Ultra ETF Promises Fall Short 36 comments
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When I first came across ProShares' UltraShort ETFs, I thought they were a brilliant idea. They seem to promise a multitude of advantages for investors:
- The ability to hedge market or sector exposure without having to go short. (Going short requires a margin account, and US law prohibits the use of margin in most retirement accounts.)
- They should have a better risk profile than shorting. With an UltraShort, you can't lose more than your initial investment. With true shorting, the potential losses are unlimited. As the underlying index rises, each percentage gain creates a smaller dollar fall, while successive declines in the market index should produce successively greater gains.
- They should tie up less capital than Short ETFs for a similar effect.
- Unlike with option strategies, there is no need to choose an option expiration date by which the market move will have occurred.
Unfortunately, it's not so simple. All Short, UltraShort, and Leveraged ETFs under-perform the seemingly equivalent long or short position in the underlying index, and the underperformance will be worse the greater the leverage and the more volatile the underlying index. This is stated in the prospectus, but the fund sponsors understate the magnitude of the problem.
I'm far from the first person to write about this. In fact, I made the mistake of including an UltraShort ETF in my 10 Clean Energy Stocks for 2009 as one option for a market hedge, because I feel that the downside risks for the market as a whole this year outweigh the upside potential, and I expect that many of my readers may not be using margin accounts. The other possible hedge I mentioned was to "reduce the allocation to large cap stocks" elsewhere in the portfolio. In some ways, my inclusion of SDS in the list was fortunate, because a commenter trashed UltraShorts, and brought the problem to my attention.
The Bad, The Worse, and the Appalling
Others have done a decent job of explaining why leveraged funds underperform, as well as looking at the evidence in the historical data, but despite considerable time on the subject with Google, I have not seen any quantification of the penalty an investor in these funds will pay. So I did an experiment. I put together a spreadsheet which randomly generates a year's worth (200 trading days) of data from an index for which the daily percentage move follows a normal distribution, except the last 10 days which are calculated to bring the index back to its starting value.
I recalculated my spreadsheet about 30 times each for 1%, 2%, 3%, 4%, and 5% standard deviation of the distribution of percentage changes in the underlying index. The table below shows the range of percentage losses I observed for each type of leveraged ETF. I was a bit surprised to note that Short ETFs and Ultra (x2) ETFs had approximately the same underperformance, while UltraShort (x-2) and Triple (x3) leveraged ETFs also seemed to have the same long term underperformance/frictional losses.
Mostly, I was appalled.
| Standard Deviation of Daily Index Returns | 1 Year Leveraged ETF Underperformance / Frictional Losses | |||
| Short (x-1) and Ultra (x2) | Ultrashort (x-2) and Triple (x3) | |||
| Min | Max | Min | Max | |
1% | 1% | 4% | 4% | 8% |
| 2% | 7% | 13% | 18% | 26% |
| 3% | 14% | 24% | 34% | 53% |
| 4% | 24% | 43% | 64% | 74% |
| 5% | 32% | 60% | 67% | 96% |
Examples
I feel the need to give examples of how to read the above table, because some readers might suspect that they don't understand the results. I did the calculations myself, and I can barely believe them.
Based on data from October 22, 2008 to January 26, 2009, the S&P 500 had a daily standard deviation of 3.62%. If you were to invest in SDS, an UltraShort ETF which has the S&P 500 as its underlying index, and were to hold it for a year, you should expect to lose between 34% and 74% of your money, if the S&P 500 is flat for that period. This assumes that there are no transaction costs, and that the expense ratio is 0% (in fact, it's 0.91%.) My experiment also assumed that daily stock market returns follow a normal distribution. In fact, the the distribution of daily stock market returns is leptokurtotic (it has fat tails.) According to my mathematical intuition (the Ph.D. is in math, in case you were curious,) if I had performed the experiment with a leptokurtotic distribution, the losses would have been larger. Obviously, this could be checked, but the results are bad enough as it is.
To put this another way, if your frictional losses were in the middle of the 34-74% range (55%, including the expense ratio,) the S&P 500 would have to drop 27.5% (=55%/2), for you to just break even. In 2008, the S&P 500 fell 39%. If you wanted to make a profit by buying SDS on January 1, and holding it until the end of December, the S&P 500 would have to fall from $903 on January 1 to below $654 by the end of the year. You would do much better (by limiting your potential losses and making profits on a smaller drop in the S&P 500) by buying December 2009 puts on SPY, an unleveraged ETF which tracks the same index.
It simply does not make sense to hold these funds for anything more than a few days (if that.) The S&P 500 is one of the least volatile indexes around, so the example above is a mild one. One reader of my recent crude oil speculation article suggested that I use DXO (an Ultra) or ERX (a Triple) instead of OIL. Using historical data from October 23, 2008 through January 28, 2009, the daily volatility of OIL was 5.18%, implying a 67% to 96% loss in ERX over the course of a year if crude oil prices do not rise. Although I expect oil prices are headed up, I'm not willing to bet it will happen in the next couple of weeks (over which time an investor in ERX might expect to lose 1-2% if crude prices did not rise.)
It is worth noting that current volatility is much higher than it has been historically. However, volatility always goes up in bear markets, precisely the time I would want to use these as a hedge.
What Can You Do?
Short and UltraShort ETFs are not appropriate for creating a long (or medium) term hedge. In a brokerage IRA, the only effective hedging option I can think of is to purchase long-term puts, or to sell covered calls on the positions in the account. Both these strategies require option trading authority, which most brokerages will grant to experienced or knowledgeable investors.
I have avoided buying puts in the past because they, too, lose value over time. However, if hedging is important to you, the time-value loss can be minimized by buying deep in-the-money puts, at the expense of tying up capital and increasing your potential losses. Selling covered calls is a strategy I use frequently, but this is more of an income-producing strategy. The potential of covered calls to offset a large loss is limited.
If you can, however, it's probably better to create a hedge for the positions in your IRA in a taxable margin account, where many more tools are available.
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On Feb 12 06:01 PM tunaman4u2 wrote:
> Interesting question... if they both continue to underperform over
> the long run couldn't you technically short both of them long &
> make out like a bandit?
> Like my example before
> SSO + SDS = 132 in 2008
> SSO + SDS = 101 in 2009
> You would have made big cash shorting both in 08. Could you short
> again in 09 with the same results seeing as they are set up to fail
> long as you say?
1) if you own equities in the underlying leveraged etfs, it's makes sense to own the inverse for more than a day. otherwise the leveraged position is 'naked' - you've heard the saying when the tied goes out you'll see whos been swimming without their shorts. long or short - the some applies.
2) the other way to hold these etfs could be to hedge by arbitrage. this is the main reason i buy leveraged etfs and i always hold them in pairs. to maintain the hedge, the weight of each etf in the pair is periodically adjusted to achieve my hedge objective. plan your work and work you plan.
DO NOT HOLD THIS FOR A YEAR. IT IS A SHORT TERM TRADING TOOL, WHEN THE HECK ARE ALL THESE SO CALLED SMART "BLOGGERS" GOING TO GET IT????
On Feb 13 10:16 AM ETFexpert wrote:
> If you were to invest in SDS, an UltraShort ETF which has the S&P
> 500 as its underlying index, and were to hold it for a year,
>
> DO NOT HOLD THIS FOR A YEAR. IT IS A SHORT TERM TRADING TOOL, WHEN
> THE HECK ARE ALL THESE SO CALLED SMART "BLOGGERS" GOING TO GET IT????
>
>
>
"In a brokerage IRA, the only effective hedging option I can think of is to purchase long-term puts, or to sell covered calls on the positions in the account."
Translation for anyone not familiar with options synthetics: "In a brokerage IRA, the only effective hedging option I can think of is to BUY long-term puts, or to SELL long-term puts."
Selling calls, and buying stock. Graph the position at expiration, compare to a long put, and explain how these are both good hedges. In fact, assuming that someone is long stock, buying puts with long stock is synthetically buying calls...selling calls and long stock is synthetically selling puts...and buying calls and selling puts is synthetically...long stock! So if we split the difference, and did both (bought some puts and sold some calls) we would have a brilliant hedge for long stock. Long stock!
"So if we split the difference, and did both (bought some puts and sold some calls"
should be "bought some calls and sold some puts"
Please note......Under the EXAMPLE section of this piece written by Tom Knorad. The first full paragraph starting with.... Based on data from October 22, 2008.......
Read that section where the author says " and were to hold it for a year"
Sir, this is what I was referencing.....in my comment re: TRADING TOOL.
Webster's dictionary defines HORSE SENSE as: common sense.....yes sir, I do have COMMON SENSE and know NOT to hold these ETFs for a year.
.
On Feb 13 01:23 PM ETFexpert wrote:
> SQUARK62:
>
> Please note......Under the EXAMPLE section of this piece written
> by Tom Knorad. The first full paragraph starting with.... Based on
> data from October 22, 2008.......
>
> Read that section where the author says " and were to hold it for
> a year"
>
> Sir, this is what I was referencing.....in my comment re: TRADING
> TOOL.
>
> Webster's dictionary defines HORSE SENSE as: common sense.....yes
> sir, I do have COMMON SENSE and know NOT to hold these ETFs for a
> year.
>
> .
So, either one of three things is true. Either the author is misusing the ETF's, or ETF's are misleading the investing public.
The third thing, and this is what I fear most, is both are partially correct.
And how do I resolve that?
that is the problem. you TRADE ETFs and ETNs. the fat tails are why you make money...it is the volatility that causes the gains.
otherwise by a SPIDER!
think again.
Politics won't allow that to happen.
OPEC will have a RIOT.
No company will sell anything below cost.
I am a complete novice trader - was thinking of taking a punt on oil and was researching ways to invest - I came across UCO, DXO and CRUD ... after reading this article I am not too sure about leveraged ETFs ...
If i purchase DXO and hold and oil goes up by $10 -$20 this year - please simplify for me if it would still be a bad move to buy DXO and hold ..
thanks
On Feb 19 08:52 AM IJF76 wrote:
> Hi all,
>
> I am a complete novice trader - was thinking of taking a punt on
> oil and was researching ways to invest - I came across UCO, DXO and
> CRUD ... after reading this article I am not too sure about leveraged
> ETFs ...
>
> If i purchase DXO and hold and oil goes up by $10 -$20 this year
> - please simplify for me if it would still be a bad move to buy DXO
> and hold ..
>
> thanks
Short sellers can't fool around with it.
Check June 2008, DXO was at $26+ level.
One international incidence can push oil up $20 easy.
Gamble ? yes, but when play with stocks, it's all about gambling.
Common sense counts.
ETFs provide a stock type of time frame.
I am not a day trader, I remain a Buy and Hold person. So, my question is: Can an ETF expire, is there an attached lifespan on any ETF?
About Ultra Long and Short ETFs: Here is an article that suggests it is not prudent to use Ultra Short ETFs in IRA accounts for long term trading due to the slippage:
www.tradingstocks.net/...