Quant ETF Opportunity?

October 08, 2009

In the last month, I’ve written about two long/short quant products, which I think may be about to experience some unusual volatility in this quarter’s market environment. Using any dips in these products as potential buying opportunities will make for a strategic long-term bet.

The first of the two long/short quant ETPs is the Elements S&P CTI exchange-traded note (NYSEArca: LSC). I wrote about LSC for our subscription-only monthly publication ETFR, so if you are a subscriber, you can see the story here.

LSC is a long/short commodity-linked note monitoring six different groups of assets: energy, industrial metals, precious metals, livestock, grains and softs. Because the note only alters its positions once a month, investors can occasionally find themselves on the wrong side of the trade for up to a period of around three weeks. For example, last month the note had a 10.5 percent short position in precious metals, much to investors’ chagrin.

LSC has since dropped its short position in precious metals, but it does have a 35 percent short position in cocoa, livestock and grains. While that might be a sensible position, I worry that we may be entering a commodity bull market where investors may chase everything and anything in the futures markets for a while.

I also worry that, after the vigorous recent rally in gold, that metal may be due for a small pullback. In other words, it is likely that investors could find nearly half their portfolio invested on the wrong side of the trade.

Sophisticated Strategy

For all the potential volatility however, a long/short commodity strategy is one that makes sense long term. It’s unclear how long emerging markets consumption will continue to grow at a breakneck pace, and the underlying economic conditions in the West are hardly growth-oriented right now. If you are a commodities investor, ignore those who tell you to dump all your money into raw materials, and instead choose a sophisticated strategy. That’s what LSC is here for.

The second ETP I want to focus on is the ProShares Credit Suisse 130/30 exchange-traded fund (NYSEArca: CSM). Many of the same arguments for LSC apply to CSM, but they are a little different.

CSM is a 130/30 fund, meaning it is 30 percent short and 130 percent long. It invests in S&P 500 companies and alters its positions monthly. (See story here.)

Since it was launched in August, CSM has beaten the S&P handily. At last count, it is up 8.25 percent vs. 7 percent for the S&P during the same time frame, and the performance disparity looks even better for the fund in the past month.

Where these types of funds tend to get stuck, however, is during a time when technical indicators take a back seat to the news flow (there’s no quant fund I’ve heard of yet that accurately predicts news events). Unfortunately for CSM, such a time is ahead of us, with third-quarter earnings.

Right now, CSM is short firms such as Tiffany & Co., KB Home and Nicor—all of which have relatively tame earnings expectations and may well beat analysts’ forecasts. If that is the case, then CSM’s performance relative to long-only S&P funds such as SPDR S&P 500 (NYSEArca: SPY) could look less impressive at the end of this month.

If third-quarter earnings disappoint across the board (and this is what I think will be the case), there could be a fairly big sell-off in stocks. Because CSM is a long-biased fund, it will fall in price along with everything else.

A round of selling in equities would present a great time to take a position in a long/short quant fund such as CSM. In 2010, equities are still likely to rise on a net basis as the economy recovers, except that this time there are likely to be some significant price adjustments (particularly among financials).

That is where CSM’s model works best, since it can capture the capital outflows in some companies, while it still gains from an overall market uptrend.

Investors shunned most quantitative models for most of 2009; next year they will likely come back to outperform us with a vengeance.


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