Artificial Intelligence could bring a strange beast to the world of exchange-traded funds.
Let me explain. The one-liner is that white label issuer Exchange Traded Concepts has partnered with Kaiju ETF Advisors to launch the BTD Capital Fund (DIP) . But to understand the sentence that just preceded this one, you need to know some terms: BTD of course stands for “Buy The Dip,” but “kaiju” is another animal. It means “strange beast” when translated from the Japanese word 怪獣. Famous Kaiju in history include Godzilla, King Kong, and any of the interplanetary creatures from the “Pacific Rim” movie series.
DIP is an actively managed ETF that started trading on Monday. The fund uses an actively managed strategy and including acquired fund fees has a stated expense ratio of 129 basis points (bps), or 1.29%, meaning a shareholder with $1,000 invested over a calendar year would pay $12.90 in fees over that period.
Active management usually conjures visions of research teams poring over reports and transcripts, distilling everything down to “firm convictions” and presenting their results to portfolio managers who then make the final decision to add or cut names from the portfolio. While there are plenty of shops that still pick stocks this way, Kaiju is not one of them. From reading through its website, it effectively makes the case that while humans are adaptable and capable of developing winning investment strategies, they tend to allow the bias of previous success to cloud their forward-looking views.
To overcome this, Kaiju relies on a quant-heavy process it refers to as “Mechanics of Reasoning,” which includes quantitative analysis, behavioral finance, quantum mechanics, and finally, artificial intelligence. Because there is no index methodology, let’s turn to the summary prospectus to get into the heart of this strategy. Additionally, Kaiju has prepared a white paper that does a great job of providing a high-level view of the overall approach.
Like virtually all strategies, Kaiju’s goal is to acquire securities it thinks are mispriced and hold them until those processes have appreciated to expected levels. Yes, Kaiju looks to buy low and sell high. The difference here is twofold. Many managers are making decisions based on company fundamentals, economic cycles, and the like, which can play out over months, quarters, or even years. Kaiju’s models are purely quantitative and combine to identify what it determines to be short-term, technical price dislocations — dips. Because of dips’ short-term nature, “Individual equity securities are typically held for a period of time ranging from one day to seven days…”
Final security selection is guided by what Kaiju describes as a Stratified Risk Distribution approach. I recently wrote about stratification and its application and while it involves a lot of heavy quantitative lifting, it’s nothing that some good programmers, computer CPUs, and a healthy amount of RAM can’t handle.
While the security selection process focuses on short-term price movements the entire process also makes two other determinations. Is the dip expected to be a short-term phenomenon or a shift in market sentiment in a given name? Also, there are additional models which monitor the overall state of the market and guide higher-level risk management and asset allocation decisions.
Perhaps because I spent too much time reading science fiction when I was younger, I generally view the use of terms like “Artificial Intelligence” as putting an extra helping of sizzle on whatever steak is currently being sold. My preference would be to refer to processes like what Kaiju is developing as a learning model or a self-re-enforcing model. Beyond that, I like the approach Kaiju is taking with DIP. Trying to be the best, fastest high-frequency trader is a losing proposition, but using powerful algorithms to identify and capture short-term price dislocations sounds interesting, especially as we move into the next phase of this economic cycle.
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