After a slow month of new product launches in August, the first few days of September have already seen a noticeable uptick in activity. Wednesday was the first day of trading for four new exchange-traded funds from QuantShares, a newcomer to the ETF industry who had filed details on the suite of market neutral ETFs earlier in the year.
Each of the new ETFs is linked to an equal-weighted index that is both dollar neutral and sector neutral, offering long/short exposure to sub-sets of the broader domestic stock market. Each of the four new ETFs will seek to replicate an index that consists of both long and short positions, with those positions derived based on various quantitative factors.
U.S Market Neutral Momentum Fund (MOM)
This ETF is linked to the Dow Jones U.S. Thematic Market Neutral Momentum Total Return Index. That benchmark identifies the securities with the highest and lowest momentum factors within each of 10 different sectors of the economy, a feature that ensures sector neutrality within the overall portfolio. Long positions are established in the securities with the highest momentum scores, and short positions are established in the stocks with the lowest momentum scores. The index is constructed in a manner that allocates equal dollar amounts to long and short positions, resulting in exposure that is “market neutral.”
Momentum is defined as the total return over the first 12 of the last 13 months. High momentum stocks are those with the best performance over that period while low momentum stocks are those with low total returns over that period.
U.S Market Neutral Anti-Momentum Fund (NOMO)
This ETF will be essentially an opposite of MOM. It also establishes market neutral exposure, but gives long positions to companies with the lowest momentum scores and short positions to those with the highest momentum scores. In other words, NOMO is a way to bet that the recent laggards will outperform stocks that have recently performed well.
The index underlying NOMO also identifies the securities within each of the 10 sectors that have the highest and lowest momentum scores using total return (price plus dividends) during the first 12 of the past 13 months.
U.S. Market Neutral Size Fund (SIZ)
This ETF will essentially go long small-cap stocks and short large-cap stocks. The underlying index consists of long positions in the securities from each sector with the smallest market capitalization coupled with short positions in the 20% of securities from each sector with the largest market cap. Again, the portfolio will consist of approximately equal dollar allocations to long and short positions, resulting in a market neutral portfolio.
U.S. Market Neutral Quality Fund (QLT)
This ETF will seek to replicate the U.S. Market Neutral Quality Index, a benchmark that utilizes two metrics to determine the “quality” of individual securities: debt-to-equity ratio and return on equity. Stocks with a higher return on equity and lower debt-to-equity ratio are determined to be of higher quality, and vice versa. The index underlying QLT will consist of long positions in the securities from each sector with the highest quality scores and short positions in the securities with the lowest scores.
QuantShares also shed some light on three additional market neutral ETFs that are now effective but not yet available for sale:
U.S. Market Neutral Beta Fund (BTAH)
This ETF will give long positions to stocks with the highest betas and short positions to those with the lowest betas, essentially generating returns equal to the spread between high volatility stocks and low volatility securities. As such, BTAH could have appeal to bullish investors looking to maintain some downside protection. Though technically market neutral, this ETF can be reasonably expected to perform well when markets climb and struggle when stocks fall.
U.S. Market Neutral Anti-Beta Fund (BTAL)
This ETF is the counterpart to BTAH. The index to which BTAL is linked gives long positions to securities with the lowest betas (i.e., the least volatile equities) and short positions to those with the highest betas. It should be noted that both BTAL and BTAH are sector neutral, meaning that the net weighting to each sector is zero upon rebalancing. So BTAL won’t simply be tilted toward low volatility sectors such as utilities and consumer staples. It will have equal long and short positions in each sector.
U.S. Market Neutral Value Fund (CHEP)
This ETF is linked to an index that seeks to establish long positions in the most undervalued stocks and short positions in the most overvalued stocks. Determination of value for this ETF depends on ratios such as earnings-to-price, book-to-price, and cash flow from operations-to-price.
Market Neutral ETFs
The performance of each of these ETFs will depend on the differential in performance between the two types of securities. SIZ, for example, can be expected to generate positive returns when small caps outperform large caps (and vice versa). Market neutral strategies are nothing new. The techniques employed by these funds have been used for decades. But the combination of these strategies with the ETF wrapper is a relatively new innovation that allows investors to access these techniques in a low maintenance, relatively cheap vehicle.
According to the recent prospectus, the management fee for each ETF will be 50 basis points but the total expenses will be considerably higher thanks to the inclusion of dividend, interest and brokerage fees for short positions. According to the filings from last month, all-in fees for the products will range from 2.07% to 2.97%. After the waiver of certain fees, the funds will charge an expense ratio of 0.81% (QLT will charge 0.80%).
It isn’t uncommon for funds with significant short positions to incur hefty fees related to achieving that type of exposure. The Active Bear ETF (HDGE), which has put up some impressive results during the recent downturn, charges a bottom line expense ratio of 1.85%.
The new ETFs from QuantShares join a growing lineup of long/short ETFs that offer market neutral exposure. Products already on the market include the ProShares RAFI Long/Short (RALS), which uses disconnects between market cap weights and fundamental weights to determine whether positions should be long or short. Credit Suisse also offers a Long/Short Liquid Index ETN (CSLS) and AdvisorShares has partnered with Mars Hill on a Relative Value ETF (GRV) that consists of long and short positions in other exchange-traded products.
The launch of the market neutral ETFs from QuantShares represents the continuation of a trend in the ETF industry: Increased use of the exchange-traded structure as a means of accessing alternatives. That asset class generally covers securities that exhibit low correlations with stocks and bonds, bringing potential diversification benefits to more traditional portfolios. Because market neutral strategies involve equivalent long and short positions, they are generally expected to exhibit low betas and low volatility, and have the potential to deliver gains (or losses) in both up and down markets.
Disclosure: No positions at time of writing.
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