Sunday, November 12, 2006

A Pair Trade?

Pair trades are one of the strategies commonly used by hedge funds. The idea is to buy a stock that is expected to perform well and short another stock in the same industry which is expected to underperform. A similar idea is to buy a portfolio of stocks that the investor expects to perform well and short index futures or ETFs etc. to remove the general market risk from the portfolio. The latter is the Hussman Strategic Growth Fund's strategy in perceived poor market conditions. I have been thinking for a while of shorting an ETF that attempts to replicate the Dow Jones REITs index - IYR. Many REITs have very high P/E ratios and high price to book ratios. Even if there were no decline in the property market it seems possible that their share prices should correct towards more historical price earnings and price book ratios. The rapid rise of IYR's share price is rather scary though for shorts.

On Friday I was reading about the upcoming IPO of hedge fund manager Fortress Investment Group. I noticed that they manage one NYSE listed REIT - Newcastle. This REIT invests in mortgages rather than actual property - largely commercial mortages. Its dividend yield is very high, its P/E is low and management is buying shares. What I don't understand is how it is managing to significantly increase earnings and dividends when it pays out 90% plus of earnings. Of course it seems strange to buy shares in a REIT when I expect a downturn in the property market.... I also have shares in my 403(b) in the TIAA Real Estate Fund. It invests directly in property and the value of the fund is based directly on the appraised value of the properties it owns. The share price cannot deviate from the fund's book value.

A solution to my reluctance to short IYR and concern about how NCT could increase earnings is to buy NCT and short IYR. It seems to me that IYR is overvalued relative to NCT. I am thinking to buy just 100 shares of NCT initially (less than 1% of net worth), but to short 100 shares of IYR (a little more than 2% of net worth). The additional short exposure to IYR will be partially hedging my TIAA Real Estate and Hudson City Bank Corp investments. For a complete hedge I'd need to short around 200 shares of IYR.

I am gradually moving short-term trading from my Ameritrade account to my Interactive Brokers account due to the tax advantages of futures trading and cheaper commissions at IB. So I am gradually turning my Ameritrade account into an investment account. I want to keep $25k of equity in the account in order to allow me to daytrade if I want to. So I want to have around $50k in investments in this account eventually (50% margin ratio). So far I have a little less than $8k (BRK/B and HCBK).


Anonymous said...

Curious if you have any point of view on whether to do short sale of stocks, buy puts or other option spread type strategies. This is of course for the leg that you think will go down. Thanks.

mOOm said...

I prefer straight shorting whenever possible - just seems simpler.