## Buy 'em cheap; buy 'em strong; trend is your friend.

**Value investing:**buy cheap stocks (see our research category on value investing)**Momentum investing:**buy stocks with strong relative strength (see our research category on momentum investing)**Trend-following:**invest with trends (see our research category on trend following)

^{1}Second, the Index is designed for a segment of investors that are 1) long-term oriented and 2) are willing to invest the time to understand our process.

^{2}In summary, the GVMT is definitely not for everyone. With that said, there are various ways in which an investor can use a unique exposure such as GVMT.

**Core Satellite:**Bolt GVMT on a core low-cost beta portfolio.**Factor Diversification:**Deploy a targeted allocation alongside large-cap global factor exposures.**Alternative Exposure:**Add the exposure in the alternative bucket, as a diversifier and a possible replacement for long/short equity.**Core Equity:**Own as a core global equity exposure with a built-in risk management system.

*transparent*and

*systematic*approach to combining value, momentum, and trend exposures into one unified process. We hope this piece helps investors better understand our Global Value Momentum Trend Index. Note: For those who want to dive right into the specifics of the Index, information is available below (for compliance purposes, we require registration for access):

## An Introduction to the Global Value Momentum Trend Index

The mission of the Global Value Momentum Trend Index is the following:- We seek to deliver global value and momentum equity exposure, while simultaneously minimizing the chance of extreme losses.

**Value Strategy:**The strategy consists of a combination of our U.S. and International Quantitative Value Indexes (QV Index and IQV Index).**Momentum Strategy:**The strategy consists of a combination of our U.S. and International Quantitative Momentum Indexes (QM Index and IQM Index).**Trend Strategy:**The strategy consists of a combination of two long-term trend-following rules (Time Series and Moving Average).

## Understanding the Value Momentum Trend Index Process

The GVMT process can be broken into three distinct aspects, which we explore in-depth so readers have a clear understanding of the approach. Here are the three components:- Value Strategy
- Momentum Strategy
- Trend Strategy

### Components 1 & 2: Global Value and Momentum Equity

In this section, we will discuss the first two components of the GVMT Index strategy: the value strategy and the momentum strategy. The goal of these 2 components is to construct a global equity portfolio with high expected returns (over the long-haul). We think our value and momentum strategies are differentiated from the rest of the pack for the following key reasons: Focused exposure, heavy R&D efforts, and our unique approach. A summary of these points are outlined in the figure below:#### Why do we care about focus?

As a starting point, we examine the historical performance of generic value and momentum strategies using “academic” portfolio constructs, which typically sort stocks into deciles based on some characteristic, and then calculate the performance of this strategy over time. Systematic value strategies simply buy cheap stocks based on a price-to-fundamental ratio (e.g., P/E). Systematic momentum strategies buy stocks that have performed the best relative to other stocks (e.g., relative strength measured over 12 months). In general, these academic “decile” portfolios, which buy the top 10% of the universe based on some characteristic, are much more “focused” than the typical “closet-indexing” portfolio with hundreds of stocks. First, let’s look at value. In the chart below we show the invested growth of a classic cheap stock portfolio using data from Ken French’s website. We map the growth of a $100 invested in the top decile (i.e., top 10%) of cheap book-to-market firms (annually rebalanced) and the S&P 500 Total Return Index.^{3}Systematic “academic” value has done well over time, but as we’ve discussed in the past, the short-term relative performance pain is often extremely difficult to digest and requires a sustainable mindset. Generic academic momentum strategies, like value strategies, has also done well over time:

^{4}Just like value, momentum “works,” but these processes require that an investor endure horrific bouts of

*relative*underperformance that perhaps only an alien could withstand.

**Bottom line?**“Academic” systematic value and momentum strategies have generated excess returns, but they are

*long-term commitments*with a large amount of risk. These academically-constructed value and momentum strategies earn high returns (arguably) because they capture market risk premiums (e.g., systematic risk exposure) and behavioral risk premiums (e.g., exploiting systematic mispricing that is painful to hold). The investors who can exploit these excess return drivers need to be process-driven and very disciplined. (Please see our sustainable active piece for a deeper dive into identifying “excess returns” in the marketplace.)

#### If focus is so great, why aren’t there more focused factor portfolios?

As was previously highlighted, systematic value and momentum strategies, as constructed by academics, have historically shown promise. This begs the question:If investors believe the evidence presented in academic research, why are they buying factor portfolios with no resemblance to the portfolios that generated the evidence in the first place?Turns out that the real world is a lot more complex and managing “academic” style portfolios may not be an optimal solution for a lot of investors and for a lot of reasons (e.g., tracking error, transaction costs, taxes, constraints). In fact, based on how many “factor-based” strategies are constructed, it is clear that there isn’t a huge demand for “academic” style portfolio constructs. For example, consider the Vanguard Value ETF (ticker: VTV), one of the largest “value factor” ETFs, which tracks the CRSP US Large Cap Value Index. The figure below highlights how closely the performance lines up with SPY, an ETF that tracks the S&P 500 Index. Why is this the case? The VTV ETF tracks an index that is not designed like academic portfolios because there is a consideration for tracking error. In other words, the CRSP Index that VTV follows is constrained to not drift too far from the S&P 500 Index. Given the mission of VTV, this probably makes sense. A lot of investors are using this as essentially an S&P 500 plug, with a small tilt towards the so-called value factor. But to be clear, because the portfolio design of VTV is so different than the “academic” portfolio design mentioned above, one can be confident that the performance of VTV will not reflect the performance (be it good or bad) associated with “academic” value portfolios that simply sort stocks on the top 10% cheapest based on book-to-market.

^{5}So what’s the point? The point is

**not**that closet-indexing or tracking-error constrained portfolios are bad. These portfolio constructs serve a purpose and can be a great solution for many investors. However, if the goal of a portfolio is to capture the premiums associated with focused academic portfolios, the portfolio construction should look a lot like the academic portfolios. And almost by definition, this means the portfolio will be more concentrated, have higher tracking error, and take on various risks. Simply put, there are trade-offs between the approaches and for additional study on this subject, you can check out a few of our posts here, here, and here.

#### Why do we care about research?

We’ve spent many years identifying ways in which we could improve the basic academic value and momentum strategies. In fact, we got so deep into the weeds we decided to write books on the subject. If you are an uber-geek, we encourage you to check them out at your convenience (Quantitative Value and Quantitative Momentum). We are also happy to mail you copies if you shoot us a note and genuinely love this stuff. But if the books are a bridge too far, you can also get a good description of the processes for our Quantitative Value approach here, and our Quantitative Momentum approach here. The basics of each system are outlined below:**Quantitative Value Index:**

*We seek to buy the cheapest, highest quality value stocks*

**Identify Investable Universe:**We typically generate 900 names in this step of the process.**Forensic Accounting Screens:**We usually eliminate 100 names, bringing the total to 800 stocks.**Valuation Screens:**Here we screen the cheapest 10% of the universe, or 80 stocks.**Quality Screens:**We calculate a composite quality score and eliminate the bottom half, leaving 40 stocks.**Invest with Conviction:**We invest in our basket of 40 stocks that are the cheapest, highest quality value stocks.

- ~40 stocks
- Equal-weight
- Quarterly rebalanced (international is semi-annually rebalanced)
- 25% sector/industry constraint
- No financials
- Pre-trade liquidity requirements

**Quantitative Momentum Index:**

*We seek to buy stocks with the highest quality momentum*

**Identify Universe:**We typically generate ~ 1,000 names in this step of the process.**Core Momentum Screen:**Select the top decile of firms on their past momentum, or 100 stocks.**Momentum Quality Screen:**Select high-momentum firms with the smoothest momentum, 50 stocks or 50%.**Seasonality Screen:**Rebalance the portfolio near the beginning of quarter-end months.**Invest with Conviction:**We invest in our basket of 50 stocks with the highest quality momentum.

- ~50 stocks
- Equal-weight construction
- Quarterly rebalanced
- 25% sector/industry constraint
- Pre-trade liquidity requirements

#### Why do we care about diversification?

As outlined above, we have our own version of value and momentum. But as part of the GVMT process, we choose to combine our value and momentum strategies into a single global portfolio. Why do we take this approach? There are reams of academic research on this subject, but to summarize, combining value and momentum strategies has the potential for large diversification benefits (here is a good post if you would like to dig deeper).### Conclusions Regarding Components 1 & 2: Global Value and Momentum Equity

As mentioned at the outset, the goal of components 1 & 2 in the GVMT Index is to construct a global equity portfolio with a high expected return. We believe our global value and momentum equity strategies are differentiated from the rest of the pack for the following key reasons:- Focused exposures that are more in line with academically constructed portfolios
- Enhanced potential via heavy R&D efforts
- The equity exposures have a low correlation and serve as excellent compliments

### Components 3: Trend Strategy

The third component of the GVMT process is a trend strategy. And the goal of this component is to minimize the impact of extreme equity market drawdowns that will inevitably be associated with components 1 & 2 of the GVMT strategy — a focused global value and momentum equity portfolio.How does one deal with equity market drawdown risk? Obviously, all investors would love to enjoy the benefits of high expected risk premiums, while avoiding the monster drawdowns. To many, this is an impossible mission. Perhaps they are right. However, while achieving zero risk with equity-like positive returns is a pipe dream, there is some evidence that *extreme* risk (e.g., massive drawdowns) can be avoided via trend-following methodologies. To reiterate why might the avoidance of large tail risks might be desirable, we present the hypothetical chart below:

The chart on the left highlights the problem with permanent loss of capital events. A 50% loss of capital needs 11 years of compounding at 7% to break even. Some investors won’t be around in 11 years, let alone have the ability to sit tight for a decade just to break even. Clearly, huge losses need to be avoided. But as we mentioned, there is no such thing as getting returns and avoiding all risk. But “risk,” if it is defined as volatility, may not be a huge issue. The chart on the right makes this a bit more clear. In this scenario, the investor eats a 15% loss. Definitely not fun, but not devastating. The portfolio only needs 3 years to dig out of its hole and get back to breakeven. Three years of sitting on your hands *is* painful — no doubt — but a lot better than 11 years.

*So what’s the lesson? *Simple: losses are manageable but large losses are disastrous!

We recognize that all investments that plan to earn an excess return have to be volatile — that’s investing — but perhaps we can explore methods to try and minimize catastrophic losses associated with these strategies? One way of achieving tail risk management is via diversification. Diversification is a no-brainer for all investors — we obviously need to be diversified. But as 2008 highlighted for many investors, diversification won’t necessarily eliminate tail risk.

Another potential option is trend-following, which is a simple approach: own risk if it is in a positive trend, otherwise, avoid risk. Based on our collective take on external research and extensive internal research, we’ve come to the conclusion that trend-following seems to be the most promising way to minimize extreme tail-risks in a portfolio. To reiterate the point expressed above regarding equity risks, trend-following ** won’t eliminate risk **— heck, in some scenarios it can

*increase*volatility — but if tail risks are your concern, trend following is the best answer we could find.

To highlight the potential promise of trend-following to curb large drawdowns, we deploy our trend strategy on the S&P 500 Index from 1928 to 2017 and compare the drawdown profile across time. ^{6}

^{7}

## Compiling the Components of the Global Value Momentum Trend Index

If you’ve made it this far — congrats — we’re almost there! To recap, we’ve covered the three core components of the GVMT Index:- Value Strategy
- Momentum Strategy
- Trend Strategy

- Determine geographic and factor exposures
- Assess trend-following rules
- Calculate hedge exposures

### Determine geographic and factor exposures

The first step in the process is figuring out how to allocate across components 1 & 2 of the system — the value strategy and the momentum strategy. As mentioned in the global value and momentum section, we have 2 core equity strategies: Quantitative Value and Quantitative Momentum. However, because we divvy the world into U.S. and developed markets, we end up with 4 equity strategies in total:- U.S. Quantitative Value Index (QV Index)
- International Quantitative Value Index (IQV Index)
- U.S. Quantitative Momentum Index (QM Index)
- International Quantitative Value Index (IQM Index)

^{8}Our process for volatility weighting is often deemed “simple risk parity.”

^{9}The downside of volatility-weighting the positions is an added layer of complexity, but the GVMT approach is 1) simple and 2) annually rebalanced to minimize the noise/frictional costs of more complex allocation strategies. The details of step 1 are outlined in the graphic below: In the hypothetical example above, the geographic breakdown is 52% international and 48% U.S. On the factor side of the house, there is a 45% allocation to the momentum strategies and a 55% allocation to the value strategies. These figures are hypothetical and meant to convey the message. But we can generate the historical geographic and factor allocations for the GVMT Index throughout the history of the Index. First, the time series allocation of the GVMT Index across geography:

**Historical Geographic Exposure from 1/1/1995 through 9/30/2018**

**Historical Geographic Exposure from 1/1/1995 through 9/30/2018**

^{10}

### Assess Trend-Following Rules

The next step in the process is to assess the trend-following rules that are generated by our trend strategy. As is described in the appendix, our trend strategy consists of several long-term trend-following rules — a time-series rule (“TMOM) and a moving-average rule (“MA”). We calculate these trend-following rules for domestic exposures and the international exposures, separately. The rules are calculated and deployed on a monthly basis. See the appendix for details.^{11}To further describe how this may work in practice, let’s work through an example. To start, the trend rules are calculated for the U.S. market and the International market, separately.

**Domestic trend rules:**Each month end, calculate the TMOM and MA rule on the S&P 500 Total Return Index.**International trend rules:**Each month end, calculate the TMOM and MA rule on the MSCI EAFE Total Return Index.

- We are sitting at the close on March 31, 2018.
- 12-month cumulative total return on treasury bills are 2%, S&P 500 Total Return Index is 5%, and MSCI EAFE Total Return Index is -1%.
- S&P 500 TR Index is above the 12-month moving average, MSCI EAFE Total Return Index is below the 12-month moving average.

**Domestic TMOM:**The S&P 500 TR Index has earned 5% relative to the treasury bill return of 2%.*No rule trigger.***Domestic MA:**The S&P 500 TR Index is above the 12-month moving average.*No rule trigger.*

**International TMOM:**The MSCI EAFE TR Index has earned -1% relative to the treasury bill return of 2%.*Rule triggered.***International MA:**The MSCI EAFE TR Index is below the 12-month moving average.*Rule triggered.*

**Domestic Robust Trend Rule:***No rules triggered***International Robust Trend Rule:**Both rules triggered

- 0% = full hedge (both rules triggered)
- 50% = partial hedge (one rule triggered)
- 100% = no hedge (no rules triggered)

**Historical Robust Trend Rules from 1/1/1995 through 9/30/2018**

### Calculate Hedge Exposures

The final step in the process is taking the calculations from step 2 and then translating them into a hedged exposure. We’ll discuss how that works and the details of how hedging works in the GVMT portfolio. Let’s work through a hypothetical example to illustrate the idea. Consider the following situation:- You conduct step 1 and determine the geographic and factor exposures:
- 48% domestic equity; 52% international equity
- 50% value exposure; 50% momentum exposure

- Next, you review step 2 and assess the 4 trend rules, using S&P 500 to determine the domestic rules and using MSCI EAFE for the international rules. You get the following assessment:
- Domestic TMOM: No rule trigger
- Domestic MA: No rule trigger
- International TMOM: Rule triggered
- International MA: Rule triggered

- No hedge (“Long”) = No rules triggered
- Partial hedge (“Hedged”) = 1/2 rules triggered
- Full hedge (“Market Neutral”) = Both rules triggered

- Domestic exposure = No hedge
- International exposure = Full hedge

## The Alternative Nature of Our Global Value Momentum Trend Index

Our GVMT Index seeks to capture the collective benefits of the three factors where we have the highest conviction: Value, Momentum, and Trend. And because the strategy is unique, the GVMT Index should not be expected to closely track a broad passive global equity exposure. In fact, the GVMT Index has a higher correlation with the HFR Global Hedge Fund Index than it has with long-only equity indices.^{12}Here are the correlations between the Global Value Momentum Trend Index,

^{13}the HFR Global Hedge Fund Index, the S&P 500 Total Return Index, and the MSCI EAFE Total Return Index from 1998 to 2017 (all returns are total returns and include distributions):

wdt_ID | Correlation Matrix | GVMT_INDEX_NET | HF_INDEX | SP500 | EAFE |
---|---|---|---|---|---|

1 | GVMT_INDEX_NET | 100.00 | 69.21 | 49.62 | 58.35 |

2 | HF_INDEX | 69.21 | 100.00 | 56.36 | 64.30 |

3 | SP500 | 49.62 | 56.36 | 100.00 | 85.45 |

4 | EAFE | 58.35 | 64.30 | 85.45 | 100.00 |

*Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. Index returns are for illustrative purposes only and do not represent actual fund performance. Index performance returns do not reflect any management fees, transaction costs, or expenses, which would reduce returns. Indexes are unmanaged and one cannot invest directly in an index.*

*underperform*passive indexes. Investors following the GVMT Index should keep this in mind when attempting to benchmark the GVMT system (see here for some ideas on benchmarking trend-following strategies). Our recommendation for benchmarking is a global hedge fund index, a global long/short equity index, or a blended global equity/bond index (e.g., 70/30 equity/bond). Nonetheless, regardless of the benchmark chosen, one should expect the GVMT Index to have large deviations from other common exposures available in the marketplace.

^{14}

## Conclusions Regarding the Global Value Momentum Trend Index

We’ve spent a lot of time developing three systematic processes: Quantitative Value, Quantitative Momentum, and Robust Trend. Each of these systems can be used individually to solve specialized problems. However, the Global Value Momentum Trend Index packages these three concepts into a single approach. For some investors, the combined approach of GVMT may be more appropriate than using the individual pieces.

In the end, the Global Value Momentum Trend Index seeks to deliver focused exposure to our favorite investment ideas: value, momentum, and trend.

The GVMT mantra is simple and we hope it stands the test of time:## Buy 'em cheap; buy 'em strong; trend is your friend.

Information on our Global Value Momentum Trend Index is available here.

Here are some specific research/educational materials:

Notes:

- There are many great ideas out there and we don’t stake a claim on having the perfect answer. ↩
- If you are reading this post, you are probably a good fit. ↩
**VAL_10**= Top Decile Value, value-weight (or “market-cap” weighted) portfolio- Ranked on book-to-market
- Annually rebalanced

**SP500**= SP500 Total Return Index**Simulated Performance:**1/1/1963 to 12/31/2015**Net of fees:**1% mgmt. fee, .5% transaction costs- Total returns, including dividends and distributions ↩
**MOM_10**= Top Decile Momentum, value-weight portfolio- Ranked on cumulative 12 months, skip last month
- Monthly rebalanced

**SP500**= SP500 Total Return Index**Simulated Performance:**1/1/1963 to 12/31/2015**Net of fees:**1% mgmt. fee, 2.5% transaction costs- Total returns, including dividends and distributions ↩
**VTV US Equity**= Vanguard Value ETF**SPY US Equity**= SPDR S&P 500 ETF Trust**Data Period:**1/1/2004 to 9/30/2018- Total returns, including dividends and distributions
- Past performance is not indicative of future results, which may vary. ↩
**Simulated Historical Performance:**1/1/1928 to 12/31/2017- All returns are total returns and include the reinvestment of distributions (e.g., dividends)
- Data sources include Alpha Architect, Bloomberg, and Solactive
**SP500**= S&P 500 Total Return Index**SP500_ROBUST**= S&P 500 Total Return Index with ROBUST_TREND**ROBUST_TREND**= 50% 12-month time series momentum rule and 50% 12-month simple moving average rule. Monthly assessed. ↩### Details for Our Trend-Following Model

Our Trend-Following Model is further described in our empirical analysis, but here are the high-level details:

The mechanics of the rules are outlined below:**Absolute Performance Rule:**Time Series Momentum Rule (TMOM)- Excess return = total return over past 12 months less return of T-Bills
- If Excess return >0, go long risky assets. Otherwise, hedge the position by shorting the passive index (S&P 500 and/or EAFE).
- A concept made popular by Gary Antonacci

**Trending Performance Rule:**Simple Moving Average Rule (MA)- Moving Average (12) = average of 12 monthly prices
- If Current Price – Moving Average (12) > 0, go long risky assets. Otherwise, hedge the position by shorting the passive index (S&P 500 and/or EAFE).
- A concept made popular by Meb Faber

**Our Trend-Following System:**Combination of TMOM and MA (ROBUST model)- 50% TMOM, 50% MA ↩
- This is especially important because our Quantitative Momentum Indexes can have a different volatility profile than our Quantitative Value Indexes ↩
- see risk parity for dummies for background or review the image below. ↩
- The dramatic changes in allocations are associated with annual rebalance periods. ↩
- The mechanics of the trend rules are outlined below:
**Absolute Performance Rule:**Time Series Momentum Rule (TMOM)- Excess return = total return over past 12 months less return of T-Bills
- If Excess return >0, go long risky assets. Otherwise, hedge the position by shorting the passive index (S&P 500 and/or EAFE).

**Trending Performance Rule:**Simple Moving Average Rule (MA)- Moving Average (12) = average of 12 monthly prices
- If Current Price – Moving Average (12) > 0, go long risky assets. Otherwise, hedge the position by shorting the passive index (S&P 500 and/or EAFE).

**Our Robust Trend-Following System:**Combination of TMOM and MA (ROBUST model)- 50% TMOM, 50% MA ↩
- In more detailed analysis we examine the beta of our GVMT Index against a variety of factor models (CAPM, FF 3-factor, Carhart 4-Factor, FF 5-factor, and AQR 6-factor) and confirm that the beta is typically around .5 to .6, depending on the factor model used. ↩
**GVMT_INDEX_NET**= Annual rebalance (First Week of May) across QV INDEX NET, QM INDEX NET, IQV INDEX NET, and IQM INDEX NET. Alpha Architect calculations through 12/31/2015; Solactive calculations thereafter. ROBUST Trend manages a dynamic 0-100% hedge component. Trend rules trigger index related trading for the hedge and components and are rebalanced monthly. Interest earned is assumed to be 90-day T-Bill minus 0.5%; Interest paid is assumed to be 90-day T-Bill plus 0.5%. Hedging can create exposures that drift from the model weights. We manage this risk by trading back to model weights when there is a trigger or there is no longer a hedge position. Downside Rebalance Trigger (% from Model): 10.00%. Upside Rebalance Trigger (% from Model): 10.00%. Net of 1% in costs.**QV INDEX NET =**Quarterly rebalanced, equal-weight, total returns including dividends. Alpha Architect calculations through 10/31/2014; Solactive calculations thereafter (Official index is QVAL Index). Net 2% in costs.**QM INDEX NET =**Quarterly rebalanced, equal-weight, total returns including dividends. Alpha Architect calculations through 12/31/2015; Solactive calculations thereafter (Official index is QMOM Index). Net 2% in costs.**IQV INDEX NET =**Semi-annually rebalanced, equal-weight, total returns including dividends. Alpha Architect calculations through 12/31/2014; Solactive calculations thereafter (Official index is IVAL Index). Net 2% in costs.**IQM INDEX NET =**Quarterly rebalanced, equal-weight, total returns including dividends. Alpha Architect calculations through 12/31/2015; Solactive calculations thereafter (Official index is IMOM Index). Net 3% in costs. ↩- In this section we address common technical questions regarding the Index. We recommend you contact us if you are interested in more details.
### Why Do We Hedge As Opposed to Going to Cash?

Let’s say a trend rule triggers and we now need a short position to hedge our long portfolio. For illustration purposes, let’s also assume we need to fully hedge the portfolio (“Full Hedge”). What happens next? As we discussed above, the GVMT INDEX is always long a portfolio of Value and Momentum stocks. Let’s say the Index value is $100. If the Index wants to short $100 of a passive index to maintain a fully hedged stance (Note one can also use futures), typically done via an ETF vehicle such as the SPY or EFA, the Index can rely on the fully paid securities ($100) as collateral to open a short index ETF position. The Index could also sell all the Value and Momentum stocks to minimize market risk on the portfolio and invest the proceeds in cash or Treasury Bills. So why did we choose to have our Index always own the underlying Value and Momentum stocks and hedge via a passive instrument, as opposed to selling down the equity? Aside from the greatly enhanced frictional and tax costs of trading in and out of the holdings, there is a potential investing benefit of maintaining the underlying stock positions during a hedging event. Please see our detailed education materials for this analysis.### Operational Costs of Hedging

To open a short position, a prime broker will assess the collateral and decide the margin requirement. Typically professional investors access what is referred to as portfolio margin (as opposed to Reg-T margin), which accounts for portfolio characteristics when assessing margin requirements. This is important in our context because the margin requirements to enter a short position, which is negatively correlated with our long positions, means that our margin requirements will often be much less than 50% (Reg-T requirement). Let’s say the prime broker determines that the margin requirement to hold the short position is 20%. In this case, the portfolio would need to borrow $20 ($100*20%) from the prime broker, and will pay an interest rate on this borrowed amount. The interest rate is typically, Borrow Rate = Fed Funds + markup, where the markup ranges across brokers. Once the prime broker determines there is the necessary collateral in place, the portfolio can initiate the short ETF position, and will receive $100 in cash from the short sell. The portfolio will pay a cost to borrow the position (often called the short rebate) to maintain the position (SPY is around 30-35bps/year), but the portfolio will also receive interest on the $100 in short proceeds. The interest rate received on the short position is typically the Fed Funds rate minus some haircut. So in total, the carry cost to the portfolio to initiate the short position is given below: Cost = (Margin Requirement %)*($100)*(Fed Fund Rate + Markup) + ($100)(Short Rebate Cost) – ($100)*(Fed Funds Rate – haircut). Let’s say the margin requirement is 20%, Fed Funds is 1%, the markup/haircut are 50bps, and the rebate is 30bps. The overall carry cost of the short position will be as follows:Annual Costs = 20%*$100*(1.5%) + $100*0.30% – $100*(0.50%) ~ 0.10% or 10bps.

In other words, there is a 10bps negative carry for holding the short position. In general, with higher interest rates the carry becomes more positive and with lower interest rates, holding a short position will have a negative carry. Last, it should be pointed out that the portfolio, like any other portfolio that engages in short-selling or other derivative transactions, does take on some counterparty risk by employing such a strategy. ↩