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By Paul Weisbruch

Back on January 31 of this year, we published a piece on using market cap oriented S&P index ETFs alongside revenue weighted as well as equal weighted ETFs that are based on the same S&P indexes. The original article appears here.

In a nutshell, this article described opportunities to capture performance in pairs trades, or "spread trades," where the portfolio manager takes a long position in one ETF, and then shorts an equal dollar amount in a "like" ETF.

In the case of the previous article, indexes such as the S&P 500 are ideal candidates for pairs trade possibilities since there are a handful of products that track the index from different ETF issuers, based on different weighting methodologies. The key to these pairs trades is the predictability and transparency that the investor has in that the underlying index constituents in IVV, SPY, RSP, and RWL are identical, as each contains the index components of the S&P 500 and will only deviate from this if S&P themselves commit to an index change.

The opportunities that present themselves is when one methodology outperforms the other over time. For instance, in the trailing one year period, SPY (NYSEARCA:IVV) are up about 18% while RWL is up nearly 24% (600 bps of out-performance) and RSP up over 29% (1100 bps of out-performance).

See link for performance chart here.

In essence, the same stocks and level of transparency, different weighting methodologies, and significant out-performance. Will Equal Weighting, Revenue Weighting, or other alternative ways of weighting a known index always outperform the market cap benchmark? The answer is "no" and this is where the opportunity is created.

Depending on the market outlook of the investment manager, he can be long market cap versus short revenue and/or equal weighting or vice versa and capture out-performance where it exists, and also be able to quantify, or "collar" the potential downside due to the overlap in the holdings between the two "like" products. For example, SPY will not go to zero with RSP climbing higher, as they both own all 500 stocks in the S&P 500, just proportionally different weightings from name to name within the indexes.

Recently, PowerShares launched a lineup of ETFs that are based on the S&P Small Cap sector indexes. Most ETF portfolio managers are familiar with the State Street Select Sector Spyders (XLY, XLP, XLE, XLF, XLV, XLI, XLB, XLK, XLU) that are Large Cap oriented sector ETFs, based on sectors within the S&P 500, namely Consumer Discretionary, Consumer Staples, Energy, Financials, Healthcare, Industrials, Basic Materials, Technology, and Utilities.

These ETFs are enormously popular with tactical managers that like to overweight and underweight specific sectors in order to achieve out-performance against their stated benchmarks. For instance, a manager may use a broad based core ETF for their S&P 500 large cap exposure like SPY, IVV, RWL, or RSP, and then rotate sector overweights and underweights, or even short specific sector ETFs, around this core position to essentially make bets on which industry sectors will lead and lag going forward.

Tactical sector portfolios have become increasingly popular among managers of ETF portfolios, many of which run these portfolios as Separately Managed Accounts that can be purchased as vehicle on a variety of brokerage house and independent platforms by wirehouse advisors or RIAs.

However, these 9 Select Sector Spyders products have attracted significant attention and assets, and competition in the "tactically managed sector portfolios" space has created a crowded pond so to speak. Tactical ETF managers can only stand out from their lookalike competitors by either making better market calls (i.e. being overweight or underweight the right sectors at the right time), and trading better (i.e. recapturing basis points through better execution and less price slippage upon the entries and exits of trades, especially larger ones.)

The recent launch of the PowerShares S&P Small Cap Sector ETFs (XLYS, XLPS, XLES, XLFS, XLVS, XLIS, XLBS, XLKS, XLUS) should be of interest to any manager who is currently utilizing the S&P large cap sector products, as they can differentiate themselves from other managers not only with expertise in the large cap space, but in the small caps as well. In a stroke of marketing genius, PowerShares kept it simple by labeling the new products with extremely recognizable symbols (think corresponding industry Select Sector Spyder and simply add an "S" to the symbol. For example, XLFS is the the symbol for the S&P Smallcap Financials.)

Not only should portfolio managers see opportunity in creating sector portfolios from a small cap standpoint using these PowerShares products, but thoughts of pairs trade possibilities versus the corresponding large cap Select Sector Spyders may creep into the forefront as well. While trading history in the PowerShares S&P Small Cap ETFs is limited since they recently launched in April, it is important to recognize that the constituent stocks in these sector ETFs are all part of a well known, established, and time tested index, the S&P 600.

That said, one can see what the specific sectors have done over time because they are all simply part of the overall return of the S&P 600 over those same times periods.

For similar reasons that managers would want to consider a pairs trade using a large cap market cap weighted ETF versus an alternative weighted large cap ETF based on the same S&P index, pairs trading a large cap S&P sector ETF against its corresponding S&P small cap sector ETF. In the market, large caps and small caps will never follow the exact same path. There will be periods where large caps will outperform small caps and vice versa, take for instance 2008 where although the market took a gigantic drubbing overall, small caps were hit notably harder than large caps. However, when the market rebounded in 2009, small caps largely outpaced large caps, and this momentum has carried over into 2010 in a big way (IJR +6.74% YTD versus SPY -1.86% YTD).

With the release of the PowerShares S&P Small Cap ETFs it is simple for a manager who believes small cap Healthcare for instance will outperform large cap Healthcare, to potentially establish a "long XLVS versus short XLV" position in their portfolio.

The strategy is different than say SPY vs. RSP however because XLVS is based on the S&P 600 Small Cap Healthcare index while XLV is based on the S&P 500 Healthcare Index, and head to head, obviously the underlying index constituents in the two products will be different. The "collar" effect will simply be much different and the manager will have to do more work in considering "max loss" scenarios when building out their trade expectations.

The transparency of the products is key to these trades however, as the investor can see the underlying holdings published daily, and can take confidence in the fact that both the Select Sector Spyders and the PowerShares S&P Small Cap ETFs are based on well known, well benchmarked S&P indices. Capable and established tactical sector ETF managers are missing out if they are only using the Large Cap sectors in their portfolios, as they are potentially missing larger alpha generation, from the nature of small caps themselves, as well as a way to differentiate themselves with additional small cap sector strategies that likely have not been fully explored yet.

Disclosure: No positions

Source: Tactical Sector Plays, Pairs Trade Possibilities With S&P Small Cap ETFs