EQLS: Market-Neutral Not A Good Play While Tech Is Still Dominant

seekingalpha03-03

Funtap Prologue to My Bearish Thesis on EQLS The current market’s heavy skew towards tech is a well-known phenomenon that’s part of the larger AI narrative that’s been at the forefront of investment ...

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Before 2023, there was a somewhat better balance of concentrations in terms of sector weighting of major equity indices such as the SP500, and although this article is primarily about The Simplify Market Neutral Equity Long/Short ETF (EQLS), I feel there’s a need to understand the backdrop against which to view my investment thesis.   eInvestingForBeginners - SP500 Composition Changes from 2003 to 2023 If you look at the S&P 500’s sector compositions and weightings over the past twenty years, some key trends are clearly noticeable. First, healthcare and financials have significantly reduced within the mix. That’s important because they’re still among the top three sectors that SP500 tracks. What’s even more apparent is the IT-heaviness that’s now nearly 30%. Since the table above is from July 2023, that hasn’t been captured, but it’s interesting to note that the weighting of tech has continued to be on the rise over the past six months. One thing is amply clear to me - that the year-long tech rally we’ve been experiencing has changed the entire dynamic of the market. If you look at some of my recent ETF coverage, you’ll see this common thread running through them. The fact remains that it’s really hard to generate alpha (on a capital appreciation basis, not necessarily on fixed-income plays such as Dividend Aristocrats and Dividend Kings) with anything but a tech-heavy portfolio in the current market, which sets the premise for my analysis of EQLS, a relative newcomer to the ETF universe and one that’s built on a market-neutral strategy that provides both long and short exposure to a filtered and algorithmically structured selection of equities from around the globe. Thesis: Although a market-neutral strategy with significant leverage to create a net-zero equity exposure ETF like EQLS is sound in theory, the current reality precludes the generation of any alpha from a capital appreciation perspective. The 8% dividend is certainly attractive, but losing NAV and market value will offset that in a strong way over time, if not completely and immediately. Holdings: EQLS Stock Selection Methodology Explained The ETF primarily holds TRSes or Total Return Swaps and is intended to yield positive returns under any market condition. The equally weighted long/short components of the chosen basket of equities are supposed to ensure this, so you’ll see a very low correlation between the ETF and the broader equities market. What’s important here is that long and short components are equally weighted. As of Jan 31, 2024, the bulk of gross allocations of roughly 840% are equally weighted to both components, complemented by a holding of T-Bills.   Morningstar The fund uses the MSCI World Index as a starting point and is structured by an algorithm that selects stocks after a key filter is put into place: stocks that have high borrowing costs are generally excluded even before the algorithm takes over. The program then ranks the remainder of the 1500 stocks (less the high borrowing cost equities) in order of expected returns, using no less than 500 different quantitative inputs to arrive at this final list. From this list, the top 300 and bottom 300 are selected for the fund to take long and short positions in, respectively. As we saw, these positions are effected through the purchase of swaps for the most part, although well-hedged with short-term T-bills. This is a key aspect because the algorithm’s model essentially uses the hedging component in case the short-, medium-, and long-term trailing models for their inputs haven’t indicated outperformance during their respective periods. The gist of this type of composition is that, because it is neutrally weighted to the overall market, it is also net-zero on market capitalization and even investor preferences for value vs growth. The end result is a fund that - theoretically - should yield market-beating returns without having to invest in a directional strategy, more so because of the hedging and gains from the swaps. EQLS Concept versus Reality We’ve seen that the fund is largely algorithm-driven, which means leveraging AI aggressively, but it also involves backing it up with actual leveraging by borrowing to purchase stocks as part of the long/short strategy. The question, however, is, has this produced the desired results? Well, that’s a tough question because the fund is relatively new, having been launched in June 2023, so we don’t even have a year of performance data. Regardless, the fund is now performing suboptimally for the most part.   SA - EQLS Market Price Since Inception Why? I think the following offers a plausible explanation… The market right now is undergoing a phase we’ve rarely seen in the past. Of course, the tech sector itself can either be cyclical or defensive depending on what time frame you’re referring to, but in general, these cycles are more apparent in areas of intense competition. These often coincide with technological leaps forward, which is what ChatGPT signified when it was released to the public in late 2022. That led to the world’s largest tech names entering the official race to AI dominance. The high level of competition that this phenomenon has engendered is now measurable in terms of AI-centric revenues. The market is apparently very confident about who the winners are, which is why the Magnificent 7 are riding high. As a result, the market is top-heavy with these tech companies, and these few equities have been carrying much of the performance burden of the SP500. One only needs to look at how the tech-focused ETF (IXN) has performed against the broader-market ETFs like SPY and, in fact, against EQLS, to see where all the momentum is coming from.   SA Charting It’s clear to me that the market-neutral nature of EQLS is not designed for such a scenario. The tech sector continues to rally hard and has lifted the SP500 to well over the 5000 level over the past few weeks. In turn, this has unleashed a renewed interest in tech-heavy ETFs like the IXN that’s returned nearly 10% in the YTD period alone - and we’re not even one full quarter into the calendar year. If you look at Q4 2024 earnings growth in the broader market, it’s clear that IT is driving the bus: At the sector level, the Information Technology (88%) sector has the highest percentage of companies reporting earnings above estimates, while the Real Estate (55%) sector has the lowest percentage of companies reporting earnings above estimates. My EQLS Recommendation The reason I believe EQLS’s strategy isn’t working right now is that the market is heavily skewed to one side while the ETF was designed with non-extreme market dynamics in mind. If not, the fund wouldn’t be attempting to achieve net-zero exposure to most quirks of the market - the value vs growth dynamic, different market cap preferences, and so on. Of course, its algorithm’s models involve historical performance, so stocks like NVDA and MSFT are bound to be part of the mix; nevertheless, the fund has failed to fulfill its investment objective. My opinion is that what’s happening now is not a quirk or even an extreme market dynamic - it’s a tectonic shift toward what the market will most likely look like for the foreseeable future. This is validated by increasingly more investors wanting exposure to the AI cycle. Despite the recent corrections, you can see the OBV for IXN trending upward for the better part of 2023 and into 2024.   SA Advanced Charting - IXN On Balance Volume 1Y For all these reasons, EQLS is a Sell as far as I’m concerned. This might be a good play in a sideways market or even one that’s sloping mildly upward or downward, but at this present time, when tech is eating the lunch of every other sector and being driven by AI-centric revenues from the world’s largest companies, this is definitely not a component that will boost your portfolio returns. The best advice for now would be to invest in companies in other sectors that have strong fundamentals, strong cash flows, robust balance sheets, and superior revenue visibility. Kongsberg Gruppen (OTCPK:NSKFF) is one of my favorite picks in that category, and I invite you to kindly read that article on a stock that most U.S. retail investors aren’t looking at. Of course, unless you’re investing overseas, you may not be able to initiate a large position in the ADRs of some of these companies, which is why your core holding should be an ETF like (GSUS), which I also wrote about recently. To be absolutely clear, there’s nothing inherently wrong with a long/short strategy that gives you market-neutral exposure to equities. However, I strongly believe it is designed to outperform only when the market is not too volatile or too skewed towards any one particular sector or investor preference.  That much is evident from this analysis, so the only logical recommendation I can give here is a Sell - this is not the kind of baggage you want to be holding on to as long as the tech rally lasts. Frankly, I don’t know how long that will be, but all signs point to a major tech cycle that’s nowhere close to its peak yet.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2416297741"}