Market Neutral

In continuing with this low beta and market neutral kick I have been on lately, I had an idea for a variation on a kind of paired trade that I mentioned a few days ago.

In that previous post I used an example of going long a stock with a high correlation to its sector, as measured against a sector ETF, and short the sector ETF. The stock component I said should have a higher yield than the sector ETF and the investor should think the long stock will outperform the sector. In my example I paired National City (NCC), a bank stock with a 4.3% yield that I don't own or follow (this is just an example) with a short position in iShares Financial (IYF). The two have a 0.70 correlation and NCC has a 2.49% yield advantage. I laid out a scenario of a return that exceeded a riskless rate of return by a decent margin.

There may be a way coming to do something similar without taking any single stock risk and also adding a little more yield.

ProShares has filed for short and double short sector ETFs. WisdomTree could list international sector ETFs as soon as this month that use the same dividend weighing methodology as the existing funds.

As I go into detail here I am conceding there are a lot of ifs to this. Picking a sector known for yield like financials, I would not be shocked if an international sector ETF that focuses on dividends yielded at least 4.5%. A double short ETF would use futures and options to be double short and so while probably an expensive fund would not have a negative dividend.

If the two funds do have a high correlation, and the WisdomTree sector fund does as well as the current batch of funds are doing, this could work out quite well.

Here are the specifics. $10,000 long into the WisdomTree financial sector ETF and $5000 into the ProShares double short financial sector ETF. I am hypothesizing a 4.5% yield advantage. If the WisdomTree fund outperforms the sector by 3.5% per year(which is in the ballpark of its other funds) which might look like an 8% (sort of) return with much less volatility than the overall market. Another component to this idea is that by using the double short ETF instead of the single short there should be $5000 left over to go into a money market. Assuming a 4.5% yield that adds $225 in return.

This totals $1025 on $20,000 ($10,000 in the long fund, $5000 in the short fund and $5000 in cash) which works out to 5.125% (not 8%).

This is far from exciting but in this thesis the volatility would be extremely low. That a portion of a portfolio goes into something like this seems far from absurd.

Since neither of these funds is trading yet this post is more of an academic exercise but it is interesting to think about. Especially if average returns for full stock market exposure decline to 7-8% annually as some say will be the case.

I will reexamine the idea if the funds list. Obviously the leverage of directly shorting a sector ETF would mean that the return theorized here would be different but IRAs can't sell short.