Paired ETFs Strategy Can Smooth Volatility

In the same period, the DBU/SDP pairing would have been up 0.9% -- not stellar, but definitely still way ahead of the S&P 500.

One last combination to check out as a broader example would be WisdomTree High-Yielding Equity Fund(DHS) paired with ProShares UltraShort S&P 500 Fund(SDS). Using the same dollars and dates going long with DHS and short with SDS resulted in the trade being up $48. Again, that's not a huge amount but it still looks pretty good compared to the broader market.

Keep this trade in context: It's a way to allocate some portion of a diversified portfolio into a holding, or in this case, two holdings, that have the potential to offer decent yield, a little price appreciation and dramatically less volatility than the overall market.

I focus on WisdomTree because, for now, it offers the highest yields for the long component and because its instruments have, in their short trading history, done a good job of outperforming their benchmark indices and the indices that underlie the ProShares inverse funds.

The pairing can really be sector-agnostic, as long as:

• It delivers yield. The long holding pays a dividend and the inverse fund pays interest because it owns Treasuries and futures contracts.
• Two products correlate properly to create the effect. For example, one sector that might seem like an obvious candidate is telecom, but ProShares doesn't have an inverse telecom fund.

One more caveat: Don't consider these sector fund combinations discussed here exposure to that sector. This really is an absolute return strategy, and I'd expect the blend of the long and short to have almost no correlation to the underlying sectors.

As a best-case scenario, a paired trade of this nature could serve as a fixed-income proxy, but without the interest-rate risk. The strategy can be problematic in that it will lag the stock market when it's up a lot, which is why anyone interested in this strategy should apply it to only a small portion of an account.

The other issue to resolve is when to rebalance. After the two-week period studied, any pairing would be off slightly from the original 2:1 ratio. I believe that rebalancing once or twice a year or after a very large move in the broader market (larger than the decline from the week before last) would suffice.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider WisdomTree International Financial Sector Fund, ProShares UltraShort Financials Fund, WisdomTree International Utilities Fund, ProShares UltraShort Utilities Fund and WisdomTree High-Yielding Equity ETF to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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