Did You Forget About This Type Of Diversification?

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Includes: BTAL, CHEP, FTLS, JPLS, MOM, QAI, QLS, QMN, SIZ, SPY
by: Kurtis Hemmerling

Summary

Diversification can smooth out portfolio volatility.

Many diversified investments can drop in a highly correlated fashion when markets crash, offering little downside protection.

Long/Short and Market Neutral products could be the unique source of diversification you are seeking.

Many investors diversify their investments across sectors and industry groups, countries, cap ranges, and dividend yields. And you can also diversify across asset classes such as cash, commodities, equities, and bonds. A balanced portfolio with these investments may smooth out the rough ride during normal market conditions when correlations are low. But when markets crash, correlations between diversified equities typically increase, which means all your stocks drop at the same time.

Diversification of Umbrella Colors

Market neutral products can add uncorrelated returns in down markets.

A market neutral product is one that typically invests an equal amount (whether it be dollars or beta risk) long as it shorts. It thus neutralizes the effect of the market. Profit is made on the difference in return between the stocks you buy and the ones you short.

Pros of Market Neutral Investments

There are some notable benefits to this strategy:

  • Volatility is generally lower than long-only products
  • Low correlation to other investment products
  • Significant downside protection in a bear market
  • The potential to earn in all markets

Cons of Market Neutral Investments

One con is that this strategy does not directly benefit from a rising market...and markets typically rise over long periods of time. When everyone is making large gains in a prolonged bull market, you may not be very happy holding a fund with low-single-digit total returns compared to the 100% you would have made holding an index fund.

Management fees are often high in market neutral funds due to the skill necessary to separate the good from the bad, as well as the additional cost of borrowing.

What are some simple low-cost ways to add a market neutral product to your portfolio? There are several ETFs you could use. Below are a few that I have found interesting.

Style Focused Market Neutral ETFs

At the bottom of the list are funds that take advantage of a single factor or theme. For instance, the fund might buy small-cap stocks and short large-cap stocks. You earn a return when small caps outperform but you lose when large caps outperform.

AGFiQ has a suite of ETFs that are highly focused on such themes based on momentum, value, size and beta:

  • AGFiQ US Market Neutral Momentum Fund (MOM)
  • AGFiQ US Market Neutral Value Fund (CHEP)
  • AGFiQ US Market Neutral Size Fund (SIZ)
  • AGFiQ US Market Neutral Anti-Beta Fund (BTAL)

AGFIQ Market Neutral ETFs

As you can see, the total returns have been poor since late 2011. I do not recommend this type of market neutral ETF as a permanent holding. Instead, I would suggest investing in them only when you feel compelled to do so. For instance, you might feel that deep value stocks will shoot up the fastest following a bear market. CHEP might be a good ETF to hold in this instance. Or you may invest in SIZ only when you forecast that small caps will outperform and remove it later. You get the point.

The expense ratio for these ETFs are listed at 0.75%.

JPMorgan Long/Short ETF

There are other ETFs which are long/short, but they may not adhere strictly to being market neutral. JPMorgan Long/Short ETF (JPLS) is one such example. This ETF currently has a slight long bias with an estimated beta of 0.1 (the market is 1.0). This ETF buys and shorts based on numerous factors including value, momentum, quality, and size.

Chart JPLS data by YCharts

I prefer JPLS over the previously mentioned single style ETFs because JPLS allows the managers to be tactical and dynamically go long and short the styles which they forecast to rise and fall. The expense ratio is a very reasonable 0.69%, putting this near the top of my "total return" ETF list. It is quite new having only been launched in January 2018, but one you will definitely want to keep an eye on.

Other Long/Short ETFs to Consider

IQ Hedge Multi-Strategy Tracker ETF (QAI) - This is the largest player in the field that I know of with over $1 billion in AUM. QAI attempts to replicate the return characteristics of hedge funds across a variety of strategies which include long/short equity, market neutral, event-driven, global macro and others. It also has ETFs which track strategies which are market neutral (QMN) and long/short equity (QLS). Their expense ratio is in the range of 0.76% - 1% depending on the fund.

QAI ETF

First Trust Long/Short Equity ETF (FTLS) - According to its prospectus, FTLS can have a range of net long exposure from 30% to 100% (80-100% long and 0-50% short) and is currently around 66% long. It based its positions on a mix of the Sabrient Systems Earnings Quality Rank and proprietary research. Inception date is September 8th 2014. The expense ratio is set at 1.07%. You will notice that the ETF tracks the S&P 500 (SPY) fairly closely thus far but with less downside volatility.

FTLS vs SPY

Interesting New Total Return Hedge Fund

One last method I want to mention is an innovative new hedge fund out of Singapore called Noviscient. It employs total return strategies and takes no management fee and even provide downside protection for the first 5% annually. The fund seeks 10% annual returns. Performance fees are 2% (total) out of the first 10% (meaning you keep 8%), and half of the returns above that.

If this type of total return fund catches on, it will completely disrupt the 2/20 style hedge funds. I tip my hat to Noviscient for taking this bold move in aligning its own interests so strongly with investors. I wish there were ETFs that followed this model of zero expense ratios, downside protection and modest performance fees on total return products. The fund earns its keep when it makes you money.

Summary

The secret to investing is to find investments with long-term return potential that have low correlation to each other in up, sideways and down markets. Finding such products is not easy since what has low correlation in a bull or sideways market can suddenly become high correlation in a bear market.

Total return, and specifically market neutral, strategies is one investment theme you may want to consider adding to your portfolio to provide a unique source of return that does not rise and fall with the general market. But before you take the plunge, look at the expense ratios and how the fund attempts to generate returns. A simple style focused market neutral ETF might be okay if you are making a short-term bet that value will outpace growth or small caps will outperform large caps, but you may want to look at multi-factor and more sophisticated long/short ETFs for a long-term holding.

Disclosure: I/we 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.