Over the last two articles of the "Beating the ETF" series, we looked at very wide assumptions and simple math to show how buying the top-weighted holdings of an ETF could outperform that basket. This is not much different than saying if you pick the largest companies of the S&P 500 you will sometimes do much better or much worse. What was interesting was how well the strategy did over the past five and two year periods. In seven of the nine ETFs we looked at, buying only the top holdings of the ETFs would have outperformed just owning the ETF. It seemed like a great idea until you realize only one of the nine sectors still had the same top holdings as they did back in 2006. While the effect seems to work on sectors that have great positive momentum, it doesn’t inspire confidence.
Okay, we know that you could play with the numbers and get different results, but some type of trend is there. The real trick is developing a simple way of betting this will continue to happen without suffering a terrible loss. Creating a long/short portfolio to mitigate the risk is what we will focus on in this article. Let’s continue to make life easy and use the popular example of XLK and the top four weighted positions. As you know XLK's top positions are Apple (AAPL) (14.13%), IBM (IBM) (8.43%), Microsoft (MSFT) (7.57%) and AT&T (T) (6.63%). Then we use the actual 2006 numbers which didn’t work out as well, but still beat the ETF. Back then the holdings were Microsoft (MSFT) (9.72%), Cisco (CSCO) (5.67%), IBM (5.66%) and Intel (INTC) (5.24%).
For our simple portfolio we made each position size equal at 25%. Then, we short a similar nominal amount of XLK. Sure, shorting costs money, but XLK is not hard to borrow and we probably shouldn’t be doing this in the first place, right? Why? For starters, a hot back-tested result will lure us into a false sense of comfort (like assuming the top positions in 2011 were the same as in 2006). Look at the results from doing this strategy over the past five years.
While it seems all too easy, the reason for this free lunch is deceptive. AAPL and IBM had incredible runs, with AAPL being the main fad stock for the last 5 years. I love my iPhone just as much as everyone else, but stocks do not grow to the sky. My point is that a real strategy is not based on the run of a single stock, but a more robust set of rules both objective and subjective. This five year run is what we call path-dependent. It was based on a good run in a single stock for a particular period of time. More importantly, the tremendous return of the 2011 portfolio was based on AAPL becoming a huge part of XLK over the past five years, not that we would have known that in 2006. Even if we used the 2006 positions, the strategy assumes that the momentum of top names will not only keep going, but that they will outperform during that period.
So, outside of a hunch that a particular sector will keep moving on up and the top positions today will continue to outperform their peers, what can we learn? A diversified sector ETF is not likely to move up 30% in a given day on a buyout rumor, leading to a big loss. Shorting any diversified basket has less event risk than shorting an individual stock.
In the end, this is not a free lunch and could turn into a disaster if any one of the four stocks hit the bricks. What we are left with is a methodology for anyone to create their own long/short strategy using an ETF and the holdings inside. My general rule of thumb for those who can’t sit still and have money to burn is simple.
- Only short the ETF, not individual stocks.
- Make sure that the stocks correlate to the ETF. This is an alpha game.
- Make sure that the strategy is based on a few outperformers, not a single hot fad.
Does XLF and the top four fit the bill? During the past five years it seems to have worked. I would suggest finding your own way of picking out some winners in the ETF basket. If you think you have what it takes to trade long and short, do some of your own work. Think for yourself, and use a basic blueprint to keep yourself in check. Good luck beating the ETF!
Disclosure: I am long AAPL.