Advisors Can Take Their ETF Skills to the Next Level with Arbitrage

For decades, I’ve wondered why investment advisors have not seized on what, to me, is a sound approach to consider when the goal of a portfolio is to seek returns with lower volatility.  

As someone who has practiced what I refer to as “ETF arbitrage,” I suspect that in today’s topsy-turvy markets, this might just be a way to reap the benefits without having to deal with the bad parts.  There’s an art and science to it. Here are the basics, as I see it. 

In its simplest form, this explanation from Harvard Business School Online is a good start. To understand arbitrage, first we must understand what arbitrage means in the financial markets. Here’s HBS’s definition: 

Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit. While price differences are typically small and short-lived, the returns can be impressive when multiplied by a large volume. Arbitrage is commonly leveraged by hedge funds and other sophisticated investors. 

Three Arbitrage Styles

This is an acceptable definition of arbitrage, except it describes some features that are not applicable to more specific ETF arbitrage. The HBS article describes three styles of arbitrage: pure, convertible and merger.  

The latter is available through ETFs like the Pro Shares Merger ETF (MRGR) which is a 12-year-old ETF that executes a strategy better known via hedge funds. That is very specialized and not the subject here, as is the case with convertible arbitrage. And pure arbitrage, another hedge fund favorite, is more concerned with exploiting short-term differences in performance between two assets, and typically piling on leverage to maximize returns. 

To all the above, I say let the hedge funds and specialized traders do their thing. There’s even an online description of what some refer to as "ETF arbitrage," but again, that often involves high frequency traders trying to profit from the difference between momentary differences between an ETF’s value and the value of its underlying index or an ETF that targets the same underlying index. Again, this is not my version of ETF arbitrage. I hope I don’t have to rename the process I started using years back, but so be it. 

ETF arbitrage (to me) has a straightforward set of goals: 

• Capitalize on the flexibility and diversity of ETF choices, both on the “long” side and those which are “long” vehicles, but which aim to effectively short a part of the market, or even a single stock, as some recent innovations now allow advisors and investors to do. 
• Pair up two or more ETFs that may be similar yet could be poised to perform differently.  
• Establish and adjust positioning as per the objective. For instance, a pairing might be 50% in both the long and inverse ETF, or tilt 60% or 70% in one direction or the other. The allocation would depend on how much “daylight” the advisor wants to leave for performance volatility. The tighter the difference in position size, the less room for decline but also a lower range of potential upside from the pair. 

In my own past work, I have applied this as a segment of a larger ETF portfolio, as well as across the total portfolio. In the latter case, there were perhaps three or four long ETFs and a similar number of inverse ETFs. And depending on the aptitude of the advisor and especially the ability of the client to understand and endorse such a strategy, leveraged ETFs can be employed as well. The ETF landscape is now so vast, this version of long-and-short investing is no longer limited to the domain of hedge fund managers.  

ETF Arbitrage in Action Hypothetically

For instance, take the iShares Core S&P 500 ETF (IVV) and the Pro Shares Short MSCI Emerging Markets ETF (EUM). They both invest in large swaths of the equity market, yet they often perform differently. And IVV is “long” the S&P 500 while EUM is essentially “short” Emerging markets. While some advisors might look to allocate a slice of a portfolio to IVV and an ETF that is “long” emerging markets, by pairing them up in this hypothetical example, if equal amounts of both were bought, the pair’s net performance would be based on how much IVV outperforms the long version of EUM, the iShares MSCI Emerging Markets ETF (EEM). 

In a business where it is hard to escape the perception of “sameness” and be thought of as a commodity in the eyes of some potential clients, ETF arbitrage might just get some of those eyes to open wide. In turn, this combination of art and science might just elevate some skilled investment advisors to another level, especially when the current market party settles down.