Build Your Own Hedge Fund, Part II: A Long-Short Portfolio With IVV, XLI, XLK and XLY

Includes: IVV, XLI, XLK, XLY
by: David Jackson

The first article in this series - The outlook for US stock sectors, and how to build your own hedge fund with ETFs - argued that ETFs allow regular investors to construct hedged portfolios and that sector ETFs are a good way to do this. Why? Because the divergence between the top and bottom sectors of the S&P 500 over the last 15 years has averaged almost 50%, so there's plenty of opportunity for profit (and loss) using sector ETFs.

The article then outlined the prognosis for U.S. stock sectors according to Jack Ablin, the chief investment officer of Harris Private Bank. Now we're going to implement his sector views in an all-ETF portfolio.

Quick recap: According to Mr Ablin, the ranking of U.S stock sectors in descending order of attractiveness for the foreseeable future is:

  1. Healthcare
  2. Telecom
  3. Utilities
  4. Finance
  5. Basic materials
  6. Consumer staples
  7. Energy
  8. Technology
  9. Industrials
  10. Consumer discretionary

Before we build a portfolio based on this sector view, a note about hedge funds and ETFs:

Building your own long-short portfolio from exchange-traded funds is dramatically cheaper than giving your money to a hedge fund manager. Hedge funds typically charge 2% of assets per year and 20% of the profits. On top of that, most hedge funds are horribly tax-inefficient. So you have to reduce the nominal hedge fund gains by 20% performance fee and then whatever your Federal, State and local income tax rates are. In contrast, a do-it-yourself long-short portfolio using ETFs will cost you hardly anything in trading fees and can be highly tax-efficient, since it allows you to time the realization of capital gains and losses and offset one with the other.

Having noted that, here's a possible portfolio (the first I want to discuss) built on that sector ranking using exchange-traded funds:

Long positions
iShares S&P 500, ticker: IVV, 100%

Short positions
Consumer Discretionary SPDR, ticker: XLY, 11%
Industrials SPDR, ticker: XLI, 12%
Technology SPDR, ticker: XLK, 18.5%

Let's suppose we're implementing this in a portfolio of $100,000, and take a look at the portfolio. With IVV currently trading at $115.67, XLY at $31.41, XLI at $29.17 and XLK at $19.36 your portfolio will look as follows (I've deducted $10 per trade for fees):

864 shares IVV

350 shares XLY
411 shares XLI
955 shares XLK

Note that this is not an entirely hedged portfolio: you're still roughly $58,500 net long at the time you put on these positions. Why do this?

The rationale would be as follows. You're not trying to construct a fully hedged portfolio. Instead, you believe that in the long run stocks will go up, and you want to leave your capital in the cheapest available index fund. But you're nervous about the market this year. However, you don't want to sell your S&P 500 index fund (perhaps you'll trigger capital gains if you've owned it for a while), and you'd like to try to make greater profits than you could by leaving your capital in cash.

So this is what you do. You leave your assets invested in an S&P 500 index fund, and you strip out the sectors that you think will underperform the rest of the market. This portfolio removes Jack Ablin's weakest sectors from the portfolio in the exact weights that they appear in the S&P 500.

What are the advantages of this strategy?

  • Reduced risk in a down market. You've left yourself "in the market", but you've removed what you consider to be the worst risk. If XLI, XLK and XLY fall substantially more than the S&P 500 (as Mr Ablin expects), you'll reduce your losses and possibly eliminate them entirely.
  • You make money arbritraging the expense ratios of the funds. Note one interesting feature of this porfolio: you are arbitraging the expense ratios of the ETFs. IVV charges an annual fee of 0.09% per year, but the select sector SPDRs charge 0.26% each. So the value of the dividends you receive on your (roughly) $100,000 long position in IVV over the course of the next 12 months will be cut by about $90 to pay the fees for the fund. But the dividends you'll have to pay on the select sector SPDRs (or the value of the stocks that underlie them) will be reduced by almost $108, even though in aggregate your short positions only total less than half your portfolio. In other words: by owning the lower expense fund and shorting the higher expense funds you've eliminated much of your investment costs. (You still have to pay for trades and the bid-ask spread on the ETFs.)
  • Tax efficient. If the market goes up, you'll do much better than if you'd just sold half of a long-standing IVV position with unrealized capital gains. If you'd sold, you'd pay capital gains taxes on whatever gains you realize. But by holding on to IVV and shorting XLI, XLK and XLY, you'll incurr a short-term capital loss on the sector ETFs without realizing your accumulated capital gain on IVV if the market rises. 

What are the downsides of this strategy?

  • Not completely hedged. If you're really worried that the market is going down, you'll want to hedge considerably more than half your portfolio. Look at it this way: if the market falls, you'll need the three sector ETFs to fall by twice as much as the overall S&P 500 to break even.
  • You'll lose more in a worst-case scenario. While it's true that you could do better than leaving your money in cash, you could also do worse if the sectors perform differently from Mr Ablin's expectations. Even if all sectors go down in equal amounts you would have done better to stay in cash. Worst case scenario: IVV goes down, XLI, XLK and XLY go up. Then your losses are amplified.
  • No interest on your cash. You could have just sold half your position in IVV and left it in cash and not shorted the sector ETFs. In that case, you'd be earning interest on your uninvested cash. In contrast, most brokerages won't pay you interest on the proceeds of your sector ETF short sales.
  • Could be tax-inefficient. If you have limited long-term gains on IVV and all the ETFs go down, your long-term gain on IVV will be reduced but you'll incur a short-term capital gain on XLI, XLK and XLY. (All profitable short sales are short-term capital gains, irrespective of the holding period.) On an after-tax basis, you might have been better off just selling IVV.

This portfolio works for someone who wants to reduce (but not eliminate) their exposure to the market. It offers a chance that you'll break-even in a down market and make money in an up-market. It generates profits by arbitraging the expense ratios of the funds, and can be tax-efficient if you have either considerable or zero unrealized capital gains on IVV.

The downside is that it's not tax efficient if you have moderate unrealized capital gains on IVV and the market falls, and increases your potential loss in a worst-case scenario.

So if you're pessimistic about the market this year, and you're investing from scratch or have a large unrealized capital gain that makes you reluctant to sell your S&P 500 index funds, this type of strategy could be far better than doing nothing or simply reducing your S&P 500 position.