past the gatekeepers and developing initial interest in new ETFs is where sales creativity matters the most,” writes Guillermo Trias of Toroso Investments in his submission, A Better Approach to ETF Sales and Distribution. “There are three main audiences for ETFs,” he continues, “which should be targeted in this order: retail, allocators, and institutional clients.” It is only once sufficient assets and liquidity have been garnered at the first “retail” rung that an ETF Issuer’s sales efforts should be re-oriented towards allocators, and then institutions.

2.) Timing is everything

“You need to launch the right product at the right time in the right market conditions,” writes Mohit Bajaj, Head of ETF Trading Solutions at WallachBeth Capital, in his submission Growing Healthy ETF Liquidity From Day One. “It will be nearly impossible to successfully gather interest in a new high yield bond ETF when Carl Icahn is on CNBC telling the world that the junk bond market is going to collapse.” Bajaj goes on to provide a survey of other important tactics new issuers can utilize to ensure their ETF’s liquidity is at a nominal level after they launch.

3.) In online advertising, context is king

Designing an ad is only half the battle, according to Erin Evans of Orbis Marketing. “All advertising campaigns have a target audience in mind,” writes Evans in her submission, Online Advertising: Reaching the Right Investors for Your New Fund.“Ideally your advertisement will not just reach the right audience but will reach them at the optimal moment when they are researching ETFs, ideally your category or particular fund.” It is also possible to optimize ads to hone in on the most effective messaging for particular slices of your target audience.

4.) ETF-Centric Advisors are a whole new breed of FA

How can new ETF issuers connect their products with ETF-centric Advisors? This is the question that Tom Lydon of ETF Trends asks in his submission, Connecting with ETF-Centric Advisors. “In addition to be disenthralled with active management, [ETF-Centric] advisors look to the cost benefits, transparency, and tax-efficiency of ETFs.” Perhaps most notably, Lydon notes that ETF-centric advisors prefer what he deems “virtual relationships” rather than in person seminars or phone calls from representatives. By far the most popular method of communication for ETF-centric advisors appears to be webcasts or virtual conferences.

5.) Millennial investors will spur further ESG innovation in ETFs

The millennial generation is unlike any generation that has come before when it comes to investing in ETFs, according to Gregg Sgambati of S-Network Indexes. “Unlike their parents,” Sgambati writes, “the motivations of these new investors is often a great deal beyond the conventional scope of profits—they don’t just want to make money on their investments, they want to put their money to work and ‘do good.’” As millennials stand to inherit trillions of dollars in the coming years, this can present both a challenge and an opportunity for new issuers as they begin to more seriously consider the details of potential funds they wish to launch.

101 ETF Lessons Every Financial Advisor Should Learn

Exchange-traded funds (ETFs) have burst on to the scene in the late 2000s and early 2010s, raking in hundreds of billions of dollars in assets and prompting a major shift towards indexing strategies in the process. ETFs have empowered financial advisors (FAs), registered investment advisors (RIAs), Chief Financial Officers (CFOs), money managers, and retail investors to take greater control over their portfolios, pushing down fees and maxing out tax efficiency in the process.

Continue reading “101 ETF Lessons Every Financial Advisor Should Learn”

Mike Venuto discusses ETFs for downside protection

It’s been a wild ride so far this year for U.S. stocks. Since the beginning of 2016, the S&P 500 has already declined some 10% in a loss that has been anything but smooth or linear.

The uptick in volatility and the poor stock market performance have many investors now more concerned with downside protection than with upside gains. We asked a handful of ETF strategists what ETFs they turn to when downside protection is what they are trying to achieve. Here’s what they had to say:

Michael Venuto, chief investment officer, New York-based Toroso Investments

Toroso manages portfolios based on three outcomes: growth, income and wealth preservation. With the recent market sell-off and volatility, investors have turned their attention to wealth preservation.

Our core wealth preservation strategy seeks to enhance the Harry Browne Permanent Portfolio through ETF security selection. A basic permanent portfolio equal-weights equities (the Vanguard Total Stock Market (VTI | A-100)), bonds (the iShares Core U.S. Aggregate Bond (AGG | A-98)), gold (the SPDR Gold Trust (GLD | A-100)) and cash (the iShares 1-3 Year Treasury Bond (SHY | A-97)).

Over the past 40 years, this concept has produced annualized returns of around 7-8%, with a third of the volatility of the S&P 500. However, over the past few years, the bull market in growth stocks and the bear market in gold have caused this allocation to produce lackluster returns.

In 2016, the strategy appears to be working again. Global X Funds offers an ETF that seeks to express the Harry Browne concept, and it’s up for the year so far: the Global X Permanent ETF (PERM).

I believe in a more rational market that’s not propped up by federal stimulus. In this market, the Permanent allocation and PERM ETF should produce returns more consistent with historical norms.

Another ETF we use to protect client assets is the QuantShares U.S. Market Neutral Anti-Beta (BTAL |F-38). This ETF shorts high-beta names in the S&P 500 while be long low-beta names. It’s worked well in this environment as a tail hedge, and is up more than 13% YTD.

Wesley Gray, CEO and CIO, Broomall, Pennsylvania-based Alpha Architect

Our robo advisor is the only robo out there that does asset allocation with downside protection.

Our approach is to own the best-of-breed for each asset allocation line, and then use trends to buy/sell outside of the ETF structure.

If you want the downside protection within an ETF, Meb Faber’sCambria Value and Momentum ETF (VAMO) has trend-following on it. The Pacer lineup [including the Pacer Trendpilot 750 (PTLC), thePacer Trendpilot 450 (PTMC) and the Pacer Trendpilot 100 (PTNQ)] has trend-following. The AlphaClone funds [such as the AlphaClone Alternative Alpha ETF (ALFA | C-35)] also have trend-following rules.

Michael McClary, Chief Investment Officer, Akron, Ohio-based ValMark Advisers

Volatile markets can often lead investors to make decisions more quickly than they normally would. Before making any major investment decision, we recommend going through the proper research process and making decisions through the lens of a disciplined investment philosophy.

Too often we see investors making investment decisions “running from” one investment and “running to” another. It is hard to make quality decisions with that mindset.

We have four sound paths that investors might consider in this market.

First, stay diversified. Long-term strategic diversification is a sound disciplined investment strategy over time. There is a reason soldiers and rescue workers go through so much training: They are supposed to rely on training to make decisions in chaotic situations. We would encourage investors not to abandon their training.

Second, we believe in and manage portfolios with a proven institutional-quality volatility management overlay. These portfolios are designed to reduce exposure to equities in periods of high volatility. Our TOPS Managed Risk ETF Portfolios have significantly outperformed the market in this year’s pullback.

However, we recommend investors choose and stick with this type of strategy over time. We would caution investors from trying to time their way in and out of these strategies, which can defeat the purpose of the overlay and leave investors disappointed. Quality strategies will deliver over time, but only cash investments are designed to deliver every day. Don’t confuse investments with the U.S. Postal Service.

Third, given the wild short-term swings we have seen in the interest rate market, investors might consider the PIMCO Enhanced Short Maturity Strategy (MINT | B) or the Guggenheim Enhanced Short Duration Bond (GSY | B). For investors who want short-term capital protection, these ultra-short strategies might provide more stable results than even IEI. With interest rates falling so much this year, many ETFs that target the short to intermediate end of the curve risk a surprise snapback in rates.

Lastly, clients may want to consider short- to intermediate-term laddered municipal bonds. In this area, we favor using individual issues or the target maturity municipal series offered by iShares.

Clayton Fresk, Portfolio Manager, Watkinsville, Georgia-based Stadion Money Management

Being a tactical manger with a defensive bias, we place enormous importance on downside protection. This protection comes in various degrees.

For our more tactical mandates, we can move completely out of equity ETFs and into cash or short-duration fixed-income ETFs. For other strategies, we may rotate into lower-beta offerings or into noncorrelated holdings.

Despite what form it comes in, we believe protecting against losing any previously captured gains is of utmost importance when measuring performance over full market cycles.

Mike Venuto Volatility exploit it or ignore it?

Everyone is talking about increased market volatility in this new year.

But if you are a long-term index investor who believes in buy-hold-and-rebalance achieved through passive vehicles such as ETFs, does volatility even matter? Should you worry about it?

Perhaps just as important is the question of whether increased volatility presents unique opportunities to capture alpha. If so, how do you go about finding alpha in this environment?

We asked these questions of a few ETF strategists and financial advisors. Here’s what they had to say:

Scott Kubie, chief strategist, Nebraska-based CLS Investments:

Volatility matters for emotional and fundamental reasons. At CLS, we believe investors have a capacity to bear risk. We call it their risk budget. When an investor is exposed to more volatility than they can tolerate, they often make rash decisions and reduce risk at the wrong time.

Volatility matters, because it is an emotional cost to investing that can lead to reduced performance. It also matters for fundamental reasons, because volatility often expresses—and magnifies—a real risk that could lower long-term returns.

The good thing about corrections is they create opportunities. We are looking for assets classes where the selling pressure has pushed prices below fair valuations and where fundamentals are attractive. Most equity asset classes have fallen in line with their risk during the recent decline.

CLS sees opportunity in rotating toward factor or smart-beta ETFs that offer exposure to the types of stocks that typically outperform in the long run. International markets that benefit from lower oil prices also provide potential price gains.

Michael Venuto, co-founder and chief investment officer, New York-based Toroso Investments:

On paper, volatility is irrelevant when evaluating a total return. Obviously, a 10% return with 20 standard deviation is the same as 10% return with 5 standard deviation.

However, it’s important to remember the client experience. Investors are social and emotional, not paper or theoretical. Even the most astute investors are likely to react incorrectly to extreme market movements. High volatility can cause investors to violently adjust their time horizon and exit the market. Lower volatility promotes participation; a 10% rate of return cannot be achieved on the sidelines.

I believe alpha is more available today than it has been for many years. First, the artificial stimulus provided by the government has ended and fundamentals are starting to matter. In the next few years, relative fundamentals should provide investors opportunities for outperformance.

Mike Venuto explains what insiders KNOW

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.

The growth of smart-beta strategies has been staggering, but quite top heavy.

Meaning, most assets have flowed to factor-based strategies and dividends. I have written in the past about a subcategory of smart beta that I call characteristic indexes. These indexes highlight a business characteristic that active investors often seek through a passive vehicle.

Many of the ETFs that follow these indexes are categorized by ETF.com as “Alpha-Seeking.” These ETFs allow investors to access buy-backs, spin-offs or IPOs in a low-cost, tax-efficient manner.

The top-performing “alpha-seeking” ETF for the past two years has been the Direxion All Cap Insider Sentiment ETF (KNOW | B-77). KNOW remains my current top pick for “characteristic” or “alpha seeking” ETF, and here is why:


I started due diligence on KNOW with the index data because, like most smart-beta concepts, live ETF data was not available during 2008. This analysis begins by evaluating the Sabrient Multi-cap Inside/Analyst Quant-Weighted Index (SBRQAM), a business characteristic index that investors can obtain exposure to through KNOW.

The index incorporates four key business characteristics:

  • Aggressive accounting practices
  • Corporate insiders’ behavior
  • Analysts’ earnings revisions
  • A defensive overlay

The process, simplified, is as follows:

Step 1 – Forensic Accounting Component:

Starting with the 1,500 stocks of the S&P Composite 1500, eliminate stocks of companies with very aggressive accounting practices, as identified by Sabrient’s proprietary forensic accounting methodology.

Step 2 – Insider & Earnings Revisions Component:

Four quantitative factors are used to rank and winnow the remaining stocks after Step 1. At least one of these four factors must be positive for a stock to make this cut:

  • Number of insiders making open-market purchases
  • Percent increase in the holdings of the purchaser
  • Number of positive analyst revisions
  • Percent increase in analyst expectations

A quantitative overlay ranks the stocks from the first cut to 600 using a forward-looking “outlook score.” This score rewards strong historical and projected growth trends, low current and projected valuation, high quality of earnings, and favorable dynamics of Wall Street analyst estimates. The top 100 stocks from this second cut are used to populate the index.

Step 3 – Defensive Component:

A “defensive sentiment” overlay is used to rank the final 100 stocks. This overlay rewards stocks that historically have performed well in weak markets and have strong free cash-flow yield and strong dividend yield.

The top 50 stocks are then weighted exponentially so that the top 50 represent a range of 2.67% (for the highest-ranked stock) to 0.96% for the 50th-ranked stock, and each of the bottom 50 stocks is given a flat weighting of 0.35% in SBRQAM.

Comparing Indexes

I have selected three broad-based market-weighted indexes as comparison for SBRQAM. Our goal in performing this comparison is twofold:

  • Assess the effectiveness of SBRQAM’s stock selection process relative to an investment in a broad-based market-cap-weighted index. For this analysis, we will compare SBRQAM to the S&P Composite 1500.
  • See whether SBRQAM could work as a “core enhancer” to two indexes, where the ETFs linked to the index represents substantial assets.
Index # Of Stocks
CRSP U.S. Total Market Index (CRSP) –
Launched 1/18/2011
Nearly 4,000
S&P Composite 1500 Index (S&P 1500) –
Launched 5/18/1995
S&P 500 Index (S&P 500) –
Launched 3/4/1957
Sabrient Multi-cap Insider/Analyst Quant-weighted Index (SBRQAM) – Launched 4/4/2011 100

Security Selection

The S&P 1500 Index and SBRQAM start from the same universe of stocks. The S&P 1500 ranks all of the constituents by market cap, whereas SBRQAM follows the ranking and winnowing process described above.

The question is, how well does this security selection process actually work? Below are some key charts to help understand the differences:

The chart above shows that an investment of $100 would have grown to over $434 since Jan. 1, 2002 if invested in the SBRQAM Index; whereas an investment of $100 in the S&P Composite 1500 for the same time period would have only returned $188.

How Costs Figure In

Both of these calculations measure the change in prices of the underlying holdings and do not take into account the additional costs of investing. However, for the SBRQAM Index, I reduced the price returns by 65 basis points per year to represent the imputed cost of the KNOW ETF (this also applies to the next two charts below).

The relative statistics over the last three, five and 10 years, presented in the chart below, show that the SBRQAM Index can enhance the return of a core investment in a market-capitalization-weighted index. The resulting returns are compelling enough to consider an allocation to an ETF tied to SBRQAM, even though SBRQAM has a higher beta than the benchmark index.

I firmly believe investing in a product such as KNOW that follows the SBRQAM Index creates an opportunity to enhance portfolio returns. The chart below shows returns were stronger in the last seven calendar years. This helps draw the conclusion that it may work well with a core market fund and may provide excess returns over time. However, we should not rely on past performance history alone.

So, from this point, my due diligence process digs into the fundamentals of the ETF to make sure it improves the overall fundamentals of the portfolio. In my opinion, if the underlying fundamentals are not better, then the likelihood of enhancing returns is diminished.

For here, I look to widely held ETFs that are often used as a core investment to represent the overall market—the SPDR S&P 500 (SPY | A-98), the Vanguard Total Stock Market (VTI | A-100) and theiShares Core S&P Total U.S. Stock Market (ITOT | A-100). The next chart compares the fundamentals of KNOW to three ETFs as of Dec. 31, 2015:

This shows that KNOW seems to have the opportunity to grow more than the broad-based market-cap-weighted ETFs when you look at the price to sales and price to book ratios.

The price to earnings is in line with SPY, and lower than the other corresponding ETFs, although this ratio is subject to a higher-degree accounting judgment when posting a company’s earnings. Price relative to sales and book value have a lower opportunity for such judgments. They may present a more reliable picture of the fundamentals. KNOW also has the highest yield compared with these ETFs.


Investors should ask themselves, if the correlations are so high, why has KNOW outperformed these other benchmark ETFs? Evaluate the overlap.

We define “overlap” as the percentage of the ETF that is contained or represented by an ETF to which it is being compared. There is a 12% overlap between KNOW and SPY, an 11% overlap between KNOW and VTI, and an 11% overlap between KNOW and ITOT. The index methodology behind SRQAM and KNOW has systematically chosen securities that have a high correlation to traditional indexing with a portfolio that is 88% different.

In the world of active management, the phenomenon of high correlation and low overlap is called “positive active-share.” This high level of active-share could explain the large positive performance divergence relative to these widely used broad-based ETFs.

Tax Efficiency

One of the key benefits of business-characteristic ETFs is their tax efficiency. According to Morningstar, the annualized turnover of KNOW is 827%, which would generally result in significant capital gains distributions to shareholders of a mutual fund.

However, the unique ability of an ETF to create and redeem shares allows for the distributed capital gains to be minimized significantly. So far, KNOW has distributed capital gains only in one year—2012—when it distributed $1.54 in short-term gains, or about 3%. No capital gains were distributed in 2013, 2014 or 2015.

The Bottom Line

As noted on ETF.com, KNOW has been the best-performing “alpha seeking” ETF for two years, and there is evidence to suggest this positive relative performance can continue. The fundamentals of KNOW, relative to certain broad-based market-cap-weighted ETFs, and are generally considered a better investment opportunity to the “growth at a reasonable price” investor.

The high level of active-share generated by the SBQAM Index makes KNOW an attractive ETF for diversifying core U.S. equity exposure. The tax efficiency of the ETF allow the investor to retain exposure to a series of companies that meet its selection criteria and avoid massive capital gains as the fund holdings turns over. With this ETF, I intend to “stay in the know.”

At the time of this writing, Toroso had positions in KNOW. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products, and designing asset allocation strategies, using ETFs that seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call 646-465-5930, visitwww.torosoinv.com or email info@torosoinv.com. For a list of relevant disclosures, please click here