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The Lowdown on Long/Short ETFs (FTLS DYLS PHDG RALS)

Long/short ETFs are designed to protect your backside, but how effective are they in practice?

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Long/short ETFs are in a category 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 indices. 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 long/short ETFs 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

FTLS: One of the largest in this space is the First Trust Long/Short Equity ETF (NYSEARCA: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%.

DYLS: Another contender to consider is the WisdomTree Dynamic Long/Short U.S. Equity Fund (BATS: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.

PHDG: The PowerShares S&P 500 Downside Hedged Portfolio (NYSEARCA: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.

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