There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
- Ludwig von Mises
Before I begin, let me state that we do not believe that anyone has the predictive ability or insight to accurately and consistently time global events or the movement of the markets. Some will always get it right, and some will get it wrong. We are in the business of finding and exploiting individual investment opportunities where we are able to purchase securities for an attractive price with respect to downside; where our research gives us an edge; and where there is a specific corporate event or catalyst to unlock value regardless of the direction of the markets.
I spend a lot my time scouring the markets for paradoxes. In most cases, we find them in niche areas of the financial markets where structural inefficiency, narrow mandates, and leverage cause the price system itself to fail. Sometimes these paradoxes present themselves in larger parts of the market as well when public policy, investor bias, and logic no longer intersect.
The U.S. 30-Year Treasury trades near its lowest yield in history. The demand in the market for safety and cash yield has pushed the price of Treasuries to an extreme high. At current yields and prices, even a small increase in interest rates could cause dramatic reductions in the value of these securities and perpetuate further selling. So, do I think investors should take a short position on U.S. Treasuries? Yes. Do I think investors should short U.S. Treasuries? Absolutely not.
Trying to call the top of the Treasury market is nearly impossible, especially when public policy plays such a key role in the Fed's buying program. However, there is a way that I think one could position to take advantage of this paradox with a higher degree of safety, through the use of leveraged ETFs.
Broadly, we tend to be skeptical of financial innovation, and we have been particularly interested in shorting leveraged ETFs for several years now due to their horrendous structural flaws. The mechanics used by these leveraged funds create a "constant leveraged trap" that erodes their value over time. To operate, the fund has to add or reduce leverage on a daily basis to match the index. If the underlying index goes up in value, the ETF must increase leverage; if the index goes down, the ETF must decrease leverage. Essentially, this boils down to the ETF being forced to increase leverage on up days, and decrease leverage on down days (buy high/sell low). Regardless of the performance of the underlying index, all leveraged ETFs are designed to fail over the long term. The more volatile the underlying index, the more quickly the ETF erodes.
For example, in 2011, one of our best investment ideas was writing calls on ProShares UltraShort Silver ETF (ZSL). ZSL provides 200% leverage over the daily inverse price movement of silver. In 2011, a basic ETF to track silver prices returned -11% for the year. One would conclude that an investor who made an inverse bet against silver in 2011 would have made money.
The Direxion Daily 20-Year Plus Treasury Bull 3x Shares ETF (TMF) is an exchange traded fund designed to track 300% of the daily performance of long-term U.S. Treasuries. This ETF, however, suffers from the same structural decay problem as ZSL or any other leveraged ETF. We even recently wrote about this phenomenon and the effect it has had on volatility ETFs and ETNs.
Is there a catch? From their performance, it is clear that volatility drag has crushed the performance of nearly all leveraged ETF. Shorting them all almost seems too easy. In our experience, it has been. While this security is on a long list of our leveraged inverse short ideas, we think that it is the best because the underlying security is at the most extreme price such that mean reversion has the greatest impact.
We like this trade because, on one hand, if we are correct, our position helps to hedge the portfolio in the event of a systematic reduction in the principal value of U.S. Treasuries. If we're wrong, and Treasuries continue their unprecedented climb to ever high prices, the structural inefficiency of the leveraged ETF itself should erode the value of the security anyway.