A Special Report by Jared Dillian,

former head of ETF Trading at Lehman Bros., editor of Street Freak

THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing
A Special Report by Jared Dillian,
former head of ETF Trading at Lehman Bros., editor of Street Freak

THE 5 ETF TRADING STRATEGIES YOU SHOULD

KNOW ABOUT BEFORE INVESTING
ETF trading strategies are really quite simple. They are different from op-
tions strategies with a million different permutations and different things
you can do. Here are the most common ones.

Strategy #1

BEING LONG AN ETF.

Let’s pretend you want to be long energy in the US. You could just buy the
Energy Select Sector SPDR ETF (XLE), and that’s that. It tracks oil very
well, but with less volatility:

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

You can do all kinds of exotic things with ETFs—you can trade them, you
can do outperformance trades, you can use options—but for most people,
it’s enough to have a portfolio of these low-cost index funds. Just buying
and holding is all you’re going to want to do.

As I said, really simple.

Strategy #2

BEING SHORT AN ETF.

There are a couple of things you need to think about when you are short-
ing an ETF, so let’s go back to the original example.

Let’s say you want to be short the US energy sector, so you decide to short
XLE.

To do so, you have to borrow XLE. There’s a cost associated with that, and
you probably don’t know how much that is. So it’s key that you go to your
broker—if you use an online broker like TD Ameritrade or E-Trade—and
find out what their margin rates are and how much you will be charged to
borrow.

You could be charged as much as 6%–12% a year to put on a short posi-

tion, which probably makes it uneconomic.

The other thing you have to consider is dividends. You owe the dividends
on a short position. So if XLE pays 2.5% a year on dividends, that cash ac-
tually comes out of your brokerage account. You owe the cash to pay the
dividends.

There is one good thing about shorting ETFs, though.

ETFs have a management fee—and when you’re short an ETF, believe it

or not, you’re actually getting paid the management fee. It actually works
to your benefit.
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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

Let’s say XLE has a management fee of 50 basis points. (It doesn’t; it’s
lower than that, but just pretend it’s 50 basis points.)

So if the value of XLE declines by 50 basis points over the course of the
year, and you are short XLE, you’ll receive that benefit. A lot of people
don’t understand that.

So there are two things working against you: One is the dividends, and
one is the cost to borrow, but the thing that works in your favor are the
fees.

I have to mention that many ETFs have lowered their fees to microscopic
levels so that you don’t get a lot out of them, but maybe you do.

Strategy #3

BEING LONG ONE ETF AND SHORT ANOTHER.

You can do this in three different ways: indices, sectors, and countries.

Indices
Here’s an example: you could go long value with an ETF like the iShares
S&P 500 Value Index (IVE) and short growth by shorting the iShares S&P
500 Growth Index (IVW).

You could have that trade going for 5–10 years; there are big divergences
in value and growth over time. I am not recommending you do this… but
value/growth-type trades can really work if you get them right.

For example, if you had put $5,000 in a long growth position and anoth-
er $5,000 in short value, your performance over the past 10 years would
have looked like this:

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

Small-cap/large-cap-type trades can also work.

Sectors
Let’s say you want to be long energy and short tech, or long real estate
and short utilities. There are a million different ways you can do this, es-
pecially if you fancy yourself a macro trader.

Since Trump’s election, there have been some easy sector ETF trades
going on. People are short tech and they’re long financials—that’s an easy
one and is probably going to work for a long time.

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

Countries
You could go long one country and short another, or even do regions.
So you could be, say, long emerging markets through the iShares MSCI
Emerging Markets Index ETF (EEM) and short developed markets in
Europe, Asia, and the Far East through the iShares MSCI EAFE Index ETF
(EFA). Or you could be long Italy and short Germany. There are a lot of
different things you can do.

Those are the three ways you want to be long an ETF and short an ETF.

Strategy #4

OUTPERFORMANCE.
The outperformance trade means you believe that a particular stock will
outperform an index.

Let’s say you think ExxonMobil is going to outperform energy. So you go

long ExxonMobil (XOM) and short XLE. Very simple.

Now, here’s one thing people don’t really understand: When you start
putting on these outperformance trades—which include the ETF-versus-
ETF trades—you’re using up a lot of capital.

If you put on these trades, say $200,000 a side, you’re short $200,000 and
you’re long $200,000. That means you’re actually taking up $400,000 of
balance sheet… and, once again, you still have to go back and borrow for
your short position, and there’s a cost of capital. This is an important fac-
tor to take into account.

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

Strategy #5

UNDERPERFORMANCE.
So for an outperformance trade, you could go long XOM and short XLE, or
you could do the inverse. If you thought ExxonMobil was going to under-
perform, you could go short ExxonMobil and long XLE.

If you had put $5,000 into both positions (long XLE, short XOM), here is
what your 10-year performance would have looked like:

These trades are hard and risky.

If correlation is high within a sector, the outperformance or underperfor-

mance might not be that great.

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

So you put on these big positions, tie up a lot of balance sheet, and pay
cost to borrow so you can make 5% or 10% in a year (unless you get it
really, really right; then maybe you make 20%).

That’s why these out- and underperformance strategies are mostly used
by institutional investors because they get favorable rates on borrowing
stock and commissions.

Recap
These are the five major trading strategies for trading ETFs:

1 Long
2 Short
3 Long/Short (e.g., long small-cap stocks, short large-cap stocks)
4 Outperformance (e.g., long a single stock, short a sector)
5 Underperformance (e.g. short a single stock, long a country)

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THE 5 ETF TRADING STRATEGIES
You Should Know About Before Investing

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