ProShares Planning RAFI Long/Short ETF

 |  Includes: AGLS, CSM
by: Michael Johnston

Rob Arnott’s footprint on the ETF industry just might be getting a little bit bigger. ProShares, the Maryland-based leveraged and inverse ETF giant, recently filed details with the SEC on an ETF that would seek to track the performance of the RAFI US Equity Long/Short Index. That benchmark is based on a methodology devised by Arnott’s firm, Research Affiliates, that more and more investors are embracing as an alternative to traditional market cap weighting. PowerShares currently offers a handful of equity ETFs linked to RAFI indexes, and earlier this year swapped out the index on its high yield bond ETF (NYSEARCA:PHB) in favor of a RAFI index.

Steering clear of market capitalization, the RAFI methodology uses four “fundamental” metrics to determine a company’s size: sales, cash flow, dividends, and book value. Determining the holdings of the index underlying the proposed long/short ETF would require a calculation of both RAFI weight and capitalization weight–the weighting each stock would receive in a cap-weighted index. The index would establish long positions in the stocks with the largest RAFI weight compared to capitalization weight, while shorting those with the smallest RAFI weights relative to their capitalization weights.

The investment thesis behind the proposed product is relatively simple. If the RAFI weight is a more appropriate measure of firm size, firms with significant disconnects between the calculated capitalization weight and RAFI weight would be incorrectly valued. Those with a significantly larger capitalization weight would be overvalued, while those with a smaller capitalization weight relative to RAFI weight would be undervalued. By establishing both long and short positions, the proposed ETF would maintain market neutral exposure that essentially seeks to exploit the inefficiencies of market cap weighting.

RAFI weighting methodologies have steadily gained a following among investors who have identified potential pitfalls of cap-weighting, as these enhanced indexes break the link between weightings afforded to individual securities and stock price. Although the impressive rise of the ETF industry has occurred primarily around funds linked to cap-weighting strategies, ETFs have also helped to highlight a number of alternative weighting strategies. In 2010, the cap-weighted SPY has lagged behind many funds that hold similar stocks but utilize different strategies to determine weightings.

Long/Short ETF Options

Earlier this year AdvisorShares launched the Mars Hill Relative Value ETF (GRV), a fund that seeks to establish long positions in regions expected to outperform the MSCI World Index and short positions in those expected to underperform that benchmark. While the same general strategy is similar, the proposed ProShares fund would be different from GRV in a couple key areas. First, GRV is actively managed, whereas the ProShares fund would seek to replicate a rules-based index. Second, the ProShares long/short ETF would limit its holdings to U.S. stocks; GRV has the latitude to invest in a number of international markets (India, Thailand, Malaysia, and Chile are currently among its largest long positions).

ProShares also offers the Credit Suisse 130/30 (NYSEARCA:CSM), an ETF that shorts stocks expected to underperform the S&P 500 and uses the proceeds to enhance positions in those expected to beat the benchmark. CSM is linked to an index developed by MIT professor Andrew W. Lo, an expert in quantitative finance.

Disclosure: No positions at time of writing.

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