「Trend Research by LD Capital」Enhancing Crypto Asset Management through the Lens of US Stock Index Returns
Introduction
In recent years, the traditional financial market has witnessed rapid growth in index-based products, such as ETFs, with Smart Beta ETFs exhibiting a higher inflow rate than regular index ETFs. The asset management industry has gradually shifted its focus from conventional index products to more innovative index product series, including ESG ETFs, actively managed ETFs, and thematic ETFs. Among them, active ETFs in the equity market have made significant breakthroughs, attracting off-exchange products to actively transform and becoming a hotbed of active product development in recent years. Global index providers continue to innovate and improve their index systems to meet new market demands, driving the industry towards refined, diversified, and profound development, while fostering continuous innovation in index-based products. Compared to the traditional financial market, crypto index-enhanced products are still in a very early stage. With the overall market capitalization of the crypto market growing, the market space for structured products utilizing index enhancement is expected to increase rapidly. We believe that the market size and current status of US stock index funds and index-enhanced funds/ETFs can provide valuable insights into the development path of crypto index-enhanced funds. We also believe that crypto index-enhanced funds can achieve excess returns that meet the diverse needs of investors with different risk preferences through various enhanced strategies, such as multi-factor quantitative stock selection models, subjective market timing models, sector rotation models, or index futures derivative-enhanced models.
Scale and Development Trends of Regular Index ETFs and Index-Enhanced Funds/ETFs in Hong Kong and US Stock Markets
Between 2015 and 2023, both regular index ETFs and index-enhanced funds/ETFs in the Hong Kong and US stock markets experienced steady growth. However, the scale of index-enhanced funds/ETFs, representing actively managed ETFs, has shown a faster growth trend, increasing tenfold over an eight-year period. By 2023, the scale of index-enhanced funds/ETFs have reached nearly one-third of that of regular index funds.
Table 1: A Comparison of the Total Scale of Regular Index ETFs and Index-Enhanced Funds/ETFs in Hong Kong and US Stock Markets from 2015 to 2023.
In traditional financial markets, there is a trend where the scale of index funds in the US stock and Hong Kong stock markets can even surpass the market capitalization of the corresponding indices. However, in the crypto market, the scale of index funds/ETFs is far from reaching its market capitalization. With the increasing interest of traditional investors in cryptocurrency asset management products, the development prospects for cryptocurrency index funds and exchange-traded funds (ETFs) are vast.
Table 2: A Comparison of Market Capitalization in the US stock market, Hong Kong stock market, and the cryptocurrency market, along with the corresponding scale of index funds/ETFs.
Characteristics of Index-Enhanced Funds’ Active Management
Index funds aim to generate returns (β returns) by tracking the characteristics of an index, such as tracking error, market capitalization style, valuation style, industry weight allocation, and individual stock weight allocation.
On the other hand, index-enhanced funds seek to achieve additional returns beyond the market (α returns) through active management by fund managers. They aim to minimize losses compared to the benchmark index during market downturns and capture higher returns compared to the tracked index during market upswings. Over the long term, index-enhanced funds strive for stable compounded performance.
Regarding index tracking, index-enhanced funds have a broader range of indices they can track. They can track broad-based indices, single-industry indices, or other thematic indices. In the current market environment of the US and Hong Kong stocks, popular choices for index-enhanced funds to benchmark against on the β side include the S&P 500, Nasdaq-100, Russell 2000, DJIA, HSI, and HSCEI.
Approaches to Enhancing Index Fund Returns
With ongoing financial market innovations, index-enhanced funds can employ various strategies to achieve excess returns and enhance their overall performance. The “enhanced” portion of index-enhanced funds’ returns can be achieved through strategies such as multi-factor quantitative stock selection models, subjective market timing models, sector rotation models, and index futures derivative-enhanced models. These are commonly utilized approaches in current index-enhanced products.
Quantitative Multi-Factor Enhancement Strategies
The objective of quantitative multi-factor enhancement strategies is to select stocks by simultaneously utilizing multiple factors to achieve better returns. These factors span various dimensions, including technical factors (market dynamics and technical indicators), macro factors, statistical data mining (machine learning, deep learning), and fundamental factors. Fundamental factors may include company financial stability, dividend yield, valuation, among others.
Table 3: Common Multi-Factor Stock Selection Enhanced Index Funds in the US Stock Market.
Using Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) as an Example
SPHD tracks the S&P 500 High Dividend Low Volatility Index and utilizes a multi-factor stock selection strategy, focusing on stocks with high dividend yield and low volatility. It selects the top 50 securities with the highest dividend yield and low volatility from the S&P 500 Index. The component stocks are weighted by dividend yield, with an individual stock weight cap of 3% to ensure diversification. To maintain its low volatility objective, the fund rebalances semi-annually, reassessing stock selection based on updated dividend yield and volatility indicators. Due to its low volatility, this ETF generally outperforms the broader S&P 500 Index during bear markets but may lag behind in strong bull markets.
The enhanced portion of SPHD’s returns comes from overallocation to high dividend and low volatility stocks. However, SPHD has significantly underperformed the S&P 500 benchmark in the past year, primarily due to sectors with high dividend yield, such as finance, energy, airlines, and tourism, being heavily impacted during the pandemic. High dividend stocks in these sectors may have performed poorly during the pandemic. In particular, the financial sector, which accounts for 26% of SPHD’s portfolio, has been severely affected by recent banking crises. The underperformance relative to the benchmark has led to a significant decline in its assets under management (AUM).
Strictly speaking, SPHD and QUAL are considered passive management funds with some enhancement strategies. These enhancement strategies aim to optimize specific factors within the portfolio, but the overall investment strategy of the funds remains focused on tracking specific indices. On the other hand, QARP not only uses passive management to track an index but also employs some enhancement strategies and active management to select the constituents of its portfolio, making it a more typical actively managed fund.
When implementing a quantitative multi-factor enhancement strategy, factors’ weights and the number of holdings in the portfolio need to be considered. Different factor weights and portfolio holdings can be used to achieve different investment objectives based on actual circumstances. For example, using more factors related to financial stability and earnings stability to invest in defensive stocks or employing more market momentum and technical indicators factors to invest in growth stocks.
Subjective Market Timing Enhancement Strategy
Subjective market timing, as an investment strategy, can be subdivided into multiple methods, including technical timing, fundamental timing, macro timing, sentiment timing, and event-driven timing. These methods are based on different analytical and decision-making factors, aiming to identify market trends, values, and opportunities to better determine to buy, sell, or adjust portfolio decisions.
- Technical Analysis Timing: Technical analysis is a method that identifies potential market trends by studying historical price and volume data. Investors can utilize technical analysis tools such as trendlines, moving averages, and relative strength indicators to determine market direction, strength, and reversal points, thereby identifying buying or selling opportunities.
- Fundamental Analysis Timing: Fundamental analysis focuses on factors such as a company’s financial condition, competitive advantages, and industry position. Investors can conduct in-depth research on a company’s fundamentals to evaluate its value and growth potential. When the market price undervalues a company’s true value, investors can buy, and when the market price overvalues a company’s true value, investors can sell.
- Macro Economic Analysis Timing: Macro timing enhancement strategies are based on analyzing the impact of macroeconomic data on market trends to achieve more accurate asset allocation. These strategies typically involve analyzing factors such as interest rates, inflation, monetary policies, and geopolitics. For example, during an economic expansion, investors may increase their stock investments, while during an economic recession, investors may reduce their stock investments or shift to safer assets. Fund managers adjust portfolio strategies based on their outlook and expectations of the global macroeconomic conditions, potentially generating excess returns from macro timing compared to passive index funds that simply track benchmarks.
- Market Sentiment Analysis Timing: Market sentiment analysis focuses on the influence of investor sentiment and psychological factors on market prices. Investors can utilize market sentiment indicators (such as fear/greed indices, investor confidence indices, etc.) to assess whether the market is overly pessimistic or overly optimistic and make timing decisions accordingly. Buying during periods of excessive pessimism and selling during periods of excessive optimism may help investors achieve excess returns. Sentiment strategies are becoming increasingly popular, and other sentiment indicators include the AAII sentiment index, VIX, market breadth indicators, put/call ratios, etc.
- Event-Driven Timing Strategy: Event-driven strategies focus on specific events (such as mergers, spin-offs, and restructurings) that can impact company value. By anticipating and analyzing these events, investors can determine the timing for buying or selling.
Using Pacer Trendpilot US Large Cap ETF (PTLC) as an example, Pacer Trendpilot US Large Cap ETF (PTLC) is an exchange-traded fund (ETF) based on the US stock market that employs an active timing strategy. Its objective is to adjust exposure to US large-cap stocks based on market trends to achieve relatively stable investment returns.
The fund primarily tracks the S&P 500 Index and utilizes a trend-following timing strategy based on moving averages. When the S&P 500 is above its 200-day moving average and has closed above its five-day moving average for the last five trading days, the fund fully invests in the S&P 500 Index. When the S&P 500 is below its 200-day moving average, the fund allocates 50% of its assets to the S&P 500 Index and 50% to short-term US Treasury bonds. When the five-day moving average of the S&P 500 stays below its 200-day moving average for five consecutive trading days, the fund invests entirely in short-term US Treasury bonds.
Observing the performance of Pacer Trendpilot US Large Cap ETF (PTLC) in specific market environments, such as the bull market in 2017, the volatile market in 2018, and the market turbulence caused by the COVID-19 pandemic in 2020, reveals the characteristics of an enhanced timing fund. In 2017, the S&P 500 Index achieved a high annual return of approximately 21.8%. In that year, PTLC generated a return of approximately 20.4%, slightly lower than the benchmark index. While PTLC captured some gains in the rising market, its performance was slightly below the S&P 500 Index due to management fees and trading costs.
In the volatile market environment of 2018, the S&P 500 Index experienced significant fluctuations, with substantial gains at the beginning of the year followed by a notable decline by the end, resulting in a total annual decline of approximately 4.4%. In comparison, PTLC performed relatively well in 2018, with an annual return of approximately -3.7%, achieving a certain level of loss mitigation relative to the benchmark index.
In early 2020, the COVID-19 pandemic triggered significant market turbulence globally. The S&P 500 Index experienced a rapid decline of approximately 34% but subsequently witnessed a strong rebound, ending the year with a gain of approximately 16%. PTLC exhibited relatively weaker performance during this year, with an annual return of approximately 11.5%. While the fund mitigated losses to some extent during the market downturn through its timing strategy, its performance lagged behind during the subsequent rebound, resulting in a lower annual return compared to the benchmark index.
Therefore, in rising markets, PTLC’s performance is similar to the benchmark index. In declining markets, the fund’s timing strategy may help mitigate losses, but due to tracking errors, it may not consistently outperform the benchmark in all market conditions.
Sector Rotation Enhancement Strategy
The sector rotation enhancement strategy involves rotating allocations among different sectors based on their position in the business cycle before market trends emerge. It aims to increase exposure to sectors expected to outperform by allocating more to industries experiencing an upward trend (“overweight”) and reducing allocations to underperforming sectors (“underweight”). By deviating from the tracking index’s sector allocations, the strategy aims to achieve excess returns compared to the index’s performance.
Table 4: Common Industry Rotation Stock Selection Enhanced Index Funds in the US Stock Market.
Using PDP (Invesco DWA Momentum ETF) as an example, PDP aims to track the performance of the Dorsey Wright Technical Leaders Index using a relative strength strategy. It selects and weights investments in 30 U.S. stocks that exhibit the highest relative strength. Assuming that the technology sector performs the best in the market and has high relative strength, PDP would select stocks that perform the best within the technology sector.
To execute the strategy, PDP periodically rebalances its holdings to ensure continued investment in the technology stocks with the highest relative strength. If the market environment changes and the relative strength of other sectors begins to rise, such as the consumer goods sector, PDP may adjust its holdings and allocate investments to the new top-performing sector based on the updated relative strength data and market trends.
Overall, PDP’s strategy execution method is based on the stock selection using relative strength and adjustments based on market performance and trends. The selection criterion is relative strength, which refers to performance relative to other stocks or sectors. The portfolio is periodically rebalanced. The two funds in the table have outperformed benchmark performance over a one-year time frame, but have shown relatively weaker performance year-to-date (YTD).
Derivative Enhancement Strategy
Derivative enhancement strategies involve using derivatives such as options, futures, swaps, etc., to enhance portfolio performance. These strategies typically involve considerations of leverage, risk hedging, and speculation.
Some derivative enhancement strategies based on the US stock market include:
- Index Futures Investment: If there is a discount between stock index futures contracts and the spot index, one can invest in stock index futures to simulate a portion of the index position and gain enhanced returns from the negative premium convergence. By allocating a portion of funds to stock index futures to track the underlying index, the remaining idle funds can be invested in fixed-income or arbitrage strategies to generate relatively stable returns.
- Calendar Spread: Exploiting the price difference between futures contracts with different expiration months of the same index for arbitrage. When the forward contract has a higher premium compared to the nearby contract, one can establish a long position in the nearby contract while simultaneously establishing a short position in the forward contract. Over time, the price difference between these two contracts may converge, resulting in excess returns.
- Inter-market Arbitrage: When there are pricing differences between two highly correlated markets (such as commodities, interest rates, exchange rates, etc.), one can establish a long position in one market while simultaneously establishing a short position in the other market. Over time, the pricing differences between these two markets may converge, resulting in enhanced returns.
- Options Strategies: Options are another common derivative. For example, one can enhance the returns of existing stock investments by selling covered calls. In this strategy, the fund holds a certain amount of stock and sells an equivalent number of call options. This allows the fund to collect option premiums and increase overall investment returns. However, the risk of this strategy is missing out on potential gains if the stock price exceeds the exercise price of the options.
- Pairs Trading: This strategy involves two stocks from the same industry or with high correlation. When the price difference between the two stocks exceeds historical normal levels, one can establish a long position in the relatively undervalued stock while simultaneously establishing a short position in the relatively overvalued stock. Over time, the price difference between these two stocks may converge, resulting in excess returns.
Taking ProShares UltraPro Short QQQ ETF (SQQQ) as an example of an index-enhanced fund using derivative strategies based on the US stock market,
ProShares UltraPro Short QQQ ETF (SQQQ) aims to provide daily returns that are -3 times the performance of the Nasdaq-100 Index. This inverse leveraged ETF is designed for experienced investors who anticipate a short-term decline in technology and large-cap stocks within the Nasdaq-100. To achieve its investment objective, SQQQ utilizes financial instruments such as swaps, futures contracts, and options to gain short exposure to the Nasdaq-100 Index. As a result, SQQQ can magnify returns when the underlying index declines, but it can also amplify losses when the index rises.
Specifically, in the swap strategy, SQQQ obtains short exposure to the Nasdaq-100 Index by entering into swap agreements with other financial institutions. Under the swap contracts, SQQQ agrees to exchange the returns of the underlying asset (such as the Nasdaq-100 Index) at a fixed price over a specified period. This allows SQQQ to gain short exposure to the Nasdaq-100 Index without actually holding the stocks.
In the futures contract strategy, SQQQ obtains short exposure to the Nasdaq-100 Index by selling Nasdaq-100 Index futures contracts. Through this approach, SQQQ agrees to sell the underlying asset (Nasdaq-100 Index) at a specific price on a future date. This strategy enables SQQQ to engage in short trading of the Nasdaq-100 Index without actually holding the stocks.
In the options strategy, SQQQ utilizes the purchase of put options to achieve short exposure. Put options grant SQQQ the right to sell the underlying asset (Nasdaq-100 Index) at a specific price on a future date. By purchasing put options, SQQQ gains profits when the underlying asset declines, thus achieving short exposure to the Nasdaq-100 Index. SQQQ executes these trades on multiple trading platforms and venues to ensure liquidity and obtain optimal prices. However, this ETF is generally considered a high-risk short-term investment and is not recommended for long-term holding.
Various enhanced strategies that track the same index provide investors with suitable risk exposures.
Even when tracking the same index, investors can choose index funds that offer different tracking strategies and leverage products based on their risk tolerance, investment objectives, and expected returns. Here are some introductions to a selection of products tracking the Nasdaq-100. Most of these products fall under passive management and aim to provide investors with different strategies to track the Nasdaq-100 Index for corresponding exposures and returns.
QQQ (Invesco QQQ Trust): As Invesco’s flagship product, QQQ is the most popular and well-known ETF (AUM 175,780 million) that tracks the Nasdaq-100 Index. It aims to replicate the performance of the index by investing in the same securities in the same proportions. The index includes the 100 largest non-financial companies listed on the Nasdaq stock market. QQQ is a market-cap-weighted ETF, which means the holdings are weighted based on their market capitalization.
QTR (Global X NASDAQ 100 Tail Risk ETF): The QTR aims to track the performance of the Nasdaq-100 Index while mitigating tail risk. The ETF invests in the same securities as QQQ but also holds put options on the Nasdaq-100 Index to hedge against significant market declines.
QQQM (Invesco Nasdaq-100 ETF): QQQM is a low-cost alternative to QQQ. It also tracks the Nasdaq-100 Index but with a lower expense ratio. The investment strategy and holdings are similar to QQQ, but with lower costs, making it more cost-effective for long-term investors.
QQQN (Invesco NASDAQ-100 Triple Q Disruptive Innovators ETF): QQQN is an ETF launched by Invesco. It aims to track the Nasdaq Q-50 Index, which includes non-financial companies ranked from 101st to 150th by market capitalization on the Nasdaq market. These companies are typically considered to be in the growth stages with innovative and disruptive technologies. QQQN provides investors with exposure to a group of potential growth-stage companies.
QQQA (ProShares Nasdaq-100 Dorsey Wright Momentum ETF): The strategy of QQQA aims to track the performance of the Dorsey Wright NASDAQ OMX CTA Momentum Index, which includes a momentum-based approach that selects stocks based on relative strength signals. Relative strength refers to the performance of individual stocks relative to the market or industry. Based on relative strength signals, stocks that perform well in the short term among the Nasdaq-100 Index constituents are selected. Using a momentum investment strategy, stocks are chosen and weighted accordingly based on their relative strength. Stocks with stronger performance will receive higher weights, while stocks with weaker performance will receive lower weights or may be excluded from the portfolio.
TQQQ (ProShares UltraPro QQQ): TQQQ aims to track the Nasdaq-100 High Beta Index and is a leveraged ETF designed to provide three times the performance of the Nasdaq-100 Index’s gains. It aims to track the overall performance of the entire Nasdaq-100 Index. Due to its leverage effect, TQQQ typically exhibits higher volatility and risk compared to the underlying index.
QQQX (Nuveen NASDAQ 100 Dynamic Overwrite Fund): QQQX is an actively managed fund based on the Nasdaq-100 Index. It adopts an overwrite strategy, which involves simultaneously holding the Nasdaq-100 Index constituents’ stocks and selling call options. The overwrite strategy aims to increase the portfolio’s income. In this strategy, the fund holds the stocks of the Nasdaq-100 Index while simultaneously selling corresponding call option contracts. If, on the expiration date, the price of the Nasdaq-100 Index is lower than the exercise price of the call options, the call options will expire unexercised, and the fund can retain the collected premiums. This allows the fund to generate additional income by selling call options when the market trend is stable or declining.
The objective of the overwrite strategy is to enhance the portfolio’s return through this additional income and partially mitigate the downside risk in the market. However, selling call options as part of the overwrite strategy also limits the potential gains of the portfolio in a rising market, as the fund may be restricted from fully benefiting from the price appreciation when the call options are exercised.
Conclusion
Compared to the equity ETF/Index Fund market in the US, the market for crypto index enhancement products is still in its very early stages. As the overall market capitalization of cryptocurrencies grows, there is a high potential for rapid expansion in the market for structured products that enhance crypto index performance. We believe that the various enhancement strategies used in US equity index funds and index enhancement funds/ETFs can be applied to the construction of crypto index enhancement funds. These strategies can include multi-factor quantitative stock selection models, subjective timing models, sector rotation models, or derivative-based strategies such as futures contracts to enhance returns. These crypto index enhancement funds can help investors with different risk preferences gain the desired risk exposure and achieve excess returns through these enhancement approaches.
LD Capital is a leading crypto fund that is active in primary and secondary markets, whose sub-funds include a dedicated eco fund, FoF, hedge fund, and Meta Fund.
LD Capital has a professional global team with deep industrial resources, and focus on delivering superior post-investment services to enhance project value growth, and specializes in long-term value and ecosystem investment.
LD Capital has successively discovered and invested in more than 300 companies in Infra/Protocol/Dapp/Privacy/Metaverse/Layer2/DeFi/DAO/GameFi fields since 2016.
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