FTLS - FTLS: Hedge Fund Strategies In An ETF Format

2023-11-03 21:55:46 ET

Summary

• First Trust Long/Short Equity ETF is a unique investment vehicle that aims to provide long-term total returns with less volatility than the S&P 500 index.
• FTLS has historically outperformed during bear markets and has a low standard deviation compared to the S&P 500 and a higher Sharpe ratio.
• The fund has delivered an 11.5% return this year and has shown the ability to mitigate drawdowns while capturing upside potential.
• The fund is currently net long, but has a short position in a portfolio of high beta equities.
• Long / Short equity strategies are often reserved for the hedge fund universe, since they involve very active position management and a significant turnover with an ambivalent risk factor profile.

Thesis

First Trust Portfolios L.P. operates as an investment management company based out of Illinois, and was established in 1991. The company offers ETFs, CEFs, and mutual funds. First Trust has been in the news as of late with a partial divestiture of their CEF business which we covered here .

Today we are going to look at one of their ETFs, namely the First Trust Long/Short Equity ETF ( FTLS ), which is a very interesting investment vehicle given the current market volatility. The past few days have seen a significant change in investor sentiment, with a furious risk-on rally spurred by bets that the Fed is done hiking rates this monetary cycle:

The SPY has rallied almost 5% in the past five days, and we are on track for a year end rally driven by better than expected economic data and a very light equity positioning by market participants.

As a retail investor it has been very tough to trade 2023, with only a few sectors of the market offering consistent positive returns:

The winners so far this year have been the 'Magnificent 7', large capitalization tech stocks and short dated treasuries. The equal weighted Invesco S&P 500 Equal Weight ETF ( RSP ) is flat on the year, while small capitalization stocks as reflected in the iShares Russell 2000 ETF ( IWM ) are down for the year. Similarly, REITs have been battered by higher rates, as reflected in a negative total return performance for the Vanguard Real Estate ETF ( VNQ ).

What does FTLS do?

As per its stated objective, the fund:

Seeks to provide investors with long term total return. The Fund intends to pursue its investment objective by establishing long and short positions in a portfolio of Equity Securities. FTLS aims to keep pace with the S&P 500 Index over a full market cycle, with less volatility. FTLS may lag the index in up markets, but historically has outperformed in down markets.

Long / Short equity strategies are often reserved for the hedge fund universe since they involve very active position management and a significant turnover with an ambivalent risk factor profile. A long/short fund can be long, short or neutral equities depending on its positioning at any point in time. Its returns thus very much depend on the acumen of its portfolio managers, and their ability to identify undervalued and overvalued names.

FTSL is current net long on its positioning:

Let us have a closer look at what this actually means:

The vehicle is long Apple and Microsoft for example, while short Micron and Barrick Gold. Let us have a look at how these names have performed this year:

We are not sure when the fund entered the positions, but they have done extremely well this year, with the longs up significantly, while the short positions have negative total returns.

That is the beauty of long/short equity funds - they can almost double their performance if the bets turn out right. The fund can make money both on the long as well as on the short leg with a more neutral overall equity delta.

The devil is in the detail as they say, thus a long/short fund can generally be judged on two broad metrics:

1. Historic Performance (this is a true reflection on how managers perform during bull and bear cycles)
2. Analytics

FTLS performance metrics - it delivers during rough markets

FTSL has managed to deliver during tough markets. We will have a look at it annual performance, but let us just see what it has done since the August highs in the market:

While the SPY experienced a -10% correction, FTSL was flat! Please notice that the fund's performance has an incredible low volatility, being virtually flat, although the ETF is net long currently. This translates into the high beta names it shorted losing more money than the long position it currently has. Its historic statistics corroborate that view:

The fund has a better Sharpe ratio than the S&P 500 with a standard deviation almost half of the one exposed by the index. These analytics are truly very robust, and speak well to what the fund intends to do.

Historically, the ETF's annual performance is reflective of its mission and its analytics:

The fund is up over 11% this year, and was down only -5.5% during 2022. That is a very tough feat to achieve, and it speaks well to its short positioning. The fund trails during cyclical bull markets, but outperforms during prolonged bear environments.

To that end the vehicle has exposed very shallow drawdowns when compared to the S&P 500:

You are looking at a fund which has half the drawdown in the index, but at the same time is able to capture 60% or more of the up move. Limited downside with a closely matching upside is a great equation to be part of.

The takeaway for a retail investor is that the fund has delivered historically versus its goal of outperformance during bear markets, and its analytics are supportive of a less volatile instrument. While past performance is not always indicative of future one, having a management team that was able to successfully navigate the Covid drawdown and the 2022 rates driven bear market does lay a path of success in the future.

Risk factors to consider

One aspect which is important for long/short equity funds is the ability for the vehicle to accelerate losses or gains if names are poorly chosen. To that end if the fund is long Apple and short Micron as we saw above, it can accelerate its losses if Apple loses value while Micron gains. As opposed to an outright position where both names are on the long side and there would be a profit and loss offset, a negative correlation between the two names can cause this distortion where both the long and short legs are losing value. It is basically an imperfect hedging position.

The fund's historic performance indicates that the portfolio managers are well versed in picking trends and correlations which generate net positive returns, and thus acts as a mitigant. The best example is what happened in the past two months, where the SPY lost -10% but FTLS was flat due to its shorts in high beta stocks.

Conclusion

FTLS is an equities exchange traded fund. The vehicle is a long/short fund, and aims to provide long term capital gains with a lower volatility than the S&P 500 index. The fund is currently net long equities, and has managed to post an 11.5% return this year with a standard deviation of only 9%.

FTLS is an appropriate tool to use during long bear markets, with the fund being able to deliver on the upside while mitigating drawdowns. The best example of the fund's capabilities is the total return and volatility observed in the past two months, when the SPY was down -10% while FTLS has been flat with 1% volatility. Long term the fund has a 0.45 beta to the S&P 500 and a Sharpe ratio which exceeds the index one.

We believe we currently are in a long cyclical bear market which will wring out all the excesses from the 2020/2021 period, and thus FTLS is an appropriate tool to use in today's market.

For further details see: