ETF strategy that avoids noise of open markets will arouse adviser curiosity

Five months into an investing experiment that assumes lower volatility and better total returns can be found by simply avoiding the noise that comes with daylight, the compact suite of NightShares ETFs is starting to show promise.

Over an admittedly short period and involving three funds that combine for less than $10 million, the NightShares funds might not yet be catching the attention of a lot of financial advisers. But the potential to gain appeal is there.

Since its inception five months ago, the NightShares 500 ETF (NSPY) is down 7%, which compares to a 1% decline by the S&P 500 Index over the same period.

But over the past three months, NSPY, which buys exposure to the S&P at the market close and sells it at the open each day, is down 5%, while the S&P is down 9%.

In addition to that short-term performance disparity, the NightShares ETF is generating its performance with about half the volatility of the index it is tracking.

The results are similar for the NightShares 2000 ETF (NIWM), which tracks the Russell 2000 Index, and NightShares 500 1x/1.5x ETF (NSPL), which was launched a month ago to invest in the S&P when the market is open and then leverage that exposure up when the market is closed.

Like a lot of new ideas and gimmicky concepts, much of the NightShares case is being made with back-tested data showing better risk-adjusted returns by exposing a portfolio only to the lower-volume and more sophisticated actions of professionals and institutional traders.

NightShares Chief Executive Bruce Lavine admits that he isn’t exactly sure why it works, but he’s convinced it does.

He points to a back-tested model of the S&P 500 over the past 20 years through September that shows an average annualized return of 2.4% for the index when the market is open. But the annualized return for the index over the same 20-year period when the market was closed is 7.1%.

The disparity is even more stark for the small-cap Russell 2000 Index, which shows an average annualized market-open decline of 3.1% over 20 years, compared to a 12.9% gain for exposure when the market is closed.

“The theories about why it works has to do with things like news flow, earnings announcements and M&A that all happen when the market is closed, but there’s also the institutional de-risking that happens at the end of the day when investors flatten their books,” Lavine said. “While stocks are reacting to macro news at night and during the day, only during the day do you have the behavioral component and noise that can create panic selling. You just don’t have that during the night.”

Eric Balchunas, ETF analyst at Bloomberg Intelligence, agrees that the strategy makes sense in theory, but he believes the key to success will be a solid risk-adjusted track record.

“Most regular investors don’t do risk-adjusted, but professional investors might appreciate that,” he said. “This will take off when the S&P goes positive again if it keeps pace with about half the volatility of the S&P.”

While NightShares might be onto something that has long-term potential, the short-term market volatility has not presented the best example of how the strategy might work.

“NSPY has held up better over the last three months in a down market but lagged in the past month when stocks bounced higher,” said Todd Rosenbluth, head of research at VettaFi.

The point is those same kinds of knee-jerk investor reactions that NightShares seeks to avoid by sitting on the sidelines during the day can cut both ways, which can be exaggerated during times of market volatility.

“On the surface it’s gimmicky, but that doesn’t mean it can’t be successful,” said Paul Schatz, president of Heritage Capital.

“NightShares found an anomaly in the markets, but I don't think it's permanent,” Schatz said. “I don't know that I'll use it, but it is worth watching.”

Thus, while NightShares points to the impressive performance of its back-tested models, financial advisers are dutifully focused on the much shorter-term actual performance of a strategy that appears to be both before and after its time.