There is no denying that the ETF boom is in full swing, as billions of dollars continue to flow into the industry every month despite a difficult economic environment. As individual investors and advisors alike become more informed on the nuances and potential benefits of ETFs, usage has surged. Part of the impressive surge in assets is no doubt attributable to the flexibility of the exchange-traded structure; these securities have found homes in the portfolios of investors across the risk tolerance spectrum. ETFs have been embraced by long-term buy-and-holders because of the extremely competitive expense ratios relative to traditional actively managed mutual funds. They’ve also become quite popular as “replacements” to equities; more active investors who measure holding periods in hours have gravitated towards the exchange-traded structure because it provides exposure to a basket of securities that can be traded throughout the day.
There are other, more creative uses for ETFs as well. These securities can extremely useful for investors looking to implement market neutral pairs trading strategies that generally involve equivalent long and short positions in related (but unique) asset classes. By identifying two securities that are seemingly mispriced relative to one another, investors can capitalize by purchasing the undervalued asset and shorting the overvalued asset. Because the net exposure is zero, these investors don’t really care if broader markets boom or bust; so-called “market neutral” positions can thrive in any environment.
Such a strategy theoretically carries significant risk; (moreover, the presence of a short position means that potential losses are infinite). But by implementing such a strategy with two related assets, investors can effectively establish a low volatility position, since the two will almost always move in the same direction.
Pairs trading is nothing new. All walks of investors have been using market neutral strategies for decades, most commonly establishing long and short positions in two similar stocks (e.g., long BAC, short JPM). But ETFs have changed the game of pairs trading, allowing investors to make plays on perceived high level macroeconomic price discrepancies instead of company-specific disconnects.
Six Ways To Play
There are a number of ways to construct market neutral portfolios with ETFs, including strategies that seek to capitalize on relative mispricings between sectors, countries, market capitalizations, and slivers of the fixed income pie:
There has been a tremendous amount of research done on the relative merits of value and growth investing styles, and ETFs offer investors an opportunity to capitalize on differences in the performance between these two strategies. For example, going long the iShares Russell 1000 Growth Index Fund (IWF) and short the Russell 1000 Value Index Fund (IWD) creates an opportunity to profit if growth stocks outperform value equities (the opposite strategy would allow investors to profit if value stocks beat their growth counterparts).
5. Market Cap
Another pairs trading idea within the same economy involves splitting up equities by market capitalization. Within an individual economy, equities will usually exhibit strong correlations. But different sizes of stocks can maintain very unique risk and return profiles, creating opportunities to capitalize on differences in performance. An investor who thinks small cap Indian equities will perform better than large caps could go long SCIN/short INP. Those who think large cap Brazilian equities are a better bet than mid caps could go long EWZ/short BRAZ. And of course, there are dozens of combinations within the U.S. market.
4. Single Sector
There are a couple of variations on the pairs trading idea that can be implemented within a single sector. The first is to establish a market neutral position consisting of long exposure to a sector in one economy and short exposure to the same sector in a different economy. For example, investors might think that emerging market financials carry less risk and greater potential for return than the U.S. financial sector; going long EFN and short XLF would be an intriguing way to make this play while maintaining net zero equity exposure.
It’s also possible to bet on different market caps within a single sector. Earlier this year PowerShares rolled out a suite of nine sector-specific small cap ETFs that can serve as both alternatives or complements to the sector SPDRs from State Street. An investor looking to stay within the domestic energy market could play long XLES/short XLE, positioning a portfolio to benefit if small cap energy companies beat large cap energy stocks. Because the correlation between these ETFs would likely be strong, such a position should exhibit minimal volatility regardless of whether markets surge higher, plunge lower, or trend sideways.
3. Cross Sector
Some investors like the idea of pitting various corners of the market against each other, betting that a certain industry will perform better than others. This pairs trade idea may have significant potential for return, as various corners of the economy often perform significantly better than others. So far in 2010, the Industrial SPDR (XLI) is up more than 11%, while the Health Care SPDR (XLV) is down almost 5%.
Head-to-head sector ETF pairs trading isn’t only an option within the U.S. EGShares offers a suite of sector-specific emerging market products; investors could go long EMT/short EEO if they think metals & mining firms hold brighter prospects than energy companies. And Global X offers a number of sector-specific ETFs targeting various corners of the Chinese and Brazilian markets, creating dozens of potential market neutral strategies.
2. Cross Region
For investors with informed opinions on the outlooks for various countries, ETFs offer the fuel to power near-limitless strategies. With funds covering every major world economy, investors can access any corner of the globe through a single ticker [use the free country lookup tool to identify ETFs with exposure to a specific country]. The options for cross-region ETF strategies are numerous: long PLND/short EZU could allow investors to bet on relatively strong performance from Poland relative to the euro zone. Long ILF/short GMF would be appealing to those who think Latin American emerging markets hold more promise than developing economies in Asia.
1. Fixed Income Duration
Moving beyond the equity ETF universe, fixed income funds present some intriguing options as well. Although interest rates are expected to remain near zero for the foreseeable future, bond prices have been somewhat unpredictable. Investors looking to play changes in interest rates or investor sentiment have a number of ETF tools to utilize; long exposure to long-term bonds coupled with short exposure to short-term bonds makes for an interesting mismatch in duration, and there is no shortage of options for implementing this play.
Disclosure: No positions at time of writing.
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