ProShares, the Maryland-based ETF issuer known as a pioneer of leveraged exchange-traded products, announced today the latest addition to its product line. Like many of the new products hitting the market in recent weeks, the ProShares RAFI Long/Short (RALS) will be the first of its kind. RALS will seek to replicate the RAFI U.S. Equity Long/Short Index, a benchmark that utilizes the fundamental weighting methodologies developed by Research Affiliates that have gained impressive traction with investors in recent years.
The RAFI methodology offers an alternative to traditional market capitalization-weighting strategies, under which a direct link exists between the price of a stock and the weighting that the security receives in an index. While there are many advantages to cap weighting–including simplified maintenance–the rise of the ETF industry has contributed to greater scrutiny on construction methodologies. Cap weighted indexes will have a tendency to overweight overvalued stocks and underweight undervalued stocks, potentially creating a drag on total return. Under the RAFI weighting methodology, four fundamental measures are used to determine firm size: book value, income, sales, and dividends [see Why Weighting Methodologies Matter When Choosing An ETF].
There are already a handful of ETFs linked to RAFI indexes, many of them offered by PowerShares. Most of these existing products utilize the RAFI methodology to construct long only portfolios, making them potential substitutes for funds linked to cap-weighted benchmarks in the same asset class. The PowerShares FTSE RAFI U.S. 1000 Portfolio (PRF), for example, will generally exhibit significant overlap with the Russell 1000 Index Fund (IWB), but investors looking to avoid the potential pitfalls of cap-weighting may see it as a more efficient way to access large cap equities [Pro Members can see a RAFI Portfolio here].
RALS is designed with an absolute return objective, and introduces short selling to the equation in an attempt to capitalize off of discrepancies between the weightings suggested between market capitalization weighting strategies and the RAFI methodology. Basically, the fund will establish long positions in stocks for which the RAFI weighting is larger than the cap weighting and short positions in those for which the cap weighting is larger than the RAFI weighting. “Lifting the long-only constraint extends the potential benefits of the RAFI approach,” said Rob Arnott, founder of Research Affiliates. “We are excited that ProShares is providing access to another important alternative strategy for investors.”
Each year, the universe of potential constituents will consist of the 1,000 largest U.S. stocks by market capitalization and the 1,000 largest U.S. stocks by RAFI weight. The companies included in the underlying index are then selected for each of 10 industry sectors; within each sector, the 20% of the securities with the largest RAFI weights relative to their market cap weights are selected to comprise the long portfolio. The 20% of securities within each sector with the smallest RAFI weights relative to their market cap weights are selected to comprise the short portfolio. Weights are normalized within each sector so that the resulting sector weights in both the long and short portfolios match the model sector weights of a hypothetical RAFI weighted US 1000 long only index [also read Does Your Portfolio Need A RAFI ETF?].
If the RAFI weight proves to be a more meaningful indication of each company’s potential to generate returns than its market capitalization, this methodology would deliver positive returns. Because the fund is market neutral–it is rebalanced monthly to ensure that it has equal dollar investments in both and short positions–it should exhibit low volatility and correlation to stocks and bonds. “We are pleased to partner with Research Affiliates and Rob Arnott on ProShares RAFI Long/Short,” said Michael L. Sapir, Chairman and CEO of ProShare Advisors LLC, ProShares’ investment advisor. “This ETF may appeal to investors looking for strategies that strive to deliver low correlation and favorable returns regardless of market direction.”
Alternative ETF Company
Along with the launch of RALS, ProShares is introducing a new marketing campaign with the themeline “The Alternative ETF Company.” RALS is the second product in ProShares “Alpha” product suite, joining the Credit Suisse 130/30 (CSM). That fund is the only ETF to offer a 130/30 strategy in an attempt to take advantage of both negative and positive expectations for stocks. The underlying index, developed by MIT Professor Andrew Lo and Pankaj Patel of Credit Suisse, establishes short positions in stocks with negative expected alpha and uses the proceeds from shorting to establish overweight positions in stocks expected to generate the highest alpha [see Seven Alpha-Seeking ETFs That Have Crushed Their Benchmarks].
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Disclosure: No positions at time of writing.