Capturing a Sector With a Low Beta Strategy

Roger Nusbaum submits: In continuing with the low beta and market neutral kick I have been on lately, I had an idea for a variation on a kind of paired trade that I mentioned a few days ago.

In that previous post, I used an example of going long a stock with a high correlation to its sector, as measured against a sector ETF, and short the sector ETF. The stock component I said should have a higher yield than the sector ETF and the investor should think the long stock will outperform the sector. In my example I paired National City (NCC), a bank stock with a 4.3% yield that I don't own or follow (this is just an example) with a short position in iShares Financial (IYF). The two have a 0.70 correlation and NCC has a 2.49% yield advantage. I laid out a scenario of a return that exceeded a riskless rate of return by a decent margin.

There may be a way coming to do something similar without taking any single stock risk and also adding a little more yield.

ProShares has filed for short and double short sector ETFs. WisdomTree could list international sector ETFs as soon as this month that use the same dividend weighing methodology as the existing funds.

As I go into detail here I am conceding there are a lot of 'ifs' to this. Picking a sector known for yield like financials, I would not be shocked if an international sector ETF that focuses on dividends yielded at least 4.5%. A double short ETF would use futures and options to be double short and so while probably an expensive fund would not have a negative dividend.

If the two funds do have a high correlation, and the WisdomTree sector fund does as well as the current batch of funds are doing, this could work out quite well.

Here are the specifics. $10,000 long into the WisdomTree financial sector ETF and $5000 into the ProShares double short financial sector ETF. I am hypothesizing a 4.5% yield advantage. If the WisdomTree fund outperforms the sector by 3.5% per year(which is in the ballpark of its other funds) which might look like an 8% (sort of) return with much less volatility than the overall market. Another component to this idea is that by using the double short ETF instead of the single short there should be $5000 left over to go into a money market. Assuming a 4.5% yield that adds $225 in return.

This totals $1025 on $20,000 ($10,000 in the long fund, $5000 in the short fund and $5000 in cash) which works out to 5.125% (not 8%).

This is far from exciting but in this thesis the volatility would be extremely low. That a portion of a portfolio goes into something like this seems far from absurd.

Since neither of these funds is trading yet this post is more of an academic exercise but it is interesting to think about. Especially if average returns for full stock market exposure decline to 7-8% annually as some say will be the case.

I will reexamine the idea if the funds list. Obviously the leverage of directly shorting a sector ETF would mean that the return theorized here would be different but IRAs can't sell short.

Comments

[Internet2k4:]

Subject to all RN's caveats about how the instruments work, this is helpful in thinking about how to use those new double-short ETFs as a hedge instead of a bet on market direction.

2006 Oct 05 06:28 PM

[Geoff Consi...:]

Hi Roger:

A note for the above from a quanty type. First, 0.7 correlation is actually not very high--that means only 50% of the covariance is explained by the relationship--not enough for a decent 'pairs' strategy. Second, a more basic question if the stock market as a whole returns only 7-8%: will volatility go down accordingly. The answer is probably yes. If returns are down on average, volatility will also tend to be lower. Without getting into issues like shorting or short funds, inveators might simply want to think about managing their total volatility levels. If the market is quiescent--as we have seen for the last three years (SD

2006 Oct 06 01:33 PM

[Roger Nusbaum:]

you do see where I say it is just an example?

2006 Oct 10 03:10 PM

[Aj White:]

Roger, Since your idea is a work in progress try considering NAV. If the fund is selling at a premium to NAV than sell it short and buy that favorite stock of yours. Incorporate your idea and you might have an edge with low risk.

2006 Oct 09 03:36 PM

[Roger Nusbaum:]

I'm sorry, NAV? As in Navistar? I think I am missing your intended point, can you elaborate? TY

2006 Oct 10 03:12 PM

[Aj White:]

Roger,
Net asset vaue. Unlike mutual funds, ETFs don't necessarily trade at the net asset values of their underlying holdings, meaning an ETF could potentially trade above or below the value of the underlying portfolios. Since you had your idea rolling around in your head for a few weeks I thought that might be something to consider when you are trying to go the other way with only one stock.

2006 Oct 13 02:51 AM

[Roger Nusbaum:]

Aj,

The premium/discount in an ETF, as opposed to a CEF, is quite negligible, at least the times I have ever noticited. It's not clear to me that the premium of an ETF could be big enough to disrupt the concept. There could be several other things that make it a bad idea but not sure about this.

2006 Oct 13 12:15 PM