EMAIL INBOX: Dave – read your article today.What is your take on the long-short ETF space at this point in the market?Products like DYLS and DYB are looking more appealing in my opinion.Interested to hear your take.

The long/short ETF category is one that many investors may not even know exists. These strategies have typically been the realm of institutional portfolios and sophisticated hedge funds. Now, they are readily available in the form of a diversified and liquid investment vehicle. 

Long/short funds should be considered “absolute return” strategies because they seek to mitigate downside risk when the market takes a turn lower. They generally contain some sort of hedge in the form of short positions in individual stocks, futures contracts, or stock indexes. They may also use a volatility-linked channel such as the CBOE VIX Volatility Index as a form of risk management when paired with a long-only index such as the S&P 500.

Some are consistently long and short at the same time. Others may seek a more sophisticated method of using rules to turn the hedge (short) on or off when needed. This would theoretically reduce the performance drag in up markets and dampen price volatility in down markets. Nevertheless, there are many pros and cons of each that must be considered before implementing these funds in your own accounts.

Evaluating The Field

One of the largest in this space is the First Trust Long/Short Equity ETF (FTLS), which has $111 million dedicated to a balance of long and short equities. FTLS is an actively managed fund that gives the portfolio manager leeway to select an allocation of 80%-100% long stocks and 0%-50% short positions.

Most of the FTLS holdings are individual stocks, with more than 200 positions currently established. The fund fact sheet touts both fundamental and quantitative reasons for selecting the individual positions in the portfolio. The best case is for the fund manager to be long stocks that outperform and short stocks going in the opposite direction. That sounds a lot easier than it probably is to execute.

Furthermore, FTLS carries a hefty annual management fee of 0.95% and additional fund fees that push the total expense ratio to 1.41%.

Another contender to consider is the WisdomTree Dynamic Long/Short U.S. Equity Fund (DYLS). This fund takes a more nuanced approach by holding long positions in 100 large-cap U.S. stocks based on top growth and value scores. It also dynamically adds a hedge when its index variables identify the need. The index is evaluated monthly and the hedge consists of short positions in the S&P 500 Index that are incrementally added based on rules.

The goal is to participate in equity performance on the upside while seeking to mitigate the downside risk in a prolonged bear market. DYLS charges a gross expense ratio of 0.53% for this privilege.

The PowerShares S&P 500 Downside Hedged Portfolio (PHDG) goes a slightly different direction by using volatility futures as its hedge. PHDG allocates to S&P 500 Index stocks and VIX Index futures contracts that can dynamically adjust over time. As volatility ramps up, the PHDG portfolio allocates more money to the hedge versus the stock allocation and vice versa. PHDG charges a net expense ratio of 0.39% to own this strategy.

Lastly, it bears mentioning a type of long/short fund that is known as “market neutral”. The ProShares RAFI Long/Short ETF (RALS) owns equal amounts of long and short exposure.Long positions track the RAFI US 1000 Index, while short positions track the market-cap weighted Russell 1000 Index.

The result is an arbitrage of sorts between the fundamental (quality) factors that make up the constituents of the long index versus the passive short components.RALS charges an expense ratio of 0.95%.

Using Long/Short ETFs

There are many factors that must be weighed before you decide to add long/short ETFs to your portfolio. Primarily, what the benefits of this type of strategy might be versus other options that would achieve a similar effect.

Long/short funds are going to primarily outperform during a prolonged downtrend in the market. That is when their hedges will be most effective and gain an edge versus a traditional low-cost and passive index ETF. During a choppy or up-trending market, these funds will underperform versus their peers. The combination of higher embedded costs and the obvious drag from the short component will severely impair these funds ability to keep pace with unhedged benchmarks. They are most appropriate to be added at market highs or potential inflection points to reduce downside risks.

Long/short ETFs that use the hedge as an on/off switch may find that they perform better in a sustained uptrend. However, they will be impaired in a sideways choppy market that adds and removes the short component at inopportune times. This is like a whipsaw in the trend following world. There is also some pre-determined gap of downside or upside before the hedge is put on or taken off. This leaves you susceptible to falling behind the curve in a fast-moving market.

It’s worth considering, if you own a conventional 60/40 mix of stocks and bonds, that reducing your stock exposure and moving to cash or additional fixed-income would be a reasonable alternative. This method would reduce your net stock exposure without adding the additional risk and costs of short positions. You may also be able to achieve similar results with options or other sophisticated trading strategies as well.

The Bottom Line

These tools aren’t for everyone and should be used with the implicit knowledge that they come with higher costs and more varying risk dynamics than traditional ETFs. Taking the long view, I wouldn’t be surprised to see additional interest in these funds pick up in the event we experience a more pernicious or sustained decline. After all, everyone loves to buy insurance after the disaster has already taken place.