Back when the exchange-traded fund industry was still just a kid (we’re talking turn of the century), Lee Kranefuss was overseeing the team that created the iShares family of ETFs for Barclays Global Investors. Under his leadership, iShares went from product launch in 2000 to become the world’s largest suite of ETFs by the time iShares was bought by BlackRock in 2009. Under the BlackRock banner, the iShares business has remained the top dog in the ETF space.
Kranefuss, 55, departed BlackRock in 2010. And while he’s not particularly well-known to the investing public, he remains a presence in the ETF industry. Post-BlackRock, he was executive-in-residence at Warburg Pincus, an international private equity firm based in New York City, where he helped with ETFs, index investing and asset management. He was also executive chairman at Source ETFs, a London-based outfit that competes in the European ETF space.
And in 2015, he co-founded 55 Capital Partners, an asset manager with offices in San Francisco, New York and Mumbai. According to the company, it delivers “dynamically managed” liquid global portfolios using ETFs. Simply put, 55 Capital is an ETF strategist firm that constructs global macro strategies akin to what’s found in the hedge fund world but with the cost efficiencies and transparency afforded by ETF-filled portfolios.
These days, Kranefuss has been promulgating the message that the ETF industry is at the end of the beginning. The first phase of ETFs—product creation—is essentially played out. As he sees it, the second phase is upon us now with the emergence of investment strategists who use ETFs to create diversified portfolios in separate accounts. But the current crop of strategist portfolios, he claims, are by and large not expansive enough to provide truly diversified strategies.
And that brings us to what Kranefuss believes will be the next driving force in ETFs—their use in portfolios providing global macro coverage of the investment landscape. Considering those are the kinds of portfolios that 55 Capital is building right now for its clients, one might argue that Kranefuss’s message to the industry is self-serving. Then again, he’s making that argument—and he started 55 Capital—because he believes that’s where the next big ETF opportunity lies.
Glass Onion
There are more than $3.4 trillion in global exchange-traded product assets (that includes exchange-traded notes, but the bulk of those assets reside with ETFs), and the growth seems to have no end in sight thanks in part to the proliferation of smart-beta strategies, the continued rollout of increasingly micro-targeted—if not niche—products, and the potential growth of actively managed ETFs. But while new products are either being launched or filed for registration with regulators every week, 2016 also saw a record number of combined ETF and ETN closures.
That fits Kranefuss’s narrative that the barriers to entry in the ETF industry are very low but the barriers to success are actually high and getting higher. “Everyone wants to get in on that growth and come up with the next hit song,” he says. “But I think if you’re not already in the manufacturing business it’s too late. Where people are going wrong—both small and large producers—is reaching the conclusion that the answer must be in coming up with more and more clever ETFs.
“People keep trying to slice the onion finer and finer to come up with new interesting ideas,” he adds. “But many of them don’t match what they’re supposed to do, and that doesn’t serve the needs of the industry because the cleverness that people are coming up with often isn’t that fresh or it doesn’t have an investment thesis or doesn’t serve the needs of sophisticated investors.”
The rise of factor-based funds has taken the ETF industry by storm, but they usually come with higher fees than traditional index-based passive funds do (though they’re still cheaper than actively managed mutual funds). Kranefuss calls them quasi-active strategies that will attract reasonable flows for three to four years—until they fail to deliver what people thought they would.
Regarding the smart-beta phenomenon, Kranefuss references a paper written by Cliff Asness, managing principal and chief investment officer at AQR Capital Management, in which he points out that any alternative weighting that tries to get away from overvalued stocks is simply a value strategy.
“You can implement a value strategy in a portfolio by simply properly weighting low-cost sector ETFs,” Kranefuss says. “You don’t have to pay 50 basis points for somebody’s weighting. Something like low volatility is an interesting idea, but right now we’re in a time period that might’ve ended where low-vol ETFs were more volatile than standard ETFs. The process of trying to turn it into a product, even if the idea has merit, can concentrate investors into doing things at the same time. It has all of the problems that active managers have with trade crowding, and when you’re large, how do you get rid of positions without getting picked off by hedge funds?”
Tilting At Factors
The growth of ETFs as investment tools helped propel what Kranefuss calls the first wave of ETF strategists. “With ETFs, you can basically own 100% of the investable universe with 50 to 60 positions,” he says. “If returns are more driven by what you broadly hold rather than securities selected within markets, we now have all of the tools to do it.”
But Kranefuss offers that many strategists’ portfolios don’t realize their potential because they aren’t taking full advantage of what you could do with ETFs. “They are often somewhat narrow strategies,” he says. “Sector rotation is close to a stock-picking approach where you’re trying to time things, but that’s not the same as having broad global exposures that can buffer one another.”
The industry’s next phase, Kranefuss believes, will be the rise of comprehensive global macro strategies where you can run small separate accounts for people with institutional-quality portfolios that have greater downside-to-upside capture and reduced volatility, and which catch all of the return drivers such as factors, beta leverage and the like in a way that all fits together.
Call it ETF 3.0, if you will.
“With the portfolio I’m talking about, it’s easy to get a factor tilt into that and you’re using eight to 10 basis points to do it,” Kranefuss says. “And you get the more appropriate factor exposure where people won’t be racing for the same exit at the same time because you’re making decisions across a portfolio, and not just for a fund. It will be a bigger fundamental shift than anything we’ve seen so far. What currently exists so far treats everything like a security, and not thinking about constructing the harmonious portfolio you can build with them.”
55 Capital follows three main tenets in managing assets: It incorporates a broad set of return drivers across asset classes, sectors, regions and factors; it minimizes downside exposure through dynamic risk forecasting; and it systemically harvests tax losses. Its five different strategies employ ETFs in an open architecture platform for the firm’s separately managed account and limited partnership structures.
When it comes to tilting a portfolio toward a certain factor (i.e., value, momentum, minimum volatility, etc.), Kranefuss says the firm sometimes selects factor-based ETFs, but other times his team manufactures the tilts more cheaply using other ETFs focused on sectors that are known to lean heavily to a particular factor.
“We are focused mainly on risk management, so our goal is to capture 70% of the upside in order to suffer only 20% to 30% of the downside,” Kranefuss says. As of November 30, 2016, 55 Capital’s flagship Dynamic Macro strategy had returned 4.40% since its inception on April 1, 2016. Its benchmark (a combination of 60% in the MSCI ACWI Index and 40% in the Bloomberg Barclays US Aggregate Bond Index) returned 3.16%. Back-tested data—from March 31, 2004, through March 31, 2016—puts the fund’s annualized return at 9.67% while the benchmark’s return was 5.93%.
The firm’s account minimums start at $100,000, and its fees range from 35 to 100 basis points, depending on the strategy. Kranefuss says RIAs and small institutions are 55 Capital’s main focus, but it will expand to broker-dealers and wirehouses later in 2017.