This chart compares the StateStreet REIT ETF (RWR), which was the highest yielding ETF in the sector I could find, against the Short Real Estate ProFund (SRPIX). According to PortfolioScience.com the two have a negative 0.962 correlation.So if last October 13 you put $20,000 into RWR and $20,000 SRPIX you would have bought 336 shares of RWR and 605 shares of SRPIX.
RWR would now be worth $28,717 a gain of $8717 and SRPIX would have dropped to $14780 a decline of $5220. The $40,000 invested a year ago would have had gain of $3497. You also would have picked up $1162.22 in dividends from RWR and a $24.20 dividend from SRPIX (I did not read the prospectus to see how this fund could pay a dividend but Yahoo Finance says it paid $0.04 this past September 29). The total return was 11.7%.
During the same time period the S&P 500 was up about 15%. So you captured most of the return of the market, although clearly with a lag, with very little volatility.
If RWR had declined in price by 10% SRPIX might have gone up by 9.6% for a net loss of $80 but add in the dividends of $1186.42 and it would have netted out a 2.7% gain. Of course since this is not what happened there is no way to know how realistic this downside scenario is nor can we know what the S&P 500 would have done if the REIT sector declined by 10%. This was just an example.
Another flaw in this exercise is of course that it is looking backwards. The example as it worked out though does make the point; this concept is not the single dumbest idea ever written. I will continue to explore this idea.
13 comments:
Roger, Barron's had a nice write up on water plays, which I'm sure that you've seen. I would enjoy seeing your take on it if your financial writing muse so strikes you.
My favorite Barron's section is Sandra Ward's interviews. This week there is one with Charley Maxwell, an energy analyst (with some 50 years of experience). With the tidal move out of energy equities, I found this article to be very interesting. One of my (pre-Amaranth) investment thesis was that natural gas had bottomed. So I allocated $10K to Fidelit's NG mutual fund in one of my retirement accounts. Seemed like a good risk/reward until Amaranth hit. Down 15%. I'm still looking for some energy, but the funds exodus from this sector have left me scratching my head--hence my finding this an interesting article.
leisa: with all the etfs on energy why a mutual fund?...curious...if bottom feeding, why not uso?..i took a position there on pullback late last week.
I like your concept and willingness to share. But, as something new, it seems complex. In slow mo, I follow but in real time the "no free lunch" seems haunting. I hope you keep posting to demystify what could be quite useful. Any chance of a virtual pairing portfolio and to watch the process of creation and risk management?
Anonymous (11:13) The account was a Fidelity Retirement account that only is set up to do mutual funds. Period. I do have another retirement account in which I can do all brokerage activities except to short stock.
My favorite energy names in the past and in which I have had successful trades have been XTO and DVN.
Its hard enough for me to pick a stock or sector that offers a profit. To have to pick the right sector as well as the right stocks in that sector to go long and short seems adding a great deal of risk when I am trying to add alpha and keep beta low.
The free lunch question is probably the right one. For now it is just a concept. Keep in mind that the expectation is that it lags the overall market. With the new ETFs coming this type of pair becomes doable in many sectors with no single stock risk, that much is clear.
Depending on how far the long strays from the short conceptually, it becomes possible, though unlikely, that both go down. Maybe in a flatish environment both decline. The SPX is up 2% one year and an etf held long that is a tad more specialized that the broadest sector ETF drops by 1% when the broader long candidate goes up by 1%. This means the short fund would be down 1%.
A little quirky but possible.
QUESTIONS. Will the new short etf sectors pay dividend? Will long sector etfs pay yield, besides the obvious ones like financial and reit? Is the dividend an essential component to the pairing? Does the long etf need to have a higher reward and the short etf more of a lower beta just to dampen the blow of a negative long return? Is there the risk of the two bets just cancelling each other out and it becomes an opportunity lost on just having cash in MM? This kind of stuff gets me confused. Unless one has been doing hedging for a while, murphys law is there in the most elusive ways. But this is not a knock, just my own floundering to follow. Love the website.
Interesting concept. I'd hope you continue explore and post on it.
Dear Roger, long time reader, first time poster,I just felt like I could say a few things on my mind about investing -- and you would be a good person to tell. Mostly I have been thinking about hedge funds, and how so many people have been hurt by these funds.
I work at Stillwater Capital, and was thinking about hedge funds and some of these funds blowing up, and thought that I would add my two cents and see if you had anything to add too – I hope I’m not being too off topic from your post here, but I just wanted to say a few things after reading your last thought here… many investors were hurt by Amaranth and other funds, and I was thinking about the ways some of those affected are going to sort through the damage, here are some principles they may want to have in mind:
1. Sophisticated hedge funds apparently have no clue about should have basic concepts like money management, position sizing and ‘risk of ruin‘ knowledge, and should use stops or have a point where they know to exit.
2. Bennett McDowell once said that, “Money management in trading involves specialized techniques combined with your own personal judgment. Failure to adhere to a sound money management program can leave you subject to a deadly “Risk-Of-Ruin” exposure and most probable equity bust.”
3. The smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.”
4. And of course it goes without saying that a good hedge fund investor has to pick good funds to invest in. The key, though, to success in this business, is not to choose the best performing managers, but actually to evade the frauds and blowups.
5. With both frauds and blowups, contrary to public opinion (and myth), size does NOT matter: Beacon Hill was $2 Billion, Lipper was $5 Billon, Amaranth was $9 Billion).
Suffice it to say that these should be some of the main points investors should think about as they interview and select hedge funds to entrust their dollars to.
Do you agree with this?
Jack Doueck
Stillwater Asset Backed Strategies
Stillwater Capital
Stillwater runs deep.
deep, into spam.
First time poster Jack? I remember reading a very similar post from you on another of Roger's threads - maybe on SeekingAlpha.com? Anyway, limiting position sizes seems like basic common sense.
Getting back to the subject, I think Roger's paired trade example might be improved with the use of CEF's trading at historically steep discounts rather than an ETF. The size of the hedge may have to be adjusted to compensate for leverage used within the fund, but now we add a 'narrowing discount' arbitrage opportunity to our yield opportunity.
Case in point, in February of this year I was buying JRS at an ~11% discount to NAV. Today it trades at a 7.8% premium. I'm taking gains and moving into NRO (~14.74% discount). If I could hedge out the beta risk and just capture the yield and the change in discount, that would be attractive in a REIT bull market that seems to be long in the tooth. The thing that bothers me about this trade though, is that it ties up too many dollars in the hedge. Seems like I could accomplish the same thing by buying IYR puts and invest the remaining funds in a non-correlated investment and have a little portable alpha thing going on. Am I missing something?
Jack your comment seems to gravitate toward common sense, I like the term "risk of ruin." From that stand point what's not to agree with?
However you are asking me about this and I only manage separate accounts. Hedge funds is a different world. Risk taking is much different and should be veiwed as different. A hedge fund is a pool of money from many partners who are not all in. THe likelihood of a separate account being all of a person's money is much higher. This sets the stage for more risk taking. So every once and a while kaboom as some strategy that has picked up steam unravels suddenly. It will happen again and again.
To anon about CEFs, no question there are way to enhance the trade, hopefully this can be explored.
In using CEFs the first risk that comes to mind is a reliance on the market. Fear and greed is a big mover in changing premiums/discounts. Figuring what a discount should do certainly complicates the idea if nothing else. Puts as the hedge also creates issues with picking the strike, what happens when you roll if volatility has spiked, there would be several ways to buy the wrong option. I am not the best resource for this aspect of it but it is more complex.
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