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ETFs - Opportunities in ETF Arbitrage?

Just this past Monday on 9th July 2018, I attended the Invesco ETF Luncheon hosted by Invesco Asset Management Singapore. The lunch seminar was headlined by Jason Bloom, director of Global Macro ETF Strategist at Invesco. Jason shared some interesting insights with regards to the global macro environment and also introduced a new product offering by Invesco, the Invesco BulletShares - corporate bond ETFs with a maturity date.

Since the introduction of the first American ETF in the US, the index tracking S&P SPDR in 1993 (which has gone up 630% since inception), ETFs have evolved drastically to include bond ETFs, actively managed ETFs, inverse ETFs, sector ETFs, commodity ETFs, and now, ETFs with a maturity date. Undeniably, the popularity of ETFs has been immense, especially with global ETF assets having just surpassed the $5 trillion mark.

There have been diverging viewpoints with respect to the effects that ETFs have on the global economy. While passive fund managers believe that buy-and-hold investors have driven the growth in ETFs, and hence, the underlying assets, traditional hedge fund and mutual fund managers have found that individual stocks began moving increasingly in tandem, frustrating fund managers that depend on idiosyncratic movements to beat their benchmarks. On the other hand, there are still hedge fund managers such as Flow Traders that have the competitive advantage of sophisticated technology to reduce latency, making them capable of capitalizing on an inefficient market where mispricing often occurs in order to generate average annual profits of 6.7% over the 2001-2010 period through the use of ETF arbitrage.

Some also believe that ETFs will be the trigger for the next crisis. More importantly, there has been evidence to show that a company that joins a major index has increased volatility, gaining a significant risk premium of up to 56 basis points monthly.

Figure 1: Cumulative Returns in Share Price Over Past 10 Years

Source: GAO Proprietary Research

Here, we look at how the top 4 companies that launch ETFs fared against the S&P 500. As evident from Figure 1 above, the correlation of the returns of the various companies with the S&P 500 has all been relatively high over the past 10 years, with BlackRock performing the best amongst all its peers and even the S&P 500, tripling in its share price over the last decade.

Figure 2: Cumulative Returns YTD

Source: GAO Proprietary Research

In contrast, the cumulative returns for this YTD has shown the performance of the S&P 500, BlackRock, and State Street Corp flattening out, remaining largely stagnant this YTD. Interestingly, Invesco has greatly outperformed its peers, having gone up 31.95% this past half a year. On top of that, its correlation with the S&P 500 has also fallen drastically to 0.05, from 0.86 previously. (Deutsche Bank, needless to say, has fallen to crisis levels driven largely by the Italian political crisis and their restructuring move, making them an anomaly in this analysis.)

Figure 3: Invesco Earnings 1Q 2018

Source: Invesco Ltd

However, when looking through Invesco’s earnings report for the first quarter of the year, their net income has in fact fallen 37.8% as compared to the last quarter of 2017. Compared to BlackRock and State Street Corp’s net incomes which fell 53% and gained 81.1% respectively, it didn’t appear as though their share prices were directly affected by their earnings.

Figure 4: Invesco QQQ 1Y Volume

Source: MarketWatch

Upon further research, our team found that Invesco has been garnering increasing demand in some of its ETFs, particularly its QQQ ETF which has exposure in tech, growth, and large-cap equities on the NASDAQ-100. The average weekly trade volume for the Invesco QQQ Trust Series I is typically 34.54 million. As evident from Figure 4 above, the trade volume for QQQ has increased visibly this year. Hence, we believe that this spike in demand for Invesco’s product offerings such as its QQQ Trust Series I and the more unique BulletShares has contributed to positive market sentiments that in turn drove up Invesco’s share price this year, giving them an edge in their performance over their peers.

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