By Michael Johnston forETFdb
Rob Arnott's footprint on the ETF industry just might be getting a little bit bigger.
, the Maryland-based leveraged and inverse ETF giant, recently filed details with the SEC on an ETF that would seek to track the performance of the
RAFI US Equity Long/Short Index
That benchmark is based on a methodology devised by Arnott's firm,
, that more and more investors are embracing as an alternative to traditional market cap weighting. PowerShares offers a handful of equity ETFs linked to RAFI indexes, and earlier this year swapped out the index on its high yield bond ETF
in favor of a RAFI index.
Steering clear of market capitalization, the RAFI methodology uses four "fundamental" metrics to determine a company's size: sales, cash flow, dividends and book value. Determining the holdings of the index underlying the proposed long/short ETF would require a calculation of RAFI weight and capitalization weight -- the weighting each stock would get in a cap-weighted index. The index would establish long positions in the stocks with the largest RAFI weight compared with capitalization weight, while shorting those with the smallest RAFI weights relative to their capitalization weights.
The investment thesis behind the proposed product is relatively simple. If the RAFI weight is a more appropriate measure of firm size, firms with significant disconnects between the calculated capitalization weight and RAFI weight would be incorrectly valued. Those with a significantly larger capitalization weight would be overvalued, while those with a smaller capitalization weight relative to RAFI weight would be undervalued. By establishing long and short positions, the proposed ETF would maintain market-neutral exposure that essentially seeks to exploit the inefficiencies of market cap weighting.
RAFI weighting methodologies have steadily gained a following among investors who have identified potential pitfalls of cap-weighting, as these enhanced indexes break the link between weightings afforded to individual securities and stock price.
Although the impressive rise of the ETF industry has occurred primarily around funds linked to cap-weighting strategies, ETFs have also helped highlight a number of alternative weighting strategies. The cap-weighted
SPDR S&P 500
is lagging behind many funds that hold similar stocks but use different strategies to determine weightings.
LONG/SHORT ETF OPTIONS
Earlier this year
Mars Hill Relative Value ETF
, a fund that seeks to establish long positions in regions expected to outperform the
MSCI World Index
and short positions in those expected to underperform that benchmark. While the same general strategy is similar, the proposed ProShares fund would be different from GRV in a couple key areas.
First, GRV is actively managed, whereas the ProShares fund would seek to replicate a rules-based index. Second, the ProShares long/short ETF would limit its holdings to U.S. stocks; GRV has the latitude to invest in a number of international markets (India, Thailand, Malaysia and Chile are among its largest long positions).
ProShares also offers the
Credit Suisse 130/30
, an ETF that shorts stocks expected to underperform the
and uses the proceeds to enhance positions in those expected to beat the benchmark. CSM is linked to an index developed by MIT professor Andrew W. Lo, an expert in quantitative finance.
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