Market-Neutral Strategy Using Ultra Sector ETFs

Roger Nusbaum submits: ProShares finally listed its ultra sector ETFs. They go double long or double short eleven sectors or sub-sectors.

I wrote about a possible market neutral trade involving these a while back, and I had an article run on TSCM over the weekend that captures the idea with more detail.

The basic idea, using the utilities sector as an example, would be to buy $20,000 into Wisdom Tree International Utilities Fund (DBU) and $10,000 into ProShares Ultra Short Utilities (UPW). Conceptually you are only taking spread risk, which should be much less than market risk.

Since DBU's inception it has outperformed iShares Utilities (IDU) by a surprising 800 basis points. The reason for this chart is that IDU and UPW track the same index such that $2 in IDU would be offset by $1 in UPW, save for the tracking error.

Using the dollars above, DBU would be up $3200 and UPW might be down $1600. The dividend in that time from DBU might be 0.92% or $184. In this scenario (there are plenty of caveats) the return might be $1784 for the $30,000 or 5.9% for about one calendar quarter. Another nugget is that the double short ETFs could pay interest because they use derivatives to create the exposure and have cash that earns interest.

The move in DBU versus IDU is larger than what I thought could be possible when I first wrote about this. I think if the trade had been placed as theorized back in October it would need to be rebalanced fairly soon, depending on how true the holder wants to be toward market neutral.

This type of trade is certainly not going to be a market beating trade very often -- something to keep in mind. The double short funds have only been trading for five minutes, so we can't be 100% certain they will do what they are supposed to. Not that I doubt them, but the MacroShares is a good lesson about not jumping in to a new fund right away. There will likely be some sort of tracking error too. Also the goal of UPW is double the inverse on a daily basis, so over a year it may not look like twice the inverse.

Obviously this theory could also lend itself to pairing an individual stock and a double short fund too.

Much to my amusement I got an email from someone at ProShares who liked the concept, go figure.