In rocky times for stocks, sometimes the best way to protect a portfolio is to bet against the market. This is how many high-profile hedge fund managers have made their names over the years — betting against the market, or certain sectors, at key times — giving their investors returns that help offset losses elsewhere in their portfolios. Given the broad market weakness in 2022, many so called long-short strategies that give investors exposure in both directions have outperformed the S & P 500. There are many long-short strategies available to retail investors in the form of exchange traded funds. While they often carry higher fees than simple index funds, they also charge a lower amount than the 2-and-20 hedge fund model. Here are some of the top performing long-short ETFs this year that are ranked by Morningstar. Source: Morningstar There is no one approach to constructing these long-short portfolios, so investors should be sure to look at the underlying structures before buying shares. For example, the top-performing Cambria Value and Momentum ETF makes long investments in 100 U.S. stocks, ranked by combination of value and momentum factors in a quantitative model, according to documents from Cambria’s website. This portion of the fund is rebalanced quarterly. From there, the fund uses several different hedging strategies to create the short end of the portfolio. Every week, the fund checks to see if the U.S. market broadly is in an uptrend. If not, the portfolio will hedge either 25% or 50% of exposure through S & P 500 equity futures. And every quarter, the fund looks at the broad market on a valuation basis. If valuation appears stretched, then the fund can hedge 25% or 50% of exposure — once again using S & P 500 equity futures. The combined hedging is variable, and combined can stretch from 0% to 100% of the portfolio. That weekly component of the downside hedge strategy can help the fund perform well if the market turns during the quarter, and the variable total hedge allows the fund to change its total exposure wit market conditions. The Cambria fund is up nearly 10% year to date. Key considerations The tools used to create short positions, portfolio turnover and expense ratios are all important things for investors to consider when evaluating long-short funds. Unlike the Cambria fund, others may short individual stocks instead of the broader market. This can add additional risk, or additional upside, to a fund. There can also be mixes of the two strategies. For example, the prospectus for the First Trust Long/Short ETF says the fund can add short exposure through individual equities or index futures. The timeline for portfolio turnover can also add risk to a long-short fund. For example, a fund that rebalances infrequently could be caught off guard by a sudden market change. However, a fund that rebalances often can also incur higher fees because of trading costs. Risks Long-short ETFs are not guaranteed to beat or even closely track the market. This can even be true in years with big drawdowns. For example, the Cambria fund actually had a negative return during 2020, badly trailing the S & P 500. That year shows the risks of these funds: the market had a sharp drawdown caused by a macro factor in the pandemic that may not have been picked up in some quantitative models, and then saw a big rally thanks to support from governments and central banks. In 2022, markets have steadily lost ground, with the S & P 500 falling for nine out of the past 10 weeks. However, if the direction of stocks reverses course more suddenly, the long-short ETFs could miss out on much of that upside.
