Definitive Guide To 130/30 ETFs: 130/30 ETF Investing 101

by on October 9, 2009 | Updated May 17, 2010 | ETFs Mentioned:

When analyzing the of the ETF industry, most investors highlight the cheap, liquid exposure to traditional asset classes as the main reason for the popularity of the exchange-traded structure. While ETFs have indeed provided a low-cost alternative to the traditional asset classes, they have also made it easier than ever to achieve exposure to “exotic” asset classes, geographies, and investment strategies. From Van Eck’s Vietnam ETF (VNM) to Direxion’s line of 3x leveraged ETFs to various physically-backed and futures-backed commodity products, ETFs have greatly expanded the investment universe available to all types of investors (see VNM’s fundamentals here).

One of the latest innovations in the ETF industry is 130/30 investing, a strategy implemented by the ProShares Credit Suisse 130/30 (CSM) and the First Trust KEYnotes Exchange Traded Notes (JFT). In a 130/30 strategy, the fund takes a 100% long position in a benchmark (in the case of CSM, the S&P 500), and then sells 30% of the portfolio short against it. The proceeds from the short sale are then used to establish additional long positions, resulting in 100% long net exposure (see JFT’s fact sheet here).

130/30 ETF Mechanics

ProShares Credit Suisse 130/30 (CSM)

CSM is based on the Credit Suisse 130/30 Large-Cap Index, a benchmark devised by Dr. Andrew Lo, a professor at MIT, and Pankaj Patel, director of quantitative research at Credit Suisse. The benchmark is based on a quantitative model that selects the equities from a broad-based universe best positioned to outperform and underperform the benchmark. By shorting the securities expected to experience the worst performance and doubling down on those expected to post the strongest gains, 130/30 ETFs seek to generate alpha while maintaining a risk profile relatively similar to traditional equity benchmarks (i.e., the S&P 500).

As of September, the index underlying CSM had 256 long positions in companies with a price-to-earnings ratio of about 16 and 135 short positions in companies with a P/E of almost 28. Of the short positions, the largest interests were in Ciena Corp., Zions Bancorp, and Patterson Cos (see all of CSM’s holdings here).

CSM is a relatively new fund (launched in July 2009), but has quickly accumulated assets and has a daily volume of more than 125,000 shares. CSM has an expense ratio of 0.95%, on the high end for ETFs, but justified by its recent performance.

First Trust KEYnotes Exchange Traded Notes (JFT)

JFT is linked to the First Trust Enhanced 130/30 Large Cap Index, a benchmark that selects its holdings from the largest 2,500 largest U.S. listed stocks (making its “universe” broader than that of CSM). Because JFT is structured as an exchange-traded note, it is essentially a senior unsecured debt instrument issued by First Trust. ETNs are similar to ETFs, but generally have lower tracking error since they aren’t required to shuffle holdings as the index changes. ETNs do have some degree of counterparty risk, although the chances of default from First Trust are minimal.

JFT has outperformed the S&P 500 by a wide margin in recent months, but the biggest concern relates to liquidity. JFT’s average daily volume is less than 1,000 shares (see JFT’s performance charts here).

Not New, But Better

To be certain, 130/30 investing is nothing new. Large institutional and sophisticated investors have been implementing similar strategies for years, and a number of 130/30 mutual funds have popped up and become moderately popular among investors. But 130/30 ETFs offer advantages over these mutual funds, including significantly lower expenses and enhanced liquidity. (130/30 mutual funds can charge expenses of up to 1.7% and be difficult to redeem.)

Because 130/30 ETFs generally have similar risk and return characteristics to the universe of eligible securities (in this case, the S&P 500), they will generally maintain a strong correlation with this benchmark. But 130/30 ETFs offer potential for excess risk-adjusted performance relative to the more traditional cap-weighted benchmark.

Over the last several months, 130/30 ETFs have delivered stellar returns, outperforming the S&P 500 (see SPY’s technicals here).

Ticker ETF 3 Mo. Gain* Avg. Daily Volume Expense Ratio
CSM ProShares Credit Suisse 130/30 18.2% 134,000 0.95%
JFT KEYnotes ETN First Trust Enhanced 130/30 Large Cap Index 25.7% 1,000 0.95%
SPY S&P 500 SPDR 17.3% 225 million 0.09%
*Return since July 14, 2009

Disclosure: No positions at time of writing.