Sizing Up Long/Short ETF Tools

September 24, 2019 On that, one in each pair is going to be underperforming, by design. Timing here is critical.

Mazza: Yes. What's interesting is there's a lot of cyclicality to markets. Over a very long run, the difference between any particular market segment is a lot lower than I expected, even value over growth, only within a few basis points. I'm talking decades.

But over rolling one-year periods or three-year periods or five-year periods, or even shorter, the difference can be massive. Just look at a couple of weeks ago: The longstanding underperformance of value began to be reversed very quickly. Our value-over-growth strategy had excellent performance, outperforming the traditional value approach by over 1% in just one week.

These ETFs are not intended for people to be trading them on a daily basis. These are for intermediate viewpoints—somewhere between six months to, say, five years when you'd expect a trend to play out. How do you implement these ETFs? Would you replace other ETFs with them?

Mazza: I would expect these ETFs primarily to be used as your tool for over- and underweighting. I don't think it's going to replace the entirety of a growth/value position or a cyclical/defensive sector position.

But if you have a view or you have a model—whether it's informed from fundamental analysis or quantitative analysis—this is the tool for you, because it allows you to differentiate yourself from what others may be doing.

Again, if your views are right, you’ll outperform without taking on significantly more volatility. They're not intended to fully replace what people are doing, but they're really intended to be a portfolio construction complement. To your point, these strategies don't introduce necessarily another level of volatility to your portfolio.

Mazza: That was really interesting from our research. Because they're index-based, taking long-standing definitions of growth and long-standing definitions of value, you're still biased toward having a long-only exposure. It's not a true long/short strategy where you have a significant amount of tracking error relative to the market. It's 150% long and only 50% short.

So, you’re more influenced by the performance of the long side, and the spread that you're capturing from the long outperforming the short, in that case, is your additional benefit. That structure allows more people to use them in wider parts of the portfolio than a true long/short, which would be much more of an alternative. Some say this type of long/short strategy relies on two things to work: market timing and luck—that you’re on the right side of the trade. How do you respond to that?

Mazza: We all know the old saying: “It's time in the markets, not timing the markets that matters for long-term wealth creation.” That’s something I would agree with.

But what we know is there are long-term cycles that exist within markets. We don't believe these are intended for someone to try to predict a short-term short-covering sector or factor rotation.

These are intended for someone to have a view, say, “If I've been persistently underweight emerging markets, this is a capital efficient way to undo that underweight without introducing a significant amount of bias.”

You certainly do need to get the view right—the view needs to play out for you to get that benefit of outperformance. But the portfolios aren’t built on a narrow view. They use the Russell 1000 Value and the Russell 1000 Growth or MSCI Emerging Markets IMI and MSCI EAFE IMI. It's not just a few securities that define growth or a few securities that define value that drive outperformance, and that helps. Who’s the target investor here?
These ETFs were launched in January. In the short time period they’ve been around, the primary audience has been advisors, particularly those who build portfolios. Many of them are looking for ways to take that view, and they say, “This is a tool I've never had before because I've been long-only constrained.” And this is doing long/short in an index-based way.

So, the due diligence process is really on the structure (150/50) and not on the definitions of value or growth, or large cap or small cap. They're off the shelf. They have histories that go back decades. We're just combining them in a way that they've never been combined for the majority of investors.

Contact Cinthia Murphy at [email protected]

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