The Back-Test
When seeking the right ETF to buck up the short end of a paired trade play, how can you be sure you've found the right fund? A simple back-test can help ensure that the paired instruments move in tandem. Take a six-month return for both the stock and the ETF at random points for five different occasions over the last five years. If the moves are repeatedly correlated (i.e. consistently moving in the same direction by a similar amount), then you've likely got a match.
Of course, by putting on a paired trade, you're anticipating that this correlation will temporarily cease as the stock selected is now poised for outperformance relative to the benchmark.
ETFs On Both Ends
Looking to avoid stock selection altogether but still want to profit from key macro trends? A number of investors are using ETFs in paired trades to arbitrage the shifting dynamics between industries. For example, rising beef prices are expected to hurt the bottom line for a number of restaurant chains and other food purveyors that are faced with a price-resistant consumer base. But it's great news for ranchers who are now getting high prices for each head of cattle. To play that trend, you'd simply go long with Market Vectors Agribusiness ETF (NYSE: MOO) while shorting the PowerShares Dynamic Food & Beverage ETF (NYSE: PBJ).
Some investors might prefer to hedge part of their portfolio by simply investing in one of the growing number of long-short mutual funds. These funds seek to mimic hedge fund strategies without the lock-up periods and heavy-duty fees. But these funds generally have higher fees than most mutual funds. One advantage of employing paired trading using ETFs are their lower fees and the flexibility of intra-day trading.
Considering the wide range of ETF choices, matching them up with specific stocks--or other ETFs--has never been easier. The paired trade strategy can be a crucial tool to help mitigate risk and provide some upside in the current mixed-up, topsy-turvy market.
David Sterman has worked as an investment analyst for nearly two decades. He was a Senior Analyst covering European banks at Smith Barney and was Director of Research for Jesup & Lamont Securities. He also served as Managing Editor at TheStreet.com and Director of Research at Individual Investor magazine. His numerous media appearances over the years include CNBC and Bloomberg TV.