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A Pair of Ultra Trades

One thing that has been clear to me over the last couple of years is that ETF innovation would allow do-it-yourself investors to have cheap and easy access to potentially sophisticated strategies.

The latest batch of ultra short (i.e., double short) sector funds are a big step in this direction for market-neutral strategies and paired trades.

ProShares has listed 11 funds that go short various Dow Jones versions of different sectors. In this article, I will profile a possible strategy that I think could be applied to all of them, so roll up your sleeves. The example here will be with the financial sector, the Ultra Short Financials (SKF). This fund captures double the inverse of the Dow Jones Financial Sector Index. The proxy for this index exists as a single long ETF: the iShares Dow Jones Financial Sector Index Fund (IYF).

To be clear, $10,000 in IYF paired with $5000 in SKF, save for whatever the tracking error might be, would offset each other on a daily basis.

There are two types of paired trades that could offer very good results (think bases on balls and hit by pitch) with very little market risk.

Pairing Them Up

I think there is an advantage to buying this type (the Ultra Short) of ETF over selling short a regular ETF or buying a put. If you sell short an ETF, you will have to pay the dividend paid by the fund. If you buy a put, you have to deal with buying new puts over and over, and with a little bit of bad luck, buying puts poorly could offset more of the intended gain of the long holding.

The lower-risk way to implement this trade would be to pair an ETF other than IYF with SKF. Obviously, it would need to be an ETF with a different methodology that you think would outperform IYF. One that could work is the WisdomTree International Financial Fund (DRF).

In its very short life (a little over three months), DRF has outperformed IYF by four percentage points. For example, assume you put $20,000 into DRF and $10,000 into SKF. Per the chart, DRF would be up $1800 and SKF would be down $1000. While DRF has not yet paid a dividend due to being so new, the yield of the index -- prorated for one quarter and less the expense ratio -- could work out to be $141. The net gain would be $941, which on $30,000 could be 3.1% for the entire quarter.

There are obviously several assumptions in this example, but pairing two similar index funds against each other is not wildly speculative. It is not a realistic threat that one financial sector index could go up 20% while another could go down 20%.

The Dividend-Paying Trade

There is also the possibility that SKF could pay a dividend because it uses derivatives to create the exposure, so the cash left over earns interest, which could potentially add a few basis points in return. For now, ProShares has said it would pay any interest on the sector funds quarterly but has not targeted a specific amount.

The goal with this trade is the opposite of market-beating returns. If the broad market is up or down less than 5%, it could outperform, but most of the time it will not. The mindset for a market-neutral type of pair has to be to try to add a couple of percentage points over a money market yield while greatly reducing volatility.

I believe this can be done for most of the sector funds that ProShares has created, but these funds are just getting started. If you have any interest in this type of trade for your portfolio, I think you need to give these some time to see how they trade and make sure they meet their objective.

Obviously, you could pair an individual stock in a similar manner, but this becomes riskier by definition. One financial sector index going up 20% while the other goes down by that amount seems unlikely, but it would be much easier for the shares of one company to have some sort of hideous and isolated problem that took the stock down 20% while the rest of the sector went up. In that scenario, the loss could be substantial, which is why the focus here has been on ETFs.

At the time of publication, Nusbaum's clients held the WisdomTree International Financial Fund and iShares Dow Jones Financial Sector Index Fund , although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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