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There’s more to this long/short business than meets the eye. Just think about this: nearly half of the money now invested in exchange-traded long/short equity products is committed to so-called “buy-write” strategies. The rest is sprinkled across three other diverse gambits.
This leads me to wonder about all the fuss. Is buy-write the true path through the long/short landscape that leads to alpha? It’s certainly worth a closer look.
First, maybe a little bit of explication. Just what is a buy-write strategy? The name’s self-explanatory: you buy something, then you write something. The buy side is typically a stock purchase. Writing most often entails the sale of call options on the purchased stock. A buy-write done this way is known as a “covered call” because the risk embodied in the option write is “covered” by the long stock position. If the writer’s counterparty -- the call purchaser -- chooses to exercise the contract, the underlying stock is simply lifted from the writer’s account.
So what’s the point? Income, mostly. If the market for the stock’s fairly stable, varying neither too high or too low, the call expires unexercised while the stock preserves its value. The premium received for the call then becomes a realized profit for the writer who is now free to write more options, if desired.
That’s the ideal scenario, of course. If the market price of the shares held rises above the option’s strike price, the stock could be called away, leaving the writer flat consoled only by the pocketing of the premium together with any spread between the exercise price and the stock’s cost basis.
And if the stock’s price falls? Well, there’s that premium again. That’ll hedge some of the downside, but beyond that the writer’s exposed to open-ended loss.
All told, a buy-write is the equivalent of a put sale -- typically undertaken when the market for the underlying stock is expected to remain stable or rise modestly over the option’s life.
So are all those buy-write ETP investors banking on flat markets? It’s fair to say ‘yes,’ but their reasoning may be better explained in our interview with the CBOE’s Matt Moran. Let’s look more closely at the universe of buy-write ETPs.
The 800-lb gorilla
The heavyweight in the buy-write category, and indeed the entire long/short equity class, is the PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA:PBP). Launched in 2007, the PowerShares fund tracks the CBOE S&P 500 BuyWrite Index which represents a portfolio holding stocks replicating the S&P 500 index together with a monthly succession of call positions written at or slightly above the index’s prevailing market price. Dividends earned on the fund’s component stocks and the premiums banked from the written calls are reinvested in the portfolio.
PBP’s been profitable for investors (see Table 4) but its return pales in comparison to that of the S&P 500. Because of the fund’s low volatility, however, PBP still earns a 0.02 alpha. The annual expense ratio is 75 basis points (0.75 percent).
The AdvisorShares STAR Global Buy-Write ETF (NYSEARCA:VEGA) uses a proprietary strategy known as Volatility Enhanced Global Appreciation (“VEGA”) to overlay calls on the components of its global allocation portfolio. VEGA uses an active fund-of-funds approach aimed at generating a consistent income stream. At times, cash-secured puts may also be written and, when volatility is low, protective puts may be purchased to manage downside risk.
Active management isn’t cheap, even in the ETP world. The VEGA fund’s expenses run 201 basis points a year. For its year-to-date loss (see Table 1), VEGA pulls down a -0.02 alpha coefficient.
To complement the PBP fund are exchange-traded notes based on the CBOE S&P 500 BuyWrite Index. The iPath CBOE S&P 500 BuyWrite Index ETN (NYSEARCA:BWV), like its ETF counterpart, carries an annual investment cost of 75 basis points. The notes represent unsecured obligations of A+ rated Barclays Bank plc and, as such, expose investors to a credit risk not borne by holders of PBP. There’s a trade-off, though. Since the ETN tracks the underlying index without actually replicating it in a portfolio, there are no frictional transaction costs. That eliminates the major source of an ETF’s inbuilt tracking error.
Because of BWV’s light trading volume, the keen tracking of the index may be hard for the casual investor to see. Last sale prices can be stale by several minutes or even hours. That’s why the observed return varies greatly so much from that represented by the notes’ indicative value. Year to date, BWV appears to have gained 8.1 percent based on market prices. The return on the indicative value, at 6.7 percent, is much closer to PBP’s. Like PBP, BWV registers 0.02 on the alpha meter.
Rounding out our roster of buy-write products is one that really doesn’t buy anything at all. The ALPS U.S Equity High Volatility Put Write Index Fund (NYSEARCA:HVPW) is usually lumped in the buy-write category simply because there’s no other place to put it.
The fund writes cash-secured puts -- not calls -- selected by the fund’s index methodology on the basis of their implied volatilities. The index targets the most expensive options, the ones most likely to shrink in value if their underlying stocks remain flat or rise.
The fund writes new option positions every 60 days and aims for a 1.5 percent yield in every cycle. Launched in March, the fund seems to be pretty much on track with a 2.9 percent return through May 15, though its alpha is clocked at 0.00. The fund’s expense ratio is 95 basis points.
130/30 or fight!
Buy-writes, being synthesized short puts, represent a neutral-to-slightly-bullish attitude toward the market. 130/30 portfolios are decidedly bullish. The descriptive ratio refers to the products’ long/short mix -- 130 percent long, 30 percent short. If you’re wondering how a portfolio can be anything more than 100 percent anything, you need only remember the word “leverage.”
Here’s how a 130/30 portfolio’s typically built. First, all the stocks in the investable universe are ranked according to their attractiveness. The highest-scoring issues become buy candidates, the lowest are short sale prospects. All --100 percent -- of the portfolio’s cash assets are committed to purchasing the high-ranked stocks. In other words, the foundation of the strategy is a “long-only” mix. But then, the shorts are enabled. Bottom-ranked stocks are sold to generate cash equal to 30 percent of the long side. The cash is then rolled into additional purchases of shares from the “long” roster.
The portfolio's long side ends up levered by its short sales, allowing $160 to be invested for every $100 under management. Despite this leverage, there's no more than market risk undertaken. That's because the strategy maintains a beta at or around 1.00 versus its benchmark. The net result of being 130 percent long and 30 percent short is, after all, a 100 percent long position, or full exposure to the market.
You might well ask why anyone would want to invest in a complicated portfolio that delivers the same risk exposure as a long-only index product. Alpha, that’s why. A short-enabled portfolio exploits both short and long ideas to get an edge on the market.
Two ETPs make up the 130/30 category.
The KEYnotes First Trust Enhanced 130/30 Large Cap Index ETN (NYSEARCA:JFT) tracks a proprietary equal-weighted benchmark culled from the 2,500 largest domestically traded stocks. The note’s annual investment charge of 95 basis points buys investors a -0.01 year-to-date alpha, largely to the underlying index’s higher-than-market volatility.
This year, the notes’ performance pretty much matched that of the S&P 500, though you’d be hard-pressed to glean that by looking at JFT’s market price. JFT, with an average daily trading volume under 900 notes, seems to trade by appointment. This year, the last-reported sale price reflected an average 6.8 percent discount to the notes’ indicative value. On the basis of JFT’s real-time value, the notes’ year-to-date return is actually 16.4 percent.
The investable universe for the ProShares Large Cap Core Plus ETF (NYSEARCA:CSM) is narrower than that of JFT. In fact, the fund’s underlying benchmark, the Credit Suisse 130/30 Large-Cap Index, draws from a universe of stocks just 500 wide. Sound familiar?
The Credit Suisse 130/30 Index methodology is much like First Trust's. Stocks are drawn from a roster of the largest-capitalized issues trading domestically and, after culling low-priced and illiquid issues, a ten-factor screen for growth, value, profitability, momentum and technical strength is run. The output issues are then ranked by their expected alpha and a portfolio of long and short positions is optimized. Unlike the First Trust index, though, the Credit Suisse benchmark is rebalanced monthly. The ETF costs 45 basis points and has generated a year-to-date alpha coefficient of 0.01.
Hedging your bets
The hedged equity category makes up 17 percent of the total long/short equity ETP market. Hedged equity is the classic long/short play in which both long and short positions are undertaken as alpha generators, usually without constraint on the short side.
Leading the pack is the AdvisorShares Accuvest Global Long Short ETF (NYSEARCA:AGLS). AGLS seeks to outdo the MSCI World Index by actively investing in a mix of single-country ETFs. The fund’s manager uses a proprietary country ranking model which sorts countries from most attractive to least attractive based on a range of three dozen factors. High-ranked countries are bought while the least-ranked nations are sold short.
While the fund’s year-to-date returns are much lower than that of the S&P 500, its low volatility bestows a positive 0.01 alpha coefficient. AGLS is expensive, though. Its annual expense ratio comes in at 150 basis points.
The middle child of the category is the ProShares RAFI Long/Short ETF (NYSEARCA:RALS) which, for 95 basis points a year, allocates equal dollar amounts to long and short equity positions based on their Research Affiliates Fundamental Index (OTCPK:RAFI) weightings. Stocks with larger RAFI weights vis-à-vis their market capitalizations are bought; smaller RAFI-weighted issues are sold short. In 2013, RALS has chalked up a 0.03 alpha.
Rounding out the category is the Credit Suisse Long/Short Liquid Equity Index ETN (NYSEARCA:CSLS). The notes are senior, unsecured debt securities issued by Credit Suisse AG, an A+ rated financial institution. For an annual investment charge of 45 basis points, CSLS tracks the performance of the Dow Jones Credit Suisse Long/Short Equity Hedge Fund Index. Year to date, the notes have earned 0.02 in alpha.
Put it in neutral
The broadest class in the long/short equity category is, oddly enough, the lightest in market capitalization. A half-dozen market neutral ETPs make up just six percent of the market.
Market neutral products typically pair off long and short positions in different stocks to snag alpha while minimizing broad market exposure. Often, beta is nullified to allow an investment “theme” to emerge.
Investors can spend 81 basis point a year to own the QuantShares U.S. Market Neutral Anti-Beta Fund (NYSEARCA:BTAL), and index-tracking portfolio that is equal-weighted, dollar neutral and sector neutral. The underlying index’s methodology identifies low-beta stocks as buying candidates and higher beta issues as potential short sales. In 2013, long beta plays have paid off, so BTAL’s year-to-date alpha is negative (-0.01).
The IQ Hedge Market Neutral Tracker ETF (NYSEARCA:QMN) takes a fund-of funds approach to attain a zero beta exposure. QMN’s beta this yearis actually negative (-0.02) which help the fun achieve a positive 0.01 alpha coefficient. QMN costs 75 basis points a year.
If you’re looking for cheap stocks, so too is the QuantShares U.S. Market Neutral Value Fund (NYSEARCA:CHEP). CHEP’s underling index also sniffs out overvalued issues. The fund buys cheap stocks sells short, in equal dollar amounts, the priciest shares. The portfolio is sector neutral and carries an expense ratio of 99 basis points. For that, CHEP investors have earned alpha of 0.02 this year.
QuantShares also offers a size play in its U.S. Market Neutral Size Fund (NYSEARCA:SIZ). The fund’s index methodology calls for the purchase of the lowest capitalized stocks and short sales of the highest capitalization issues in equal dollar amounts within each market sector. For its 81 basis point cost, SIZ has cranked out a 0.00 alpha reading in 2013.
The Credit Suisse Market Neutral Equity ETN (NYSEARCA:CSMN) tracks the HS Market Neutral Index which encompasses North American, European, and Japanese stocks. Like CSLS, CSMN are notes issued by the Nassau branch of Credit Suisse AG. Credit Suisse levies a 105 basis point annual investment charge. This year, CSMN has notched a 0.01 alpha.
Another QuantShares portfolio, the U.S. Market Neutral Momentum Fund (NYSEARCA:MOM), provides investors with an opportunity to capture the spread between high and low momentum stocks. Momentum is based on the stocks’ total return over the preceding 12-month period. Stocks with the highest total returns receive a high ranking; lower ranks are populated by shares with more meager returns. High-ranked stocks are bought while low-ranked issues are sold short. Momentum’s not been the name of the game in 2013. The fund’s -0.01 alpha coefficient testifies to that. MOM carries an 81 basis point expense ratio.
2013’s best bet
So, after all this, what’s been the true path to alpha? Oddly enough, it’s been through beta.
While most of the money’s invested in buy-write strategies, that’s not be where the most profit’s been found this year. No, investors keen on long/short equity got better results this year if they got long beta.
The category killer is 130/30. The two short-enabled portfolios took down an average 15.1 percent year-to-date return with a mean beta of 1.02. That’s far and away better than any of the other classes. Hedged equity strategies averaged a 4.5 percent return, just slightly ahead of buy-writes’ 4.3 percent takedown. Market neutral plays lagged well behind with an average 1.1 percent gain.
A longer term perspective is illustrated in the two-year performance of representative ETPs (Figure 2 and Table 5). From the looks of things, a dollop of CSM, the ProShares Large Cap Core Plus ETF (a 130/30 fund), has been the dosage needed to replace long-only exposure to domestic equities, though PBP, the PowerShares S&P 500 BuyWrite Portfolio, outdid both the broad market and the short-enabled strategy through the summer of 2012. Beta made all the difference. PBP’s coefficient is 0.53; CSM’s is 0.98 (remember that CSM’s benchmark is an index similar to, not duplicative of, the S&P 500). Beta’s been king since last August.
That, of course, leads us to wonder if the king might soon be dethroned It’s certainly possible. What’s more certain is this: Alternative Insights will keep you abreast of the latest market trends in the long/short equity
Related ETPs in Registration:
Passive - IQ Hedge Long/Short Equity, IQ Hedge Market Directional Tracker ETF, IQ Hedge Relative Value Tracker ETF, QuantShares U.S. Dividend Absolute Value Return Fund, QuantShares U.S. Low Beta Absolute Return Fund.
Active - IQ Long/Short Alpha ETF.