As Exchange Traded Funds have poured into the market over the past several years, ETF product developers are hitting a wall. There currently is at least one ETF that tracks virtually every index in existence and also for all of the obvious strategies – e.g. dividend stocks, low-volatility stocks, etc. This overcrowding of the field is pushing developers to create ETFs that track ever more narrow market spaces, most of which are too risky for the average portfolio and thus have a high probability of dying for lack of sales.
So, where do ETF developers go to create new value in their product lines? The Research Division of the National Association of Online Investors (NAOI) looked at this question and answered it with some outside-the-box thinking. We developed a new investment type called Dynamic Investments (DIs) that creates value from combining existing ETFs in a dynamic structure. DIs unleash massive value that is now lying dormant in an ETF product line and create a vast area for new, profitable research and development.
To see how they create value let's first review how DIs work.
Created by the NAOI, a Dynamic Investment (DI) contains the components shown in the diagram below.
DIs are designed to automatically change the ETF they hold based on a periodic sampling of market trends. To create a DI for a specific goal, an NAOI-trained designer first identifies the ETFs to work with and places them in the DI's Dynamic ETF Pool (DEP). These are “candidates” for purchase.
In the DI’s Management Module, the designer specifies a Review Period – e.g. quarterly – and a price-trend strength indicator that is used to rank the ETFs in the DEP in order to find the one moving up most strongly at time of review. The "winner" is the ONE ETF that the DI buys and holds until the next review period when the DEP is ranked again and the currently held ETF is changed if necessary. A more detailed description of how DIs work is found here.
These components and the process used makes each DI “market sensitive” and capable of consistently producing returns that traditional MPT-based portfolios can’t touch with far less risk and no active management needed.
The Value Uncovered by Dynamic Investments
To illustrate how DIs uncover value in an existing product line,I provide below a simple table that shows the descriptions of three ETF types that exist in virtually all ETF product lines – we used specific ETFs from one major ETF developer for this example. The table presents for each of these ETFs the average annual return and Sharpe Ratio (an indicator of return received per unit of risk taken, the higher the better) for the 10 year period from the start of 2007 to the end of 2016. The bottom row presents the same data for a Dynamic Investment that combines all three ETFs in its Dynamic ETF Pool and uses quarterly reviews to determine which to own at any one time.
It is clear from this example that significant value was uncovered by combining these three individual ETFs in the DI structure. This is "hidden" value that is not currently being exploited by organizations that simply sell individual ETFs.
The New ETF Developer Product Line
There are an unlimited number of DIs that can be created for virtually any goal using ETFs that currently exist in a product line. By refocusing research and development efforts on creating Dynamic Investments organizations can uncover massive value that is now lying dormant and with far less time, effort and cost than creating new ETFs .
The following diagram shows how an organization’s ETF product line can be significantly expanded with a new derivative product layer in the form of a Dynamic Investment product line.
Not only does the development of DIs expand an ETF vendor's product line, it also significantly expands their market reach. DIs are comprehensive, diversified investment “products” that can be sold directly to the public in the same manner as ETFs are today. Investors simply buy and hold them while the DI automatically signals the holder when trades are needed. In essence, they are active investments that are passively managed. Dynamic Investments represent the true “productization” of investing.
NAOI research and market feedback shows us that Dynamic Investments, not mutual funds or stand-alone ETFs will be the preferred portfolio building blocks of the future. Here I have shown how ETF vendors can refocus their R&D efforts in order to multiply the value of their existing ETF product line and to start planning for the future of investing today.
The NAOI works with financial organizations to make everything discussed here happen in the most effective and efficient manner. More information is found at www.DITheory.com .
"The Future of Investing Starts Here" is a Service Mark of the National Association of Online Investors.