Beware Short and Ultrashort ETFs 24 comments
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What's the difference between a long ETF and its short counterpart? Theoretically, the price chart of one should inversely mirror that of the other, but as you can see from the charts below that is definitely not the case here.
The first chart is of the USO, the US Oil Fund. (The chart of the US Gas Fund, the UNG, is similar.)
The fund peaked July 11, 2008 and has fallen more than 70% since. Wouldn't it have been nice to have had a crystal ball so that you could have seen this coming and then done the opposite like, say, buy the ultrashort oil and gas ETF?
Let's examine this scenario and see what would have happened. Here's a chart of the DUG, the double-short oil and gas ETF.
The DUG did rise after oil began to implode. It returned more than 140% from July 11 to its peak price reached on October 10, 2008 where it formed a one-day island reversal (an evening doji star in candlesticking). No matter how you look at it, this is a bearish sign. The price turned around and fell 68% since then, but so did the USO. In fact, the USO has only fallen 60% since that date!
So what gives? Shouldn't the DUG be trading through the roof instead of scraping the basement floor right now? That's what one would expect. To clear up this mystery I went to the Proshares website where they explained why their short and ultrashort funds don't always perform the way they should.
There are two reasons for this.
The first, they say, is that their funds are designed to return their stated returns on a daily basis only. Here's their explanation
Leveraged and short funds can be valuable tools for investors who want to manage their exposure to various markets and market segments. But investors considering these funds should understand that they’re typically designed to provide a positive or negative multiple of an index on a daily basis and not for greater periods of time. As a result, fund returns will not likely be a simple multiple (e.g., 2x, -2x) of an index's return for time periods longer than one day.
No kidding!
The second reason they claim is due to market volatility
Additionally, investors should recognize that the degree of volatility of the underlying index can have a dramatic effect on the longer-term performance. The greater the volatility, the greater the deviation will be of a fund’s longer-term performance from a simple multiple (e.g., 2x, -2x) of its index's longer-term return.
In fact, it's this second reason that explains much of the discrepancy between the two charts. Let's look at the market volatility index, the VIX.
You can see that the VIX has had quite a profound influence on the behavior of the DUG—much more than even the oil and gas index that it's supposed to track! Actually, you could almost use the DUG as a proxy for the VIX—who would have thought?
Lessons learned
There's a couple things that I've learned from this exercise. The first, and most obvious, is not to blindly assume that just because a fund says that it tracks the inverse or double the inverse of an index means that over the long haul it actually will. Because of this, one should be very careful of using these instruments as hedges, especially in highly volatile markets.
You learn something new every day. Class dismissed.
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seamusobannion.blogspo...
But, worst of all there are conflicts of interests in the parties give the power to manipulate that expansion and contraction of the shares outstanding. Who is supervising, auditing and regulating these parties?
Be very, very careful with who you are dealing. Know the counterparties and leverage specifics. All ETFs are not equal, especially fixed income.
There are too many ETFs whose internals are controlled by questionable parties. Furthermore, they are recommended by salesman who are clueless and traded by many who are more clueless. A violent market change could have disastrous, uncontrollable consequences.
Like money market funds whose NAV was always to be $1.00 didn't prove to be true so can ETFs not be or have what they are supposed to be and have. The concepts are good it is the structure and parties involved that must be researched and analyze. Too many dilettantes recommending haphazardly recommending them.
Apparently, most people in DUG cannot read. CVX and XOM underpin a huge chunk of DUG's valuation, and, if you look at their PPS, then DUG's PPS makes sense.
What doesn't make sense IMO is XOM and CVX's share price and i suspect they are going to interact with 'reality' in the near future.
The ETF's that actually hold stock in companies are worth considering but when you look at them they all have a dog or two in the holdings.
At the present, I am puzzled by the action in SRS. One day a month or so ago, it dropped by over 70 points. Any reason for that?
Luck o the Irish: Thank you so much for your in-depth and thoughtful comment. I'm not an ETF expert like you so I didn't know that the Dow Jones Oil & Gas Index was more than a pure commodity play. The Proshares website along with MSN Money did not list the top holdings for the DUG which they normally do when there are company holdings in an index. That lead me to think, erroneously, that the index was only tracking oil and gas futures. That was my bad.
And you're correct in that the IYE is the long equivalent. Looking at its chart, however, emphasizes my point even further. Since October 10, it's now down only 7% compared with 68% on the DUG. That's an even more impressive comparison than the USO. BTW, the UCO and SCO are true long and short funds that track the price of crude but they've only been in existence since the end of last November--not enough time for me to evaluate.
You're also right in saying that those with an understanding of how leveraged ETFs work would have probably stayed away from these instruments for more than a day or two during times of extreme market volatility. I don't agree with your “basic” qualifier because those who were supposed to be in the know on CNBC were touting going long the DUG as a play in the drop of oil. How wrong they were!
As for shorting oil, buying puts on the USO would be the way to go, as you suggested. They're liquid and looking at the charts of the February puts, I'd say most folks are confident that oil won't see northward of $29-$30 before next week's expiration.
JE: The OIH is an ETF of oil services companies such as Transocean (RIG), Schlumberger (SLB), and Halliburton (HAL).
Theobannion: If you look at the chart of the DIG since October 10, you'll see that it's essentially flat.
Frank Yans: Hi, Frank. I guess you're still holding a grudge. I told you repeatedly in college that I wouldn't go out with you. In your case, more testosterone (and brains) was definitely needed. It's really sad that you felt the need to find a public forum to get back at me. The saying that is engraved in McCormick hall (the women's dorm at MIT) is: "The odds are good, but the goods are odd." Need I say more?
On Feb 11 08:37 AM Luck o the Irish wrote:
> ok...now seriously. How many more times are we going to write about
> the leveraged ETFs and what they do over the long. Instead of just
> writing about them, how about we profit from them?
> claruspartners.com
On Feb 11 10:59 AM welcome2work wrote:
> yea.....DUG is killing me I've been in it for a couple months....
Now that's amazing!
7/11/08: Close $21.61
2/11/09: Close $209.16
You can do the math.
I'm sorry that you felt that my reading comments here were under my radar. That's completely not true! I have several funds that I actively manage and writing an original blog every day takes up the majority of my time. Every author who posts here does it gratis.
I just want everyone to note that there's probably almost a thousand ETFs on the investing landscape. In the beginning it was the Diamonds (DIA) and the Spiders (SPY) that were the talk of the town..
As for the DTO, it's the double short oil that seeks to track the price and yield performance, before fees and expenses, 200% of the inverse daily performance of the Deutsche Bank Liquid Commodity index - Optimum Yield Oil Excess Return. The fund allows investors to take a short view on the performance of the index. The index is a rules-based index composed of futures contracts on light sweet crude oil (WTI) and is intended to reflect the performance of crude oil. [Description from their website.]
The DTO is the index I should have considered but honestly didn't know about it. I thought the double inverse tracking stock was the DUG. But the DTO is where it's at, baby, and you know it! Up 280% since October. It seems to inversely track the USO.
No options on it, though.
Thanks for everyone's comments.
Happy V-Day!
Dr. Kris
How long do you think it'll take SIRI (Sirius/XM) to go bankrupt. I am a former investor and I'm curious to hear what you think.