Using A Strategic ETF to Outperform the Market

By John Jagerson

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There is a difference between an ETF that is mostly passively indexed versus one that is strategically indexed. The ETF SPY is a good example of the former and this article will discuss a another good example of the latter. You may find that the growing pool of strategically indexed ETFs makes an interesting addition to your portfolio.

[VIDEO] Behind the 130/30 Fund

The criteria for inclusion in the S&P 500 stock index includes; market capitalization, location, liquidity, sector representation and some simple fundamental data. The requirements don’t necessarily need to be more rigid to be a very efficient representation of the stock market overall. The SPY is able to replicate this index with a very high degree of efficiency.

By contrast, an ETF that I would call “strategically” indexed would include much more rigorous fundamental and technical criteria. The ProShares 130/30 fund (CSM) is a good example of such an ETF. The fund looks for a lengthy list of positive and negative fundamental characteristics when evaluating stocks to short and stocks to buy.

For each $100 invested in CSM the fund will short $30 worth of stocks that the strategy would indicate have a negative expected return. The fund will then purchase $130 (which includes the $30 proceeds from the short sale) worth of stocks with positive expected returns.

The total portfolio now still has a net market exposure of $100 ($130-$30=$100) but could outperform a more passively indexed ETF. As you can see in the chart below, so far this ETF has been able to outperform the SPY.

There are some unique risks of funds like this that include higher costs and a limited track-record. For example, this fund has an expense ratio of .95%, which may be lower than many mutual funds but is several times higher than the expense ratio of the SPY ETF. This increases the height of the hurdle CSM will have to beat just to match the returns on the SPY over the long term.

Strategically indexed funds may be able to outperform an individual investor trying to execute a similar strategy through individual stocks because they have efficiencies in scale. It is also a lot simpler process to just buy an ETF than to do the required analysis yourself. For these reasons CSM may be an interesting opportunity for investors looking for a little more diversification.

 

Image courtesy Cia Gould.