More ProShares Ultrashorts Tomfoolery

The more I look at these double inverse ETFs the more I see how useless they are as even a medium-term hedging vehicle. It really leaves those of us who cannot short in an account (which is how Marketocracy.com is set up as are 401ks/rollover IRAs) in a pickle.

Some of them are hard to analyze directly since there is no specific index they directly short against, but the two foreign ETFs we own show how ineffective they are in any lengthier time frame. These truly are like options in which the time decay is working against you every day you hold them. I've already outlined how poorly they have done as hedges against financials or real estate dropping... here are some more cases.

I bought Ultrashort Emerging Markets (EEV) as a hedge against foreign markets dropping - I began this ETF on November 15, 2007 right near when it first began trading. I've generally held this in a 1-3% stake for most of the past 13 months, although at peak its hit 4-5% of the portfolio. At the time I originally bought, the instrument it hedges against - which is the iShares MSCI Emerging Markets Index (EEM) was trading around $49. Today it is $24 - thats a 51% drop. I made an excellent theoretical call here, and the gain one could gain by shorting the long ETF - EEM would be +51%.

Below is what EEM looks like graphically since I bought its Double Inverse


In theory an Ultrashort is supposed to give you double that return - at least conceptually. In the prospectus and as documented by other what it guarantees is only each day's inverse return - i.e. the compounding is useless. But at least in concept if you held this ETF you'd think you'd get double the inverse return. Since the EEM fell 51%, you'd think you would have made +102%. Great trade! Not so much.

Ok we say - these instruements are flawed - instead of getting +102%, well maybe you only got 51% - which is not double the inverse but single the inverse the ETF is betting against. Or maybe it's even worse than that, maybe you only got half the inverse - maybe 25.5%. That would be awful but at least you still made money.

Want to see what the Ultrashort Emerging Markets (EEV) has done since bought on November 15th @ $60?

It is now trading at $56. Now granted there were some capital gains distributions, but at $56, it's a 7% loss for holding it the entire time (ex capital gains) versus what should be (conceptually) a 102% gain. Let's say the capital gains distributions even led to a 5% gain. That's still rotten versus the concept of this ETF. So effectively, unless you catch the huge waves when this name really moves (or in fact any Ultrashort ETF) every day you hold this you lose money in a sideways market. You didn't get +102%. You didn't get half that - 51%. You didn't get a quarter of that - 25.5%. If you were lucky you got 0%. Despite making a great call on shorting foreign markets. That's terrible - I'm sorry.

*******************

I won't go through all the conceptuals with the Chinese ETFs but it's the same idea with iShares Xinhua China 25 (FXI) and its double inverse ProShares Ultrashort Xinhau China 25 (FXP). The latter is supposed to give you double the return of the index (but it only does on a daily basis). We bought FXP a few days after EEV - on November 20, 2007... or roughly at $58. If you were not around at the time October 2007 was the height of Chinese stock insanity[Aug 28: China "A" Shares Bubble] [Sep 1: The Growing Bubble in the Shanghai Index] - which we outlined daily - PetroChina (PTR) hit a $1 Trillion market cap [Nov 1 2007: PetroChina the 1 Trillion Dollar Company? Is *this the top?] , a multitude of Chinese small caps were going up 50% a day as speculators ran in and out of them, and many Chinese large caps had doubles or tripled in the year past.

It was a bubble in the making that we were pointing out. The danger is you don't want to get in front of a bubble, but by November 2007 the "decoupling" theory (foreign markets will thrive even if the US goes to recession) was starting to show flaws and with this shiny new ETF, we had an easy way to bet against China. To nail a long term bubble within a month or two of its top is a heck of an achievement. Let's see how we were "rewarded"

Here is how the iShares Xinhau China 25 (FXI) chart looks from when we began buying the Double Inverse ETF - again it was roughly $58 when we bought. Today? Despite a huge rally in Chinese stocks the past month, it has only bounced to $28. That's a 52% drop, so it looks like an excellent call!

But only if you shorted the FXI....

Because as you see below, our lovely ETF which should be double the inverse - again, should of (conceptually) netted us +104%, instead has fallen from $70 (where we started it in late November) to $40. (note: some capital gains are in that number so maybe the real price is $45, or $50). Let's be generous and say the capital gains added a whopping $10 (or 25% of the current value of the ETF).

So the double inverse has dropped from $70 to $50, or 28.5%, while the index it is shorting against has fallen 52%. So not only did we not get the double inverse (compounded) - 104%... not only did we not get a single inverse - 52%.... not only did we get HALF a single inverse - 26%... we did not even get 0%. We lost money. At $50, a "buy and hold" type would have lost nearly 30%...

Unless you are an extremely adept and nimble short term trader who held this witches brew on the exact right days/weeks and completely sold out all the other days, this is a loser. As is this whole concept of hedging by holding these vehicles - unless you are hedging for only a day or 3-4 days. And the market is going in exactly the right direction and in a very meaningful way.

Now that we have a historical record, we have to reconsider how to hedge; in a real mutual fund - I'd be happy to short the underlying indexes and it would make very large amounts of money for shareholders. Both these calls should have made investors 50%+. Frankly, even more than that since we've been trading them and had much higher stakes when they really fell off a cliff. Instead, despite some frantic trading to avoid the moves that can sap a month's worth of gains in 6 hours with these ETFs, I'm up only $10K on EEV and actually DOWN $4K on FXP. Despite both indexes I've been betting against falling 50%+ since I began these positions. I should be up $40-$60K+ in both considering the position size I've had these at, and how much they've fallen.

As a medium to long term hedge these are useless. They feed into the casino mentality and can make big bucks in very short periods of time which makes the gambling types in the market happy (along with run and gun hedgies), but for the greater investment community who are looking for a way to buy insurance for the long term against your long positions - the history shows they are inappropriate. As more suckers... err people, like me figure this out, I believe these tools will become abandoned except for the extremely short-term oriented crowd and/or during times of extreme duress in the market.

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On a personal note, I was aware of the issue here, but vastly underestimated how much this issue effected the long-term performance. I did realize they only gave double the inverse on a daily basis, but I though I'd still catch anywhere from 60-70% of the move once compounded (and I'd give up 30-40% of the gain) due to this liability. I was willing to give up 1/3rd of my gains since I have no other way to short - as long as I was correct directionally I'd still make money; that was my thinking. Instead I see I am giving up ALL of the move (and in fact one is prone to lose money even if "correct") if your holding period is of any length of time. This was the flabbergasting point. Due to this, I'll be cutting back these positions severely because in a sideways market, they steal from you each day; I'll only use them in strongly downtrending periods. For a long term hedge against long positions, I am not sure there is anything out there of use for those who are stuck in "long only" accounts.

p.s. I've taken a quick look at the Ultra Long versions of these ETFs and they have the same problems... I would make an argument that if you really want to bet against a sector, even better than shorting the underlying Index is short the Ultra long ETF. Not only do you get the drop from the underlying index, but you get the Proshares ETF "Ultra" or "Ultrashort" structural degradation I've outlined above.

So if I could, and I wanted to short Real Estate - short Ultra Real Estate (URE) which would give you a much better return than shorting the underlying index iShares Dow Jones US Real Estate (IYR). Want to see it in numbers? Since November 2007 IYR has fallen from $75 to $35 (a drop of 53%). URE? From $47 to $6 (a drop of 87%). So you get to benefit from the underlying weakness of the sector plus the flaws of the ETF for anyone who holds it medium term or longer. The pain you might suffer when the underlying stocks rallies is compensated by the breakdown in the structure of the ETF. I am beginning to wonder if due to the structure if all these ETFs are destined for a near $0 price in the "long term".

Long Ultrashort Xinhau China 25, iShares Xinhau 25, Ultra Real Estate, Ultrashort MSCI Emerging Markets in fund; no personal position

Comments

[True North_:]

Excellent review and commentary on the ultrashorts. They are only good if you hold them for a very short period. It would be nice if they offered just straight shorts as a hedge.

2008 Dec 29 01:49 AM

[taxbaby:]

Yes, I've had mediocre results using these as hedges in my Fidelity IRAs beginning in January 2008 but they have certainly contributed to keeping my annual loss well below the S&P's 30 something percent decline. This was, however, primarily due to a continuously managed SKFcall position closed completely by the end of October for a 100%+ overall return. (Fidelity made almost $200 in commissions on the 20+ SKF trades alone)

What has been successful though is selling (in my taxable account) way OTM calls (lopsided strangles and straddles) on EEV, FXI during expiration week. I usually had offsetting (taxable) positions in calls on SDS or other US indices including, as mentioned, the SKF.

2008 Dec 29 02:14 AM

[ng:]

The logic is incomplete, I have studied this in detail. FXP failed hedgers terribly, but it could have gone the other way. If the underlying instrument has excess volatility, the ultra-anything will underperform. If the underlying instrument is going in a straight line (like the nov 15 bottom in financials), then the ultras overperform. You have to learn to side step the chop.

It is also possible to rebalance frequently if you want to use it as a hedging strategy. It is better as a directional play.

2008 Dec 29 02:48 AM

[Alan Young:]

Mark, I like many of your articles, but you are barking up the wrong tree this time. It's not the fault of the fund if you used it for a purpose it was not designed for. You could have done the math before committing to a long-term strategy with it. You could have taken profits after you had tripled (!!) your investment. Stop whining and come up with another winning tactic.

2008 Dec 29 02:53 AM

[22thoroughbred:]

even though the explanation is complicated, the premis is not, the article is well written and clear as can be, I have no skin in the game on the ones which you wrote about, I have done very well TRADING the SKF, double inverse financial ETF...all the calculations may be correct, but when the financials are weak and I can make 10-20 points in a day, what is left on the table becomes the cost of doing business, and a cost I have been willing to pay since these are all traded in IRA accts. I figure the non-taxable status of the accounts offset the "cost of doing business" points left on the table

2008 Dec 29 04:33 AM

[buyitcheap:]

The ultrashort/long product gives you 2X the DAILY performance and starts from zero each morning. That is the only extent to which you can measure the success or failure of this vehicle. It is only reliable when it is trading intraday, not after hours, not over the weekend, nothing. It is indeed subject to wild swings, but it is not truly a hedging vehicle. It is a trading vehicle. You've made a classic error: inferring a relationship where there was none.

A better bet is with some of the mutual fund style vehicles that let you participate in the direction of the index you're hedging. It seems (so far) to be more correlated.

2008 Dec 29 07:29 AM

[Alan Brochs...:]

They do in many cases:

www.proshares.com/fund...

On Dec 29 01:49 AM Northern Observer wrote:

> Excellent review and commentary on the ultrashorts. They are only
> good if you hold them for a very short period. It would be nice if
> they offered just straight shorts as a hedge.

2008 Dec 29 08:21 AM

[spiff1971:]

A fool and his money....

You've displayed some amazing skills at understanding where one should put their money, and spots to stay away from, yet, you continue to complain about Double Inverse ETFs as if the problem is with the companies who offer them, not you, the person who presses the button to make the trade.

I dont understand options all that well. So if I bought options, I wouldnt be complaining that its everyone elses fault but my own.

"... in theory an Ultrashort is supposed to give you double that return"

That comment proves once and for all that you did not do your due diligence. You did not fully investigate what you were putting your money into.

ETF firms have been clear that their ETFs aim to provide double the return on a daily basis.

I've made some great returns thanks to 2x and 3x because I pay attention to what I am investing in.

I agree it would be nice if there was a trading vehicle that provided an exact inverse return. It doesnt exist.

The more you write articles like this, and seekingalpha.com/artic... the more you show that your failings as a trader.

2008 Dec 29 09:09 AM

[Luck-o-the-...:]

We've figured out a way to monetize this long term inefficiency.

claruspartners.com

2008 Dec 29 09:43 AM

[DaveW:]

For most of Proshares UltraShorts, it's actually much 'safer' to short the corresponding Ultra. Shorting URE, UYG, EEM yielded a more accurate market picture than did going long SRS, SKF and EEV.
On another note, if one bought and held SRS at ~$60/share back in Jan. 2007 wouldn't said investor begun collecting gains when shares rose above $200? One cannot let greed get in the way of a strategic trade or hedged investment.

2008 Dec 29 10:34 AM

[squark62:]

hedges are only as good as the one who trims them. pairing ultrashort & ultralong proshare ETFs has done wonders for me. hedges are for protecting you from extreme losses, not to make you profits. if you make profits on hedges, it's icing on the cake. take the money and start constructing another hedge.

2008 Dec 29 11:20 AM

[Mike in NC:]

Not a comment but a question . . .
Proshares Short S&P 500 EFT (Ticker SH), is not a leveraged ETF - it should be simply an inverse 1:1 mirror to the S&P. However, from the close 12/22 to the open 12/23, it lost 10% of its value (but the S&P certainly didn't see a 10% increase in value overnight). I have not come across any news to indicate why the ETF shifted in such a manner. Can anyone shed some light on this for me?

2008 Dec 29 11:22 AM

[fjpenney:]

I agree with DaveW. I have developed my own timers and use them to decide when to buy double long ETF's and when to sell. I stick with QLD (2 x the Nasdaq daily) because it works best in conjuction with my US timer. After reading this article I decided to run the numbers and shorting QLD comes out way ahead of buying QID ( -2 x the Nasdaq daily) when I make the timing decisions based on my timer. For example, my timer told me to get out of the US market on 06/11/08. Had I shorted QLD and covered today I would have made 207%. Had I purchased QID and sold today I would have made 72%.

For me the lesson is clear - short the bull 2X ETF rather than buy the bear 2X ETF.

Fred

2008 Dec 29 11:36 AM

[proseadvocate:]

Although there may be some disparity, my personal experience with a double inverse Pro Funds (Russel 2000) was a 60% annualized return. They did exactly what they said they'd do. My first experience before these funds was buying a put option on the S&P in 1986. I doubled my money the first day then watched it expire after losing my gains and premium. Lesson learned is the funds are the way to go or at least for me to go.

2008 Dec 29 01:03 PM

[Augustus:]

I expect that you will have a problem shorting the double longs or the double shorts.

RWM is only 1 X short the Russell. SH is only 1 X short the SPX. SH just had a pretty large dividend.

The recent period of the extreme volatility is what has lead to the tracking errors. Those errors will always be there. Large daily swings make them much worse. Look at the double short oil etf for the worst. Or SRS for another example of the tracking errors caused by the large swings.

2008 Dec 29 03:12 PM

[fjpenney:]

Augustus:

If I use my timer signals to buy or short QLD, since 08/02/06 I would have had only ten trades and would have turned $100,000 into over $900,000. Yes this is backtesting and I may be guilty of optimizing. Instead of buying QID or shorting QLD when my timer gave me a "get of the market" signal on 06/11/08, I bought IEF (iShares 7-10 Year Treasuries ETF) and am pleased with the results.

If others short sell 2X bull ETF's, I would appreciate hearing if it is difficult to do (i.e. does your broker carry sufficient shares).

Fred

2008 Dec 29 03:48 PM

[kotika98:]

You should have read their prospectuses! They have a chart somewhere showing exactly how much the fund is expected to lag its -2x objective given a level of volatility. Another thing concerns the observation that it has optionality/time-decay properties. Indeed, the prospectus is clear that in order to set up the fund they are buying a daily resetting swap from an investment bank. That means they are buying a dynamical hedge for an option of strike at zero daily. IT IS AN EXPENSIVE PROPOSITION!

2008 Dec 29 07:52 PM

[bsharvy:]

The stuff about daily re-balancing is irrelevant. That doesn't explain why the Ultrashorts consistently underperform the Ultralongs. Both rebalance daily. Ditto for volatility. The problem is only with the UltraShorts, as far as I can tell. There is very clear evidence that some of the Ultrashorts don't work as advertised. There is a fair amount of discussion about this at forums.marketocracy.co...

2008 Dec 29 11:35 PM

[bsharvy:]

Yo, defenders of the Ultrashorts, defend this:

Short MSCI Emerging Markets (EUM) 38.20
UltraShort MSCI Emerging Markets (EEV) 3.82

UltraShort FTSE/Xinhua China (FXP): -25%
FTSE/Xinhua China: -55%

UltraShort Oil & Gas (DUG): -23.18%
Ultra Oil & Gas (DIG): -64.21%

These are based on YTD (thru NOV 30) results, as stated on the ProShares Web page.

2008 Dec 29 11:40 PM

[Kunst:]

These ultra & ultrashort ETFs are extremely dangerous if you hold them for any length of time. Run some charts and you will see.

Examples, YTD:
China: FXI and FXP are both down 50%.
Oil industry: DUG is down 25% and DIG is down 75%.
Financials: UYG is down 85%, SKF is up 25%.
Real estate: URE is down 80%, SRS is down 45%.

DOG (ProShares 1x short Dow 30) is up 20%, DXD (same except 2x) is only up 15%. The single-leverage did better than the double!

If you hold on to these ETFs for more than a few days, you are on a losing track. Beware!

2008 Dec 30 01:20 AM

[Daryan:]

I looked at the UYG, and it is a mirrow of the XLF so I am not sure how the double-longs are dangerous as stated by Mark. I do however agree that the 2X and god-forbid the 3X shorts are inefficient as hedging devices. I played with the TZA for a bit, and got burned like everyone else even though I was RIGHT and this was a time frame of a couple weeks at most.

2008 Dec 30 03:07 PM

[sethjs:]

i believe that they paid a dividend overnight.


On Dec 29 11:22 AM Mike in NC wrote:

> Not a comment but a question . . .
> Proshares Short S&P 500 EFT (Ticker SH), is not a leveraged ETF
> - it should be simply an inverse 1:1 mirror to the S&P. However,
> from the close 12/22 to the open 12/23, it lost 10% of its value
> (but the S&P certainly didn't see a 10% increase in value overnight).
> I have not come across any news to indicate why the ETF shifted in
> such a manner. Can anyone shed some light on this for me?

2008 Dec 31 10:04 PM

[taxbaby:]

Quite right, in fact a sizable short term capital gain, inter alia.

www.proshares.com/fund...


On Dec 31 10:04 PM sethjs wrote:

> i believe that they paid a dividend overnight.

Jan 01 10:55 PM

[Qniform:]

The problems with these instruments over time are becoming well known. Still, I like them in my IRA and use the 2x inverse ETFs with close stops - always 3% or less. The reverse moves that eat return are eliminated (at the cost of $10 trades) while the larger moves can run.

Jan 08 01:24 PM

[Tim Jones:]

Something is really wrong in the world when people are complaining about performance in an area these funds ARE NOT IN ANY WAY DESIGNED TO DELIVER.

Let's buy and hold a fund designed for daily performance and then write articles complaining about them.

Cramer and seeking alpha need to stay away from everything but basic stock plays, anything beyond that is outside their understanding.

Feb 12 10:31 PM

[Tim Jones:]

www.proshares.com/fund...

Feb 12 10:46 PM