Uncertain about the Economy? Try Market Neutral ETFs - ETF News And Commentary

By Zacks | October 03, 2012 AAA

The market path for stocks in the near term is by no means certain. The policy course after the election is still a coin flip while issues over the 'Fiscal Cliff' could send equities in any number of directions.

Given this reality, many are uncertain as to how to position their portfolios in the short-term. Perhaps, market neutral approach could be the way to play this situation, at least during the shaky market climate (read Three Defensive ETFs for a Bear Market).

After all, this approach could take advantage of the range-bound market, putting cash to work in the top segments while going short in others. Meanwhile, since it is market neutral, the exposure is both 100% long and 100% short, suggesting that overall stock trends won't be much of an issue, at least as they hit the broad equity markets.

Luckily for investors, there is a group of funds that can offer a relatively uncorrelated level of exposure while still targeting U.S. equity markets. This group comes from upstart ETF issuer QuantShares, a small firm that has a lineup of market neutral ETFs (read Looking for Safety? Try These Money Market ETFs).

While most of the funds haven't seen a great deal of inflows in their roughly one year on the market, many could be great picks for investors seeking a new way to target equities in a long/short combination.

However, we should note that the products all have expense ratios that are far higher than the ETF average, coming in at 99 basis points a year, while bid ask spreads could be high thanks to low trading volumes.

Still, these products are among the most unique funds on the market today and can provide investors with unparalleled neutral market exposure, which could be very important for those who are seeking a new way to tackle the market in this cloud of uncertainty.

For these investors, we have highlighted three of our favorites from their seven fund lineup which could make for interesting picks during this uncertain market environment:

QuantShares U.S. Market Neutral Value Fund (CHEP)

CEHP could be an interesting choice in today's muddle through environment because we believe high flying growth stocks with high PEs may have trouble during a low growth economy. This trend could especially be true for companies that are having trouble meeting earnings estimates as these firms have been harshly punished in this environment which is devoid of other market moving events (see Two ETFs for the Muddle Through Economy).

A market neutral approach that cycles away from these high flyers and towards more stable stocks can easily be found in ETF form with CHEP, and could be an interesting pick for many investors in this climate. The ETF tracks the Dow Jones U.S. Thematic Market Neutral Value Index which looks to take long positions in the most undervalued, and go short in the most overvalued stocks.

The process is done by investing in securities that have below-average valuation ratios such as earnings to price, book to price, and cash flow from operation to price ratios. Then, the firm shorts securities that have the highest weightings, making sure to be equal weighted, dollar neutral and sector neutral at the same time as well.

Unfortunately, the intense methodology does result in some added costs as the product charges a net expense ratio of 99 basis points a year. Meanwhile, the strategy hasn't caught on yet as just under $10 million is in the product, suggesting bid ask spreads may be rather wide for this fund.

However, these downsides shouldn't discourage many investors, as the product shines in terms of its low standard deviation over the past six months which has come in below 12%.

QuantShares US Market Neutral Anti-Beta Fund (BTAL)

Another way to play this uncertain market with a different type of market neutral approach is with QuantShares' BTAL. This fund takes the neutral strategy but applies it to the idea of beta instead, looking for stocks that move less than the overall market.

In this technique, the fund will use an equal weighted, dollar neutral and sector neutral approach to go long in low beta stocks. Meanwhile, the fund will also short high beta stocks, hoping to capture the spread return from these two segments (also see Three Low Beta ETFs for the Uncertain Market).

Unsurprisingly, this strategy tends to outperform when markets are slumping, or when staple-type stocks are outperforming their more discretionary peers.  However, the opposite is also true; when markets are flying high BTAL can be a chronic underperformer.

Much like its counterparts, the strategy hasn't really caught on with investors as the fund has just $26 million in AUM. However, the standard deviation is quite low at 16.5% suggesting it could be a relatively low volatility way to play the markets.

QuantShares US Market Neutral Momentum Fund (MOM)

One of the top performers in the market neutral segment, that many investors have overlooked, is undoubtedly MOM. The fund has been an all-star this year, adding about 13.6% in the year-to-date period, although investors should note it has been a bit more volatile as of late (read Four Easy Ways to Play Beta and Volatility with ETFs).

This fund's focus is on momentum, seeking to deliver the spread return between going long in securities that have had above-average returns and shorting those that have fallen by the wayside and have produced below-average returns.

MOM looks at returns over the first twelve of the last thirteen months, taking into account total returns (price performance and dividend returns) and selects 200 stocks on both the long and short side of the equation.

This strategy looks to hold up rather nicely when stocks continue to move in their defined trends. Luckily for investors, this has definitely been the case as of late, as we have seen the same sectors leading and the same ones lagging for much of the year.

Surprisingly given the solid performance and the intriguing strategy, many investors have shied away from MOM. The fund has just $5 million in AUM and does volume below 4,000 shares a day, suggesting wide bid ask spreads.

While this will probably add to the total trading costs, the fund remains an excellent choice for those looking to tap into a market neutral strategy that focuses in on the recent winners.

This momentum focus, while potentially more volatile when markets swing, could be an outperforming one, making MOM a decent choice for investors who are looking to move beyond the potentially low volatility natures of BTAL and CHEP during this uncertain market environment.

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