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Roger Nusbaum submits: In trolling around some sites I saw that ProFunds has three inverse sector funds. I thought that I could use the inverse REIT fund to show an example of the pairs trade idea I have been kicking around of late.

This chart compares the streetTRACKS Wilshire REIT (NYSEARCA:RWR), which was the highest yielding ETF in the sector I could find, against the Short Real Estate ProFund [SRPIX]. According to PortfolioScience.com the two have a negative 0.962 correlation.

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So if last October 13 you put $20,000 into RWR and $20,000 SRPIX, you would have bought 336 shares of RWR and 605 shares of SRPIX.

RWR would now be worth $28,717, a gain of $8717, and SRPIX would have dropped to $14780, a decline of $5220. The $40,000 invested a year ago would have had gain of $3497. You also would have picked up $1162.22 in dividends from RWR and a $24.20 dividend from SRPIX (I did not read the prospectus to see how this fund could pay a dividend but Yahoo Finance says it paid $0.04 this past September 29). The total return was 11.7%.

During the same time period the S&P 500 was up about 15%. So you captured most of the return of the market, although clearly with a lag, with very little volatility.

If RWR had declined in price by 10%, SRPIX might have gone up by 9.6% for a net loss of $80, but add in the dividends of $1186.42 and it would have netted out a 2.7% gain. Of course since this is not what happened there is no way to know how realistic this downside scenario is, nor can we know what the S&P 500 would have done if the REIT sector declined by 10%. This was just an example.

Another flaw in this exercise is of course that it is looking backwards. The example as it worked out though does make the point; this concept is not the single dumbest idea ever written. I will continue to explore this idea.

Source: Low Beta Strategies Cont'd: Taking the Differential on a REIT/Inverse Spread