A Look at the ProShares RAFI Long/Short ETF

NEW YORK ( TheStreet) -- Almost side by side with the debut of the Advisor Shares Cambria Global Tactical ETF ( GTAA), which I wrote about last week, was the debut of the ProShares RAFI Long/Short ETF ( RALS), which also is an absolute return fund.

The basic idea is a variation on the longstanding PowerShares FTSE RAFI 1000 ETF ( PRF), a long only fundamental index fund. The methodology of the RAFI process was devised by investing legend Rob Arnott and seeks to weight index components based on four fundamental factors -- book value, earnings, revenue and dividends. Stocks in the index that score well in this process get a larger weighting in PRF than the stocks that score poorly.

The new ProShares RAFI Long/Short ETF takes the methodology one step further to create an absolute return fund by going long the stocks that score well in the RAFI system and selling short the stocks that score poorly. The underlying index targets equal long and short exposure, rebalances back equal long/short every month and will rescreen for which names to go long and short once a year. The expense ratio is 0.95 which seems reasonable given the trading that needs to occur every month.

In last week's article about the Cambria ETF , I addressed some of the general positives and negatives associated with absolute return funds. For example, they should do well during a down market but lag in a market that goes up a lot. The ProShares RAFI Long/Short ETF, however, has a different risk issue that must be understood by anyone interested in the fund.

The RAFI methodology will create a value bias in the building of the index. The value bias isn't necessarily a negative but the long/short strategy of the ProShares RAFI Long/Short ETF relies on something very specific. The fund assumes stocks favored by the screening, that is by the value bias, will do well and that stocks that fare poorly through the RAFI screening will be poor performers. While I have no doubt that the process works much of the time -- these funds wouldn't exist otherwise -- there is nothing that says an "expensive" stock can't do well and do well for a long period of time. Two easy examples of this are massive rally in 2009 and the duration of the inflating of the tech bubble in the late 1990s.

An even easier way to make this point is the fact that the fund is short Apple ( AAPL).

The ProShares RAFI Long/Short ETF relies on the premise that value does better than growth and while this is often true it is far from universally true. Contrast that reliance with the objective method employed by the Cambria Global Tactical ETF which relies on the price of each holding being above its 10-month moving average. If an ETF is below that moving average it simply assumes there is a problem; it doesn't try to assess the problem it just sells the position until that fund gets healthy again by retaking its 10-month moving average.

Clearly, the more subjective process of value investing would be more appealing to absolute return fund investors while other folks would prefer a more systematic process. Neither can always be right, and neither will always be wrong; it is simply a matter of what fits best for each investor.

At the time of publication, Nusbaum had no positions in the securities mentioned, 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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