When Two Minuses Do Not Make a Plus


As a registered investment advisor, Index Funds Advisors, Inc. is constantly solicited by mutual fund companies and ETF (exchange-traded fund) providers hoping to convince us to use their products for our client’s portfolios. Recently, we were invited to a Webinar on an ETF of ETFs that relies on combining two tactics—long/short and sector rotation. Using the nine industrial sector ETFs from State Street SPDRs, this ETF combines long positions with short positions to net out an overall zero position in the market. On a monthly basis, the managers decide which sectors are undervalued and which are overvalued relative to the overall market. The basis for these decisions is a quantitative proprietary model, a black box, which to us, is a red flag.

Until a few years ago, long/short strategies were the exclusive province of hedge funds. As Bill Sharpe pointed out, if all active management were done via long/short, their pre-expense returns in aggregate would be the same as Treasury Bills. Considering that risk is the source of returns, the avoidance of risk via long/short should result in zero excess returns above Treasury Bills. The investor who engages a long/short manager is relying exclusively on the manager’s ability to pick both winners and losers. As Yale University’s David Swensen stated in Unconventional Success, a long/short manager would need to consistently be in the top quartile of security pickers on both the buy side and the sell side for his investors to receive a reasonable risk-adjusted return after paying the manager’s fees. This is no easy task. Burton Malkiel and Atanu Saha1 found that in the eight year period ending 12/31/2003, both of their two categories of long-short hedge funds delivered a lower absolute and risk-adjusted return than the S&P 500.

Now that we have ruled out long/short as a desirable investment strategy for individual investors, let’s take a look at sector rotation. As discussed in this article, the returns of different industrial sectors are largely explained by their exposure to the risk factors of market, size and value. Furthermore, as shown in the chart below, there is absolutely no discernible pattern in the ranking of historical returns, which suggests that it is unlikely that any econometric model can be used to predict the rankings in future periods.

To summarize, if neither long/short nor sector rotation is a good idea by itself, then we have no reason to expect that putting them together will yield a profitable result. On the contrary, the only thing that will be multiplied is the expense of running both strategies simultaneously.


1Malkiel, Burton, and Atanu Saha. 2005. “Hedge Funds: Risk and Return.” Financial Analysts Journal, November/December 2005, Vol. 61, No. 6:80-88.