Have You Ever Considered 130/30?

| About: ProShares Large (CSM)

If there has been a bull market in anything in the past 5 years, it has been the production of ETF products. It sure seems like there is an ETF for every style of investment strategy one could possibly imagine - assuming every one of these products lived up to their marketing material. Recently, I have been thinking a lot about a classic hedge fund investment strategy known as 130/30. In essence, this strategy is executed by purchasing investments worth 130% of assets under management while simultaneously short selling investments worth 30% of assets under management. This results in a net market exposure of about 100%. As it turns out, there's an app for that! Well, an ETF anyways.

ProShares rolled out an ETF (NYSEARCA:CSM), a while back, that strives to track the Credit Suisse 130/30 index. Looking at the performance graph in the marketing material, one could reasonably conclude that ProShares does a pretty good job tracking the index. Yes, there is some slippage but that is probably driven by management fees vs. asset allocation. The marketing material certainly looks pretty interesting but statistically speaking, what's the point of investing in such a product?

According to the marketing material, "by broadening the portfolio's opportunity set of investment positions, a 130/30 strategy provides further diversification, resulting in more potential for risk-adjusted outperformance of long-only benchmark indexes." Regardless of how persuasive that may sound as it rolls off the tongue, the statistics have yet to materialize.

According to this data, CSM looks awfully similar to the S&P 500. In fact, based on this data, I am not sure why one would choose CSM over SPY. The performance of CSM definitely left something to be desired. I was anticipating performance characteristics with a beta very slightly below 1, lower volatility than the S&P 500, and perhaps a little bit of alpha due to the short positions that the fund incorporates into the portfolio.

After reviewing the data, my curiosity began taking over. After all, what is the point of short sales if they don't actually benefit the 130/30 portfolio in any discernible way? For that matter, what is the point of short sales in any predominately long-only portfolio?

The simplest answer is that an investor can, in theory, earn a decent return on a well thought out short sale. But, who wants to get into specific stock picking in an asset allocation article. Broadly speaking, short sales are really just a means of reducing an investor's exposure to a market sell-off. This is true up to the point that the portfolio is net short the market. Keeping this thought in mind, you know what else is like short selling BUT not actually short selling? Fixed income. Incorporating fixed income into a portfolio looks strikingly similar to short selling at the portfolio level - statistically speaking anyways.

Look back at that table above for a moment. Did you notice that the beta of the TLT index fund is -0.778? Just to ensure everyone is on the same page, beta is a Greek letter that, in finance, is used to represent the "correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to." In the simplest terms, a security with a beta of 1.2 vs. the S&P 500 can be reasonably expected to move (up and down) roughly 120% that of the S&P 500. So, if the S&P 500 rises 10% in a year, this mythical security should be expected to rise roughly 12%. In contrast, if the S&P 500 declined 10%, this same security should be expected to fall 12%. A security with a beta of 0.80 should be expected to move roughly 80% of the S&P 500. Thus, with an S&P 500 rising (falling) 10% the security with a beta of 0.80 will rise (fall) roughly 8%.

Is this gibberish even relevant? Yes. A short sale reduces a portfolio's gross exposure by taking on a negative beta. Moreover, if you purchase a long position in a security that naturally exhibits a negative beta it will impact the portfolio in a similar way to short selling a stock.

What does this have to do with a 130/30 investment strategy? You can actually use the ETFs included in the table above to construct a portfolio that is, in principle, consistent with a 130/30 framework without actually shorting any security. This portfolio is 130% invested, with a gross market exposure of about 100% (i.e. beta of 1.0).

Consider the newly revised table…

This newly constructed portfolio has no explicit short sales; however, by incorporating securities that exhibit low or even negative betas, the overall portfolio beta is 0.99, despite gross investments of 130%. Additionally, I deducted an annualized fee of 7.75% to reflect the cost of margin. Based on the data, I believe a portfolio of ETFs constructed using similar techniques, in my opinion, is superior to investing in something like the CSM. This portfolio exhibits a higher risk-adjusted return than CSM, (NYSEARCA:SPY), or (NASDAQ:QQQ) with a beta to the S&P 500 of 0.99 and very similar volatility at 15.4%.

This portfolio benefits from some added diversification across the risk spectrum by incorporating exposure to long-term U.S. government bonds (NYSEARCA:TLT), corporate bonds (NYSEARCA:LQD), high yield bonds (NYSEARCA:HYG), gold (NYSEARCA:GLD) as well as exposure to equities. Corporate bonds and gold exhibit a limited relationship (i.e. beta) with the S&P 500 which essentially is what diversification is built on - accumulating non-correlated assets. The long-term U.S. bond fund provides a modest hedge to the portfolio with a negative beta of 0.778 resulting in a portfolio with characteristics of a 130/30 portfolio.

It is important to note that statistics gathered based on historic performance are highly dynamic and as such, there is no guarantee to that the portfolio weights used in this analysis will maintain consistent performance in the future. It is important that securities be monitored, measured and analyzed followed by rebalancing to ensure a portfolio is behaving the way it is intended.

The moral of the story is that there is more than one way to skin a cat. If you have ever come across the 130/30 investment strategy, or are interested in the benefits of short selling but are hesitant to short sell securities, consider broadening your horizons by utilizing strategies or techniques that achieve statistically similar results.

Thanks for your time.

Disclosure: I am long TLT, SPY, GLD, LQD, HYG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.