Is CSM really sluggish out of the gate? Looking beneath the hood reveals some interesting notes about how it’s trying to gain some alpha.
Since the Lehman Brothers fiasco a year ago, quantitative investment approaches have not exactly been all the rage among investors.
In that light, the ProShares Credit Suisse 130/30 Index ETF (NYSEArca: CSM) has been raising eyebrows.
Compared to its exchange-traded note rival First Trust Enhanced 130/30 (NYSEArca: JFT), CSM is about evenly matched in performance gains since its launch in July.
And with returns of 6.9 percent heading into Wednesday, it’s only just beating more traditional S&P tracker exchange-traded funds such as the SPDR S&P 500 (NYSEArca: SPY) and the iShares S&P 500 (NYSEArca: IVV) in that period.
Still, a closer look at how the product seeks to create alpha reveals what might be the most exciting enhanced S&P-based ETF around right now.
The Impact Of Structural Alpha
CSM tracks the Credit Suisse 130/30 Index (CSI 130/30), an index developed by MIT economist Andrew Lo and Credit Suisse’s Pankaj Patel. A 130/30 strategy is employed by taking a 100 percent long position, and subsequently selling 30 percent of the portfolio short against it; the proceeds from that short sale are then invested in another 30 percent chunk of long positions.
In part, the index was designed as a more meaningful benchmark for asset managers to pit their performance against than long-only global benchmarks such as the S&P 500.
The leveraged component of CSM’s 130/30 strategy is offset by the fact that the fund’s quantitative model resets its positions on the third Friday of every month back to a beta of 1. In order to get a performance edge, CSM employs something known as structural alpha.
Here’s one example: Ciena and Patterson did well in August because of better-than-expected earnings, and Zions because of a stroke of luck when a Nevada subsidiary’s rival was shuttered by the FDIC. That meant a brief spike in the share prices of all three companies.
These stocks have a cumulative weighting in the S&P of just 0.1 percent, so their day-to-day price movements don’t affect the index that much. By shorting them at around the time of their price spikes, while remaining long in the index’s major components, an investment manager can attempt to gain structural alpha.
And that’s exactly what CSM is doing right now, with a net 4.05 percent short focus on these stocks. Meanwhile, the fund’s top holdings -- Exxon Mobile, JP Morgan Chase and Apple -- collectively make-up just 5.96 percent of the fund, way underweighting the S&P’s allocations for all three of 7.37 percent.
Greater Tracking Error
The strategy gives the fund a tracking error of around 2.3 percent against the S&P compared to average errors of around 0.4 percent that might be expected for most S&P-weighted ETFs. In certain market environments, the tracking error translates into outsized gains versus the index.
Naturally, these types of trades perform best in relatively stable market conditions where there are rational periods of equity re-pricing; they can also protect some of the fund’s losses in times when there are contained periods of pressurized selling. (For example, in the last 12 months the tracker index CSI 130/30 has fallen around 2.4 percentage points less than SPY, IVV and the S&P 500 index itself.)
But, in periods where all stocks are surging at once, as we have seen since March of this year, this type of investment approach isn’t at its most effective level.
For instance, in terms of more defensive weightings such as Microsoft and Johnson & Johnson, which are the S&P’s second- and third-largest weightings, respectively, the latter doesn’t even figure among CSM’s top 10 holdings in August. And Microsoft is only the fund’s eighth-largest holding.
A sudden return of capital to all mega-caps after a China-led selloff temporarily appears to have constrained CSM’s relative performance in that period.
ETF Sticking To Tight Set Of Rules
As the economy emerges from recession, and equity prices normalize, finding value among equity prices will become an increasingly challenging task, however. Some of that scenario is already starting to unfold: as the S&P has surged 16.5 percent, to a year-to-date closing high of 1,052.63 at Tuesday’s close, investors are asking what’s worth buying and what’s worth selling.
CSM cannot take a short position in a stock with a weighting of higher than 0.4 percent in the S&P, and no fund manager can override its quantitative inputs. That tight focus in an increasingly stable market environment is beginning to attract the attention of investment advisers who want to give their clients enhanced U.S. equity focus, and in particular, in endowments and pension funds.
With a management fee of 0.95 percent, CSM is a much cheaper and an easier alternative to traditional 130/30 mutual funds, which can be more cumbersome to cash out of and charge fees of up to 1.7 percent or more.
Most big bank traders agree right now that while indexes are unlikely to go substantially higher or lower in the rest of the year, there is somewhat of a cash bubble forming around the market’s edges ($840 billion is on the sidelines of the Federal Reserve Bank, effectively doing nothing right now).
In that context, individual stock re-pricing might become one of the dominant themes again, giving CSM’s long/short focus a big edge.
Plus, the strategy looks like it’s around to stay for a while, too, since ETF designer Direxion has filed for its own product line making use of the 130/30 strategy.
Investors ought to be wary about when they buy shares of CSM, however.
In times of significant equity re-pricing, the leveraged component of the fund may force its neutral Beta to stray towards the date when it resets again. Buying this fund as closely to the date when components are readjusted can help to offset some of the volatility incurred in CSM’s strategy.
While it’s still too early to tell whether CSM will end up beating traditional U.S. benchmarks then, the old adage “make sure you know what it is you are buying and when you are buying it” rings especially true for CSM and any other 130/30 strategy ETFs.
Daniel Harrison is a senior writer for IndexUniverse.com. He welcomes comments and suggestions for future columns at: [email protected].