ETFs To Smooth Volatility: Looking at Some Long/Short Options by Stoyan Bojinov
by Stoyan Bojinov on October 31, 2011 | ETFs
One of the oft-cited benefits of the ETF boom over the last several years is the democratization of asset classes, such as commodities and volatility, that were previously available only to sophisticated and wealthy investors. The marriage of these asset classes with the exchange-traded structure allows investors to tap into securities that can be extremely valuable to both long-term portfolios and more active, tactical investing approaches.
The rise of exchange-traded products has also had the effect of bringing countless investment strategies within reach of the average investor; there are now products that segment the markets in almost every way imaginable. From investment disciplines to factor models to quant-based screens, ETFs allow investors to achieve cheap, easy access to stock portfolios that would otherwise require significant time and expenses to construct.
When building a long-term portfolio, the primary focus is often on the expected returns of the component securities. But savvy advisory and investors also realize that volatility must be analyzed as well; big swings in the value of a portfolio can be undesirable for risk-averse investors. By combining assets that maintain low correlations to one another, the overall volatility of a portfolio can be reducedĂ˘â‚¬â€śa characteristic that should have obvious appeal to the majority of investors.
Enter a relatively new development in the ETF industry that exhibits low correlations to stocks and bonds while still maintaining the potential to appreciate in any environment: long / short ETFs. The idea behind these products, which are often described as Ă˘â‚¬Ĺ“market neutral,Ă˘â‚¬Âť is pretty straightforward. Equal long and short positions are combined to create a portfolio that is neutral to the overall market. This technique results in very low volatility, since gains in long positions are generally offset by losses in short positions, and vice versa. In effect, market neutral strategies depend on the relative performance of the two positions. If the long position outperforms the short position, the fund will appreciate. If the securities that have been sold short perform better than those in which the fund has gone long, the value will decline.
Long / Short ETFs
Market neutral strategies should generally exhibit very low volatilty, and have a correlation of about zero with broad equity markets. So for those looking to reduce the fluctuations of a portfolio, these funds can be useful tools. There are currently a number of ETFs and ETNs that allow investors to achieve exposure to long / short strategies, each of which implements a unique approach to identifying stocks that make up the long and short positions:
ProShares RAFI Long / Short (RALS)
This ETF employs a long/short investment strategy with a twist; its underlying index is based on the RAFI methodology, and unlike the traditional market cap-weighted approach, this strategy determines allocations based on a firmĂ˘â‚¬â„˘s book value, income, sales, and dividends. RALS is designed with an absolute return objective, and introduces short selling to the equation in an attempt to capitalize off of discrepancies between the weightings suggested between market capitalization weighting strategies and the RAFI methodology. In essence, the fund will establish long positions in stocks for which the RAFI weighting is larger than the cap weighting and short positions in those for which the cap weighting is larger than the RAFI weighting. This ETF is rebalanced monthly and the universe of potential constituents consists of the 1,000 largest U.S. stocks by market capitalization and the 1,000 largest U.S. stocks by RAFI weight.
Mars Hill Global Relative Value (GRV)
This actively managed ETF seeks to generate consistent positive returns in excess of the average annual return of the MSCI World Index. GRV employs a Ă˘â‚¬Ĺ“relative valueĂ˘â‚¬Âť approach, which identifies the perceived attractiveness of one investment versus another by considering expected risk, anticipated return, and liquidity. This fund combines long positions in the most attractive country, sector and industry ETFs with equal dollar amounts short in the least attractive country, sector and industry ETFs. This Ă˘â‚¬Ĺ“ETF of ETFsĂ˘â‚¬Âť offers an appealing market neutral approach along with the added benefits of global diversification. GRV however may turn away cost-conscious investors, seeing as how this is the most expensive fund in the Long-Short ETFdb Category, charging a steep 1.49%Ă‚Â all-in expense ratio.
QuantShares U.S. Market Neutral Beta Fund (BTAH)
This is a fairly new offering from QuantShares, a newcomer to the ETF industry, which employs a long/short strategy based on volatility. BTAH goes long stocks with the highest betas and shorts the ones with the lowest betasĂ˘â‚¬â€śessentially generating returns equal to the spread between high volatility stocks and low volatility securities. Although this ETF is technically market neutral, its volatility-based approach makes it more appealing to bullish investors looking for downside protection, as the strategy can be expected to generally perform better when markets are climbing, and struggle when stocks fall. QuantShares also offers a Market Neutral Anti-Beta Fund (BTAL), which swaps the long and short positions.
QuantShares U.S. Market Neutral Anti-Momentum Fund (NOMO)
This QuantShares products allows for investors to bet that recent laggards in the market will outperform stocks that have recently performed well. NOMO achieves market neutral by establishing long positions in companies the lowest momentum scores and shorts the companies with the highest momentum scores. Momentum is defined as the total return of a security over the first twelve of the last 13 months; high momentum stocks are those with the best performance over that period while low momentum stocks are those with low total returns over that period. QuantShares also offers a Market Neutral Momentum Fund that maintains long exposure to stocks with high momentum and short exposure to those with low momentum scores.