I thought that David Cantor’s thoughtful response to our recent blog post “Innovation in Access: Market Neutral ETFs” deserved its own article. The “Innovation in Access: Market Neutral ETFs” post discussed four long/short ETFs that were launched by our friends at QuantShares in 2011. One of these ETFs, QuantShares US Market Neutral Anti-Beta (BTAL), implements a long position in low beta U.S. equities and a short position in high beta U.S. equities. David wondered why BTAL* is down since 2003 even though low beta stocks have outperformed high beta stocks both on an absolute and a risk-adjusted basis over this same period. David is absolutely correct in his assessment of BTAL’s performance relative to the long and short sides of the strategy in isolation.
|BTAL||Low Beta||High Beta|
What is going on here? Shouldn’t a long/short portfolio in which the long side outperforms the short side make money? The answer is yes if we are considering a period without any rebalances. For example, if an investor bought the low beta stocks and sold the high beta stocks at the end of 2003 and didn’t touch the portfolio, the results would be as follows:
|BTAL||BTAL no rebalance||Low Beta||High Beta|
BTAL, which rebalances monthly, that the answer to the underlined question is no over periods with rebalances. A simple example might provide some more clarity on this point. Consider two stocks with the following returns:
|Year 1||Year 2||Total Return|
Without rebalancing, a long/short portfolio that is long ABC and short XYZ would return 2% over the two-year period. However, with annual rebalancing the portfolio would be down 1.6% [ (1+20%-0%) * (1+0%-18%) – 1 = 1.6%].
This result implies that investors with a specific view on two securities that they wish to express through a long/short portfolio should not rebalance during their investment horizon if they wish to profit if their view turns out to be correct.
This does not mean that there are not good reasons to rebalance a long/short portfolio. The need for and frequency of rebalancing should be tailored to the portfolio’s objective. For example, a market neutral long/short portfolio whose objective is to diversify core holdings should be rebalancing periodically since market fluctuations can erode the market neutral nature of the portfolio over time. In a similar vein, retail long/short products should in many instances rebalance periodically so that investors entering the fund at different times get the same exposure.