It seems to have become popular nowadays to beat up on purveyors of leveraged ETFs, most notably ProShares and to a lesser degree, Rydex, not to mention newcomer Direxion which just launched some triple-leveraged products (upping the ante on the double leverage that’s attracted attention thus far). One has to wonder how many public-relations firms are drooling as they anticipate new campaigns by the ETF providers.
The latest salvo comes from Morningstar, which titled its 1/22/09 offering Warning: Leveraged and Inverse ETFs Kill Portfolios. Come on Morningstar, don’t be shy. Tell us how you really feel! After having just recently panned Morningstar research for what appears to be too much youth and inexperience, I really had no inclination to take another shot, but having successfully used leveraged ETFs, coupled with the stridency of the tone, I felt I really had to point out the flaws in this one.
Facts are facts
What’s interesting here is that every fact asserted by Morningstar and in the other articles it cites (including one that was previously published on Seeking Alpha) is completely correct. For example, Morningstar claims that one who correctly anticipated the decline in iShares Dow Jones U.S. Real Estate Trust (IYR) since 12/31/07 would not have made a killing in the UltraShort Real Estate ProShares (SRS). With IYR having fallen about 40 percent, one would think an ultra short based on similar stocks would rise about 80 percent. Instead, SRS fell a bit more than did IYR.
Wow! If that doesn’t justify a “warning,” what does?
As Morningstar asserts, “these funds have attracted billions of dollars over the past year alone.” Perhaps there’s some cosmic coincidence in the fact that I’m writing this now, after having viewed an hour or so of Boiler Room on cable last night. So I guess we have another example of the suckers running amok within the ignorant Wall Street rabble.
Or do we? Is it possible others are seeing things Morningstar is missing?
As noted, I’ve used some leveraged ETFs (ultra shorts) at various times since they’ve come out, and frankly, I’ve been satisfied with the results. And to tell you the truth, I’m feeling a heck of a lot more pain from my position in Berkshire Hathaway (BRK.B) which, by the way, Morningstar loves judging by its five-star and wide-moat ratings.
Context is king
Critics of leveraged ETFs explain how you cannot assume daily moves (even if they each come in on target) will add up as expected when assessed in the context of multi-period compounding. In other words, an ETF may deliver twice the inverse performance of the S&P 500 on a daily basis, but when you view results over the course of a year, you cannot assume it will work out anywhere close to double inverse. Whether it does or doesn’t depends on the pattern of daily movements. I’m not going to explain in detail. Morningstar and the others do this quite effectively.
My issue is with the grand conclusions (“kill portfolios”) offered by Morningstar: “If you're hell-bent on using leverage for any period of time longer than a day, you'd be better off using a margin account in almost any real-world scenario. This is not an opinion--it's a highly likely statistical probability. And interestingly enough, each successive time you bet against the odds, probabilities tend to become mathematical facts.”
Morningstar doesn’t strike me as the type of firm that would encourage people to load up on margin. Presumably, that was a back-hand way of saying it’s OK to use leveraged ETFs for day-trading. I agree. But I strongly disagree with any assertion (express or implied) that these products are too dangerous for use over periods longer than a day. I also take issue with the tendency of critics examining more than a day to lock in on any fixed holding period. And I suggest that the author has not come close to earning the right to link the phrase “mathematical fact” to the conclusion he apparently wants readers to draw.
Consistent with my own experience and based on looking at data without any sort of “hell-bent” attitude, I maintain that these leveraged ETFs have the potential to fulfill reasonable goals over the course of time periods defined by meaningful directional movements of the target (a market index, a sector, etc.).
What is a meaningful directional movement (beyond a day)?
There is no single good-for-all time answer. It depends on the market. That may disappoint those who cherish simple black-or-white answers. But come on folks, this is the stock market. If anything, anything at all, were that simple, we’d all be gazillionaires. People who need simple black-or-white answers really should stick with FDIC-insured CDs.
While I can’t give an ironclad definition of meaningful directional movement, I can provide some real-world examples.
For purposes of illustration, I’m going to stick with real estate, a topic that, for better or worse, is close to the hearts of many nowadays. As per Morningstar’s examples along these lines, iShares Dow Jones U.S. Real Estate Trust is the bullish play and UltraShort Real Estate ProShares is the bearish solution.
First let’s address the phrase “reasonable goals.” Expecting an ultrashort to actually deliver twice the inverse of the target is not reasonable. Tracking error is part of the picture here to a larger degree than we expect from the more classic ETFs like SPY or QQQQ. The strict definition of tracking error is based on differences between market price performance and NAV performance which, in turn, is based on the underlying index which in this day and age, will more often than not be an index nobody ever heard of that was created solely for use with the ETF in question (that being the case with IYR and SRS).
I’m going to offer a new phrase, strategic error. This will be the difference between the market price performance of SRS and twice the inverse of the performance of IYR. I can’t call this tracking error because SRS is designed to deliver twice the inverse of the index nobody cares about, not twice the inverse of IYR. But measuring strategic error with reference to IYR is reasonable because that reflects how investors think. If I want a bullish equity play on real estate, I’ll buy IYR. If I’m aggressively bearish, I’ll accept SRS as a tolerable approximation of a double short position in IYR. Strategic error will help me assess “tolerable.”
I examined daily price percent changes (adjusted for distributions) for IYR and SRS from 2/1/07 through 1/22/09. That’s 497 observations. I measure strategic error as the absolute value of the difference between the daily percent change in SRS and the daily percent change in IYR multiplied by minus two (I use absolute value because I care only about the size of the difference, not the direction).
Median daily strategic error: 0.44%
Average daily strategic error: 0.71%
Standard Deviation: 0.92%
The maximum figure is pretty high, warning us that we are exposed to some big-time oddball individual days. But it doesn’t happen often. Daily strategic error was equal to or greater than 1% on 104 out of 497 days. It was equal to or greater than 2% only 29 times. In assessing the average strategic error (0.71%), consider that the average (absolute) daily price change in SDS was 4.49% and the median was 2.86%.
So, what about this strategic error? Is it reasonable or excessive?
Excess, like beauty is in the eye of the beholder. In my personal opinion, it’s reasonable.
Within the 497 observations, the worst-case was 7.72%. That’s certainly bad. But as a long-time equity-market participant, I know full well there are many, many, many ways I can get smacked with even bigger and more frequent daily errors on more “respectable” investments (imagine all the hits you took when management of a company whose shares you own reduced earnings guidance).
Now lets’ get down to the main course, looking at some examples of meaningful directional movement.
click to enlarge
So what do you think?
After what the other critics explained, it should come as no surprise to see variation between target and actual SRS. But the question is whether Actual SRS is a reasonable outcome given what you had a right to expect to achieve.
Let’s look at the longest time period, 2/1/07 through 1/22/09. The strategic error is considerable, but if you were using real money, how angry or upset would you be?
Clearly, I’d have been happy that I’d have been right to not be bullish on real estate stocks. IYR lost more than 60 percent. I wish I could have achieved the better-then-100% target SRS return but instead I just broke even since the daily movements didn’t break nearly as well as would have been necessary for me to get the full-period target gain. But look at the time period. Real estate got crushed. The market got crushed. Blue chips got crushed. Lots of things got crushed.
True I’d have missed my target by a county mile. But honestly, if I were to have an opportunity to get into a time machine to buy SRS on 2/1/07 and unravel my Berkshire Hathaway purchase, heck, just try to keep me out.
Moreover, I’d have been perfectly happy to have owned SRS between 5/30/08 and 7/31/08, and between 12/31/08 and 1/22/09. As to the 5/15/08 through 11/20/08 period, holy cow: How great would that have been. These weren’t random intervals. All matched noticeable declines in IYR, meaning SRS could benefitted those who had correctly anticipated the trends.
It would have been different had I been bearish on real estate in December 2008. IYR had a nice gain. SRS, on the other hand, got drilled, much more so than the target decline. But that’s life. I’d have been wrong with a high-risk strategy. I’d have suffered. It wouldn’t have been fun, but I’d have legitimately gotten what would have been coming to me as a result of a decision to go into a leveraged short at the start of a rally.
Would I have been better off if the Actual SRS returns were closer to Target SRS. Absolutely! But they weren’t. What can I do about it? Should I hold my breath and stamp my feet? Nah, I’m too old for that. Should I forego SRS altogether? That doesn’t grab me considering that each accurate expectation would still have been nicely rewarded? (And I’m no more scared of being wrong here than I am with a lot of other things, including Morningstar five-star stocks.) I guess the only thing I really can do is have a realistic understanding of what I’m doing. Hey, that works!
Can it be said that these time periods were contrived to show what I want you to see. Heck yes! The whole point, here, is to show what could be considered meaningful directional moves. Had I been oblivious to that, I’d have been likely to get results that are all over the place.
It is not my purpose, here, to tell you to buy or avoid any particular leveraged products at any particular points in time. Instead, it’s been my goal to refute suggestions to the effect that these products are of no use to anybody (even those who properly anticipate meaningful directional moves) except day traders.
Consistent with what the critics of leveraged ETFs maintain, we cannot assume the target daily return will prevail when we start compounding over longer periods. But contrary to what the critics suggest, these ETFs can be used to properly execute a trading strategy over the course of a meaningful directional movement however long or brief that may be.
Ultimately, I suspect we’d find that the cleanliness of the outcome (i.e. proximity between target result and actual result) will be a function of the length of the period, the persistence of the move, and the strength of the move. (Increases in length provide more opportunities for things to get messed up by counter-trend days, increases in persistence mean we’re less likely to get as many counter-trend days as we fear, and increases in strength enhance the potential for on-trend movements to overwhelm whatever counter-trend episodes we get.)
Perhaps some day I or someone else will quantify such a function. I believe this is the task that has to be accomplished before one’s thesis could be described as a “mathematical fact.”
But we don’t have to get nearly that far for someone who understands what these leveraged ETFs are about and who knows how to align his/her expectations with these realities to benefit from their use. It’s also important to correctly anticipate trends, but that’s hardly unique to these products! And it seems to me that the error and pain to which we would be exposed if we mess up is in line with what should be expected by one who chooses to pursue volatility, and with the sort of pain we so often feel from the more “respectable” investments.
NOTE: There is another important topic that became prominent for leveraged ETFs in 2008: far less tax efficiency than had traditionally been assumed for ETFs. It’s beyond the scope of this article but it is important if you use these in taxable accounts. Fortunately for those who need to know, it’s been very well covered on Seeking Alpha. Here’s a link to the results of a “leveraged etfs distributions” search I conducted here.
Disclosure: Author owns BRK.B