Research says shorting ETFs in a 1X0/X0 portfolio holds unique benefits
Apr 7th, 2008 | Filed under: 130/30
Hedge fund managers often contend that long-only managers lack the skills required to short-sell. They will point to things like the fact that short positions will actually grow as they move against you (unlike long positions which shrink as they move against you). They will also point to the fact that shorts tend to be driven more by catalysts than longs. But one of the most legitimate concerns raised by hedge fund managers is the simple fact that good short ideas are often in short supply.
This was a concern raised last June in this MarketWatch article (see related posting, “So Much for Double Alpha”):
“Some equity hedge funds have quit short selling stocks because the strategy is riskier in a rising market and has become too crowded to be profitable. Instead, more managers are shorting exchange-traded funds. That’s a problem, according to some experts, who argue that using ETFs to hedge equity portfolios is a poor substitute for the real thing.”
“ETFs are also indexes, and so, by definition, they provide so-called beta — that is, the return generated by the market. Hedge-fund managers are in the business of creating alpha and outpacing the market benchmarks. So if they build short positions with ETFs, that part of their strategy will track whatever portion of the market they’re betting against. That could end up looking more like beta than alpha.”
While it may be true that hedge funds are in the business of creating alpha, 130/30 funds may be a little different. Institutional investors, the early adopters of these hybrid strategies, seek alpha too. But they do so with a watchful eye to volatility (known to them as “tracking error” vs. a benchmark index). The key ratio for them is the “information ratio” (alpha/tracking error).
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You know, take ANY TWO equity strategies, call them “A” and “B”. Assume they each have a positive expectancy, and that they have a less than perfect correlation to each other.
Now it’s pretty obvious that combining them would end up reducing volatility and probably increasing CAGR. This could be 50/50, 67/33, or any other split. Let’s say … 81.25/18.75! That’s “A” having 13/16ths weight.
Now take this blended strategy, and lever it up 1.6 to 1.
Gee, think it would outperform either one of its components (”A” or “B”)? Why would 130/30 be an exception to that logic?
[…] “(I)n a world of scarce great shorting opportunities, shorting ETFs may not be that bad after all - as long as the information ratio is your key metric.” (All About Alpha) […]