An ETF Strategy For An Uncertain Market (CSM, JFT)

As investors look for ways to add diversification and alpha, implementing the 130-30 strategy could be a way to go.

The 130-30 strategy uses financial leverage by shorting poor performing stocks and purchasing shares that are expected to have high returns.  A 130-30 ratio implies shorting stocks up to 30% of the portfolio value and then using the cash from the short position to take a long position in the stocks that are expected to outperform the market. 

The ProShares 130/30 fund (NYSE:CSM) is a good example of such an ETF.  (NYSE:CSM) utilizes a quantitative analytical system to rank all of the large-cap stocks in the U.S. market, then takes a 130% long position in the high-ranked stocks and a 30% short position in the low ranked stocks.  At the end of the day, (NYSE:CSM) aims to generate alpha superior to that of a comparable long-only cap strategy over the long run and generate higher returns.  As of July 16, 2010, the index that (NYSE:CSM) tracks had 241 long positions with a Price/earnings ratio of 15.58 and held 123 short positions with a price/earnings ratio of 21.47.

Another way to gain access to this strategy is through the First Trust KEYnotes Exchange Traded Notes (NYSE:JFT), which is a senior unsecured debt instrument that is linked to a benchmark that selects its holdings from the largest 2,500 US listed stocks, making its universe larger than CSM’s.  As of August 17, 2010, the index that (NYSE:JFT) seeks to replicate held 109 long positions and 106 short positions. 

Although the 130/30 strategy is a unique one which could add diversification and generate alpha, it is important to keep in mind the unpredictability and risks that are involved, like getting the longs or the shorts or both wrong. 

Written By Kevin Grewal from Smart Stops 

Kevin Grewal serves as the editor at www.SmartStops.net, where he focuses on mitigating risk and implementing exit strategies to preserve equity. Additionally, he is the editor at The ETF Institute, which is the only independent organization providing financial professionals with certification, education, and training pertaining to exchange-traded funds (ETFs). Prior to this, Grewal was an analyst at a small hedge fund where he constructed portfolios dealing with stock lending, exchange-traded funds, arbitrage mechanisms and alternative investments. He is an expert at dealing with ETFs and holds a bachelor’s degree from the University of California along with a MBA from the California State University, Fullerton.

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