ETF Arbitrage May Help Advisors Thrive

Many investment researchers have a concept or two that they just can’t get out of their head. 

You put it to use here and there, but you keep coming back to the idea that there’s even more to it than you already know. For me, that concept is what I call ETF Arbitrage.  

By using that term, I do not mean to confuse it with “arbitrage” as applied to market areas such as merger transactions, or broader-based long-short or “market neutral” investing. There are ETFs for that. But I am speaking of something investors can customize themselves, or that forward-thinking investment advisors can create for their clients.  

The concept is straightforward. With all the ETFs now available to profit from declines in specific market segments, the broad stock or bond market itself, sectors and industries and even single stocks, that creates an opportunity for savvy investors once reserved for hedge fund managers and professional speculators. 

And, as opposed to those actors in the past, time frames can be varied. That is, an ETF pairing can be left in place for months or even years in some cases.  

ETF Arbitrage: Not Just for Traders

To help investors grasp this concept, here’s an example—one of an infinite variety of possibilities, in which a portfolio (or portion thereof) is divided between two ETFs. Both ETFs represent a major market segment. However, one of them is “long” and one is “short.”  

I looked at six-month time frames, to keep it simple. Financial advisors who are familiar with the Risk Score made popular by Riskalyze last decade will recall that six months is the period that that score seeks to represent. That is based on some past academic studies which indicated that half a year is about as much time as many investors will give an investment before they start to evaluate it critically.  

Profiting by Being Directionless

So, let’s say that six months ago, an investor decided that the Invesco QQQ Trust ETF (QQQ) would outperform the SPDR Dow Jones Industrial Average ETF Trust (DIA). Note that I did not say anything about whether either ETF would rise in price. Because ETF arbitrage seeks to profit from the difference between two or more funds over the time they are held.

/DIA/DIAThis approach takes the market direction out of it. That alone might make it more attractive, particularly during the next stock bear market.  

Over the six months ended Monday, QQQ gained 9.2%, and DIA gained 6.5%. So QQQ outperformed by 2.7%, or about 45 basis points (0.45%) per month since late February of this year. If you had 50% of a portfolio in each, your return would have split the difference and gained about 7.8%. But that portfolio would have been subject to full stock market risk.  

A QQQ-DOG Pairing?

So, if instead of pairing QQQ with DIA, we paired it with the ProShares Short Dow 30 ETF (DOG), a single inverse ETF with $169 million in assets, a 50%/50% pairing would send the portfolio in opposite directions at the same time. Its profit or loss would depend on the extent to which QQQ outperformed DIA, roughly speaking.

As it turns out, DOG only fell 2.1% over the past six months. This is not an isolated case, but the issue of how single-inverse ETFs are often misunderstood is another article for another day.

So, a 50-50 mix of QQQ (up 9.2%) and DOG (down 2.1%) would have produced a six-month gain of more than 3.5%. That’s not bad for taking much of the market’s broader impact out of the picture.  

There’s no rule about splitting the long-short allocation down the middle. It can be tilted one way or the other, or flipped upside down, in which, in this case, the Dow is the “long position” and the Nasdaq 100 is the short side. As recently as 2022, the Dow outperformed the Nasdaq by a whopping 25%, falling just 7% that year while QQQ faded by 32%.  

This is a simple example of ETF arbitrage as I use it. We are in a market climate where stocks are volatile, and bond rates may be peaking. And ETFs offer yet another way to piece together and provide an alternative path toward long-term returns, while keeping risk in check.