Manage ETF Volatility With Matched Trading

by: David Cretcher

Here's a strategy that individual investors can use to help lower the volatility in their portfolios. Hedge funds often employ a market-neutral strategy called "pairs trading". This can involve a lot of things, but typically it involves buying a pair of securities, one long and one short.

For instance, if they think something good is going to happen to Ford F, they might go long Ford and short General Motors GM. This allows them to benefit from the good thing that happens to Ford without participating in potentially bad things that might happen to the auto sector as a whole.

Pairs trading is a sophisticated strategy that may not suited to the average investor. But, by using a strategy I call a matched trade, regular investors can use a version of this strategy to lower their portfolio volatility. This involves matching non-correlating assets to one another.

Matched trading during the financial crisis

Here's an example that worked well after the financial crisis crash and is continuing to work. During the crash, many investors lost their appetite for participation in the stock market, but still needed equity type gains. A strategy yo accomplish thus was to match junk bonds, or for polite company high-yield bonds, with their opposite counterpart US Treasuries.

The thought behind this strategy is if the economy improves then marginal companies will be able to pay off their bonds. If this happens the junks will improve with it. If the opposite happens and the economy continues its downward spiral, people will continue to move into treasuries and the treasuries will gain. Either scenario yields one winner and one loser.

At the time junk bonds ETFs were paying over 10 percent and treasury ETFs were in the two to four range depending on maturity. So with a 50/50 match the pair will yield in the six to seven range, with one loser and one winner. This gave the investor a nice dividend cushion to the strategy. If nothing much happens either way, then you simply collect the dividends. At seven percent, the investors purchase money is returned in roughly ten years. Currency the spread is more like seven percent and three percent.

In a nutshell, this trade works because at a macro level because it counterbalances the money flows in the economy. People can do three actions with their money they can spend, save or invest. If the economy is bad, they are not spending, if they are not spending or investing they must be saving, and last, if they are not saving or spending they must be investing.

The only safe place for US citizens to save large amounts of money without solvency risk is in US treasuries. If people are spending, the economy will do well and junk bonds will benefit. If they are not spending or investing, then they must be saving and treasuries will benefit. In reality, it's a little more complicated than that, but not much more. You can learn more about these macro money flows in my book on risk-management.

How to execute a matched trade

The mechanics of the trade are as follows. For high-yield bond ETF, you can use JNK, HYG, HYS, PHB, HYLD, BSJI, then match the trade with a long-term treasuries ETF like TLH, TLO, VGIT, TLT, PLW. If you are sophisticated investor with a more aggressive nature, you can use a higher match ratio of high-yield bonds to treasuries and use a zero coupon ETF like EDV or ZROZ.

To see this trade in action here is a graph of JNK and TLT, coming out of the crash. This matched trade pays around a dividend of around 4.75% currently.

Courtesy of Yahoo Finance

Notice how the money flows from investing to saving into treasuries?.

A broad market matched trade

This save or invest strategy also worked with the broad market ETFs like VTI, SPY, EXT, IWV, SCHB, IVV, RSP, however it is a riskier strategy because the dividend is lower and the investor loses the dividend cushion,.

Courtesy of Yahoo Finance

Once again we see the movement between savings and investing.

To see this broad-market trade used in an overall portfolio look at this article here.

A word of caution.

I like this strategy, but almost everyone I proposed it to passed on it. Why? Because they couldn't accept a strategy where there was a high probability one investment would lose money. In reality, the market was kind, and they both gained, but you don't know that's going in. Likewise, like most hedges, they could have both lost, but they would do so at much lower volatility and would still pay a dividend. So, there is some positive asymmetry for the investor.

For investors looking for tax write offs, there is also a tax strategy where the investor can swap the loser for a similar behaving ETF and take the write-off and still keep basically the same position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.