An overlooked, underutilized, and perhaps misunderstood ETF trading strategy is “pairs trading” where one essentially would marry a long position in one ETF with a short position in another “like ETF” in a portfolio (with the trades being in equal dollar amounts), in attempts to capture limited upside, but be able to specifically quantify the downside risk and neutralize the general market trend to a high degree.
One such strategy exists if you consider the various “S&P Index related” ETFs available. Consider a market cap index ETF that tracks the S&P 500 such as (SPY) or (IVV). Now, consider an ETF with a non-market cap index methodology that owns the same 500 underlying holdings that are in the S&P 500, but are weighted differently. Two such examples are (RSP), the Rydex Equal Weighted S&P 500 ETF, and (RWL), the RevenueShares Large Cap ETF.
2009 was a strong year for fundamental and equal weighted indexes, as RSP’s trailing one year performance is +45.25% while RWL’s is +32.35% versus SPY +26.98% and IVV +27.05%. After the market rallied from the 2009 March lows, the dynamics of the rally were largely small/mid cap driven, more so than large cap.
That said, products that were non-market cap weighted strongly outperformed last year because of the way the indexes were made up.
This was not isolated to the large cap space either, as one can look at (MDY), the SPDR S&P MidCap 40 and (IJH), the iShares S&P MidCap 400 ETF versus (RWK), the RevenueShares Mid Cap. Dispersion in returns here over the trailing one year is even more notable than large cap, with RWK +66.65%, IJH +50.39%, and MDY +50.09%. Like RWL, RWK owns the same stocks as its cap weighted benchmark, the S&P 400, but the weightings are determined by company revenue instead of market cap.
In Small Cap land, an opportunity is present as well, as (IJR), the iShares S&P Small Cap 600 ETF is up 33.90% in the trailing one year with (RWJ), the RevenueShares Small Cap ETF up 60.07%. That’s over 2600 basis points in out performance over the course of a year in two products that have the same underlying securities, with one having a revenue weighted methodology and the other a market cap weighted one.
Where’s the trade here you ask? It all depends on your broad market view. Since you know that the underlying securities will be the same in (SPY), (RSP), and (RWL), all the time, just the weighting methodologies are different, do you foresee a large cap, quality driven rally (or sell off?), or a smaller cap, lesser quality rally (sell off) like we experienced in 2009? The same questions apply to the Mid and Small Cap spaces although Rydex does not offer an equal weight mid cap nor small cap ETF, so you need to trade Revenue Weighted versus Market Cap weighted. Will Revenue Weighted S&P indexes outperform Market Cap again this year? Or will the trend reverse?
Since all of these ETFs have the same underlying holdings (S&P indexes), the portfolio compositions are a) highly transparent b) highly liquid and c) highly correlated on a portfolio level. That said, the weightings differences can result in significant out performance/under performance depending on broad market moves over short or longer periods of time (i.e. the dispersion of RWJ versus IJR last year).
Rather than being “naked long” Large Cap, Mid Cap, or Small Cap in your portfolio, you can be “Long Large Cap Equal Weight and Short Large Cap Market Cap” by buying RSP and shorting an equal dollar amount of SPY (or IVV) against it. In the worst case scenario where the market goes to zero, you are hedged on the downside because you are short the broad market (your SPY or IVV short), while you are long RSP.
If market cap outperforms equal weighting, you can and will lose on this trade, but since the underlying indexes contain the identical securities, you can quantify, pre-trade, whereabouts your losses will be because of high historical correlations between the two indexes. You could establish similar positions in Small and Mid Cap, for instance “Long Small Cap Revenue Weight and Short Small Cap Market Cap” by buying (RWJ) and shorting an equal dollar amount of (IJR) against it.
You can quantify your downside with fairly high confidence should you be wrong about which index methodology will perform better, and at the same time you are neutralizing pure market risk in just being “naked long” one Index ETF or the other. Sure, you could have bought RWJ last year, held it, and earned 60+% in the trailing 1 year period, but this carried market risk of course. On the other hand you could have shorted (IJR) against (RWJ) and netted a return of up 24% with a very low, and predictable amount of risk (you were long the S&P 600 and short the S&P 600, in essence a “collared” position if you were to examine year by year returns of the Market Cap versus Revenue Weighted S&P 600 indexes).
The dispersion in returns between the two indexes will likely not be as dramatic year to year as it was in 2009, but because the company weightings are markedly different in the Market Cap, Equal Weight, and Revenue Weighted S&P products, one should consider trading both products, long versus short if they have a specific market view on which names/sectors will drive the next rally or sell off, because these are the drivers of the differences in returns.
One final note that is of utmost importance, the Market Cap, Equal Weight, and Revenue Weighted products all have very different levels of trading volume, some very high and some fairly low. That said, the liquidity of the underlying indexes are there, these are all S&P index products.
Trades can be established with minimal price slippage, even though SPY may trade 1450,000,000 daily versus RWL’s 40,000 shares because the index liquidity is there.
With 2009 behind us, perhaps your market view will allow you to take advantage of a pairs trade in these S&P products rather than just being outright long or short, and facing the possibility of just being dead wrong in the face of the next market move.
-Written By Paul Weisbruch From Street One Financial
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