The Long And The Short Of ETF Investing

Published on by on August 17, 2011 | Updated August 26, 2013

While ETFs have been praised for their ability to offer immediate diversification and low cost exposure to a wide variety of asset classes, more and more investors are also realizing that ETFs may also allow them to tap into relatively complex investment strategies that historically would have required either significant time and analysis or a pricey management fee. The rise in popularity of ETFs has spurred a round of innovation in the world of indexing, with countless firms coming up with benchmarks designed to use objective quantitative analysis to dictate strategies that have historically been performed by teams of analysts and relied manager input and subjective decisions.

As correlations between international markets have steadily increased over the years, identifying non-correlated assets has become both increasingly important and difficult. Against this backdrop, long/short investment strategies may be an intriguing opportunity, as they maintain the potential to generate positive returns even in the most challenging of economic environments. The idea behind such an investment is relatively simple: establish a long position in an asset that is undervalued relative to a comparable security and a corresponding short position in the relatively overvalued counterpart. Because the net exposure is zero these strategies are often described as “market neutral,” meaning that performance is not correlated to the general movement of the markets but rather to the relative performances of the opposite asset classes [see also Three Low Volatility ETF Options].

The long/short strategy is certainly nothing new; investors have been utilizing market neutral tactics for decades, attempting to generate profits from relative mispricings regardless of whether bullish or bearish conditions exist. Originally employed using individual stocks (e.g., long Pepsi, short Coke), long/short strategies have become increasingly complex, and are now a staple of many hedge funds. But the marriage of long/short strategies and the ETF structure is a relatively new development, with a handful of funds popping up that seek to deliver absolute returns and low correlations. Below, we outline three ETFs that use the traditional long/short strategy:

Diversified Alternatives Trust (ALT)

This iShares product doesn’t seek to replicate the performance of any benchmark, making it a somewhat unique spot in the product lineup of the largest ETF issuer. Instead, ALT seeks to maximize returns from low correlated assets that are generally impervious to overall movements in the market. At the same time, the fund controls the risks from futures contracts by establishing long and short positions in historically correlated assets. ALT uses primarily futures and forwards contracts to implement relative value strategies, attempting to profit from spreads between asset classes that have deviated from fair value. ALT revolves around three primary strategies:

  • Yield and Futures Curve Arbitrage: Entering into long and short positions in bond futures, interest rate futures, commodity futures, and currency futures that appear mispriced relative to one another.
  • Technical Momentum/Reversal: Based on the theory that past price history may be predicative of future asset prices, this strategy can involve going long in assets whose recent performance exceeds historical performance (and vice versa).
  • Fundamental Relative Value: Identifies discrepancies between market and fundamental values of an asset [also read Seven Wildly Successful Active ETFs].

As shown by its current holdings, ALT maintains a number of both long and short positions.

Credit Suisse Long/Short Liquid Index (Net) ETN (CSLS)

CSLS measure the Credit Suisse Long/Short Liquid Index, which reflects the return of a dynamic basket of liquid, investable market factors selected and weighted in accordance with an algorithm developed to maximize returns. In other words, the underlying index uses a proprietary model to determine whether long or short positions should be established in a variety of “plain vanilla” asset classes, with the goal of delivering performance similar to those achieved by certain hedge fund strategies. Among the “market factors” in which CSLS may go long or short are the S&P 500, MSCI EAFE, MSCI Emerging Markets, and Russell 2000. The weightings in these market factors are determined through a four-stage process [see more on this process on the Index Overview].

Mars Hill Global Relative Value ETF (GRV)

AdvisorShares‘s GRV has been one of the most successful actively managed ETFs to hit the market. This ETF, the result of a partnership between AdvisorShares and Mars Hill, utilizes a relative value approach, identifying long positions in global regions and sectors that are expected to outperform while shorting those assets that are expected to underperform. The result is a market neutral asset that will generally exhibit low volatility and correlation to both domestic and international equity markets, with the objective of generating positive returns regardless of current market conditions. GRV is structured as an ETF of ETFs, making it one of the most unique products currently available.

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Disclosure: No positions at time of writing.