New Long/Short QuantShares: Long On Expenses, Short On Expectations

September 13, 2011 by  
Filed under Commentary, ETF IPOs (New ETFs)

QuantShares, a new player in ETF land, entered the fray by introducing seven market neutral ETFs based on the investment factors of momentum, quality, size, value, and beta.  Four were rolled out last week (9/7/11), and another three were listed today (9/13/11).  Unfortunately, QuantShares provides investors with little to no data regarding performance expectations, and expenses are among the highest on the market.

All seven funds are based on newly developed (August 22, 2011) Dow Jones U.S. Thematic Market Neutral Indexes and will hold approximately 200 long and 200 short equally weighted positions.  Dow Jones provides backtested results going all the way back to July 31, 2011 (three whole weeks).

The press release claims “QuantShares are the first ETFs that isolate factor returns.”  That claim appears to only be true if you somehow manage to exclude the 10-fund suite of Russell Factor ETFs, the entire FactorShares lineup, and an assortment of other funds from various sponsors.

Marketing and regulatory materials provided on the new QuantShares appear to be lacking in many areas and misleading in others.  The products are passively-managed index ETFs, yet we are told nothing about the historical performance (actual, hypothetical, or otherwise) of the indexes.  Return, standard deviation, beta, correlation, and other metrics are nowhere to be found, and they are not even discussed in general terms.  The literature completely fails to establish any expectations for the underlying indexes or the funds themselves.

Expenses

One expectation is that the new ETFs will underperform those indexes by their expense ratios, but that is where the marketing materials appear to become very misleading.  First of all, the expense ratios for QuantShares are among the highest of all ETFs on the market, ranging from 1.92% to 3.27%. 

Using the QuantShares U.S. Market Neutral Size Fund (SIZ) as an example, its 2.97% fee consists of a 0.50% management fee, 2.16% dividend, interest, and brokerage expense for short positions, and 0.31% other expenses.  Stated another way, there is 0.81% in traditional expenses and 2.16% in short selling expenses.

The SIZ summary page (also known as the primary marketing conduit) correctly states a Gross Expense Ratio of 2.97%.  It then immediately claims a Net Expense Ratio* of 0.81%.  The * explains that according to the prospectus, the advisor FFCM LLC, “has contractually agreed to waive its management fee and/or pay certain expenses of the Fund from exceeding .99% at least until August 31, 2012.”   So, which is it?  Is it 0.81% or 0.99%?  The answer will surprise you…

What the prospectus (pdf) really says is that the 0.99% limit excludes “interest, taxes, brokerage commissions and other expenses that are capitalized in accordance with generally accepted accounting principles, dividend, interest and brokerage expenses for short positions, acquired fund fees and expenses, and extraordinary expenses, if any.”

In other words, the so-called 0.99% expense cap applies only to the 0.81% in traditional expenses, which of course is not a cap at all.  It excludes the 2.16% short selling expenses, which are still there.  It would appear the stated 2.97% expense ratio will be closer to 3.15% while the so-called cap is in effect.

I do not understand how anything this convoluted and incomprehensible can get through their own internal review process let alone pass SEC muster.  If I am misinterpreting the expense ratios, then QuantShares needs to hire a few “plain English” experts to revise all their literature.

Index Construction

Each underlying index is comprised of approximately 400 stocks from among those that are in the top 1,000 by market capitalization in the Dow Jones U.S. Index and satisfy trading volumes and cost-to-borrow constraints.

Each security included in the universe is categorized as belonging to one of 10 sectors.  As part of the monthly reconstitution, each index identifies the top 20% of the securities with respect to the applicable factor within each sector as equal-weighted long positions and the bottom 20% of securities with respect to the same factor within each sector as equal-weighted short positions.

The indexes are market neutral and equal weighted both on the long and short sides.  Each index will also be sector neutral – the number of long and short positions in each sector will be equal.  For example, if a sector in the universe consists of 80 securities, the index will have 16 securities from that sector as long positions and 16 securities from that sector as short positions.

The New QuantShares

QuantShares U.S. Market Neutral Momentum Fund (MOM) buys high-momentum stocks and shorts low-momentum stocks, based on 12-month returns with a one-month lag.  It launched 9/7/11 with an expense ratio of 2.79% (MOM summary).

QuantShares U.S. Market Neutral Value Fund (CHEP) buys undervalued stocks and shorts overvalued stocks, based on standard valuation measures.  It launched 9/13/11 with an expense ratio of 2.22% (CHEP summary).

QuantShares U.S. Market Neutral Beta Fund (BTAH) buys high-beta stocks and shorts low-beta stocks, based on 52 measurements of weekly data.  It launched 9/13/11 with an expense ratio of 3.27% (BTAH summary).

QuantShares U.S. Market Neutral Size Fund (SIZ) buys the smallest market-capitalization stocks and shorts the largest stocks in the index.  It launched 9/7/11 with an expense ratio of 2.97% (SIZ summary).

QuantShares U.S. Market Neutral Quality Fund (QLT) buys the highest-quality stocks and shorts the lowest-quality stocks.  Quality is determined by combining equally the ranks of return on equity (highest to lowest) and debt-to-equity (lowest to highest).  It launched 9/7/11 with an expense ratio of 2.50% (QLT summary).

QuantShares U.S. Market Neutral Anti-Momentum Fund (NOMO) buys low-momentum stocks and shorts high-momentum stocks.  In theory, it should be the inverse of the MOM ETF.  It launched 9/7/11 with an expense ratio of 2.07% (NOMO summary).

QuantShares U.S. Market Neutral Anti-Beta Fund (BTAL) buys low-beta stocks and shorts high-beta stocks.  In theory, it should be the inverse of the BTAH ETF.  It launched 9/13/11 with an expense ratio of 1.92% (BTAL summary).

Disclosure covering writer, editor, and publisher:  No positions in any of the securities mentioned.  No positions in any of the companies or ETF sponsors mentioned.  No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

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