Is SDS a Way Around Market Volatility?

If there’s been one constant for investors over the last year, it’s been volatility. In October, the S&P 500 – an index known for its stability – hit record volatility as options traders predicted annualized price fluctuations of over 73%. Market volatility has been a constant concern for investors who want to risk money in today’s market.

That’s why the Rhino Stock Report added the ProShares UltraShort S&P 500 ETF (NYSE:SDS) to the model portfolio in a Rhino Alert sent out to subscribers on January 14. Unlike most of the newsletter’s recommendations, however, this one doesn’t fit the Rhino Stock mold. So why’d we add it?

SDS is an exchange-traded fund (ETF) that’s designed to return twice the inverse of the S&P 500 on a daily basis. What that means is that when the S&P is down 2%, SDS is up 4%.

This provides a nice hedge for our portfolio to battle the market ebb and flow that’s lopped a couple of points off of our portfolio since the first week of January. But that doesn’t mean that SDS is a “set it and forget it” investment that you’ll want to hold for the long term.

Because the ETF moves twice as far as the S&P 500 on any given day, it’s wise to keep this one in check – a market rally could cause this position to drop like a rock. Likewise, there’s always tracking error to think about.

Since ETFs like SDS (or some other members of its fund family) are designed to track an index like the S&P 500 on a daily basis, some pretty big tracking errors can pop up when you hold these kinds of funds for the long term. According to ProShares,

There are several reasons [why this occurs], but the most significant one is index volatility and its effect on fund compounding. In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted effect.

The volatility factor is one of the reasons that SDS is best in breed – and one of the reasons it was the fund I chose to add. Like I said before, the S&P 500 is known for its stability; that means that fund compounding has minimal effects on this fund. Other more volatile funds, like the ProShares UltraShort Financials (NYSE: SKF), have historically diverged significantly more over the course of a longer-term holding period.

Nevertheless, long-term tracking error continues to be a concern for our position in SDS. While the fund does a good job of evening out some of the more outrageous bumps in the market, it’s one stock that we won’t be holding for long. I'm hoping to wind out of it on early signs of market strength.

While an ultrashort fund like SDS can be great when the market's performing poorly, it can be a terrible burden when things are going well.

Disclosure: SDS is a long position in the Rhino Stock Report’s model portfolio.

Comments

[San_Fran_Sam:]

Better do your research kid. If i understand the pitfalls of the Ultrashort ETFs, it is that volatility kills you. There have been two posts on this subject at SA in the last two days.

They perform as adverstised, 2-for-1, only on an intraday basis.

Feb 12 11:59 AM

[ETFDesk dot...:]

Jonas, great thoughts. You may also want to check out the new Vix ETNs; VXZ and VXX.
ETFDesk.com

Feb 12 12:01 PM

[davboz:]

Seems like something to be prepared to react to in order to maximize benefits.
Uh, SanFran,...there's more than he's telling you. There are optimum proportions. You wouldn't go equal weight. Maybe roughly $2 SPY to every $1 SDS.

Feb 12 12:30 PM

[San_Fran_Sam:]

Davboz, Jonas --

You're right. i sent this thing off before reading the whole post thoroughly. He does mention the tracking error problem towards the end of the article.

My bad.

Feb 12 01:06 PM

[Jonas Elmer...:]

San Fran, like the article says, volatility is what creates the long-term distortion between an ultrashort and the index it tracks. The S&P's relative stability makes SDS best in breed of the ultrashorts - its distortion has been minimal over the last year.

Also, like davboz says, the proportions you hold in your portfolio matter big time. It's a hedging tool. For us, SDS makes up only 13% of the Rhino Stock Report's portfolio and it's done a good job of achieving its objective thus far.

Feb 12 01:07 PM

[tunaman4u2:]

If you bought both SSO & SDS the total value would be...
SSO + SDS = 132 in Feb 14th 2008
SSO + SDS = 101 in Feb 14th 2009

You would have made big cash shorting BOTH equally in 08 correct?
Will they continue to have a huge decay over time because if so it looks like shorting both over the long term is a pretty safe way to big returns.

What am I missing?

Feb 12 06:08 PM

[Jonas Elmer...:]

Sorry tunaman,
SDS has gained 21% since last February, so shorting it wouldn't have turned out very well. The only reason your portfolio would have made money is because SSO got creamed so badly (-68% over that period), not because they BOTH went down.

(note: it was ONLY 21% because of that volatility error we've been talking about)

Feb 12 06:42 PM

[tunaman4u2:]

So it would have worked overall though? Shorting $1,000 of BOTH SDS & SSO for a total of $2,000 would have left you $2,470 for an overall profit of 24% using your numbers right?

The market could go wherever the hell it wants to but since this funds keep sucking away over the long term couldn't a long term short of both equally keep profiting from that?

Feb 12 09:40 PM

[Jonas Elmer...:]

Oh, I see what you're getting at tunaman... a sort of ultra ETF arbitrage. While that would work great in a down market, like the one we're in, that method breaks down when things go up. Nice thinking though.

Feb 12 11:10 PM

[oldman:]

how much are you willing to loose while holding for a down market? Maybe puts on the index should also be considered.

Feb 13 09:51 AM

[Jonas Elmer...:]

Puts could be a good idea, but beyond the newsletter's limitations.

Feb 13 11:45 AM

[User 356830:]

you people need to read the prospectus. These are a day trading tools only. Don't ever - ever - hold an onvernight position in a leveraged or inverse ETF. That is not what they are desinged for and they admit that in plain English. Quit publishing garbage about these products being some kind of hedge. If you are hedging with these intraday, great. But flatten out before the close or you are not using these correctly.

Feb 13 08:16 PM

[omooc:]

Barron's has covered the problem of reverse 2x ETFs on several occasions. While I understand the end result (not SDS; Barron's used other ETFs), I am at a loss to understand the internal logic why reverse 2x does not work over an extended period of time (say, a month). For intra-day validity, does that mean one should close out at the end of each day? Then what?

Feb 13 08:19 PM

[User 356830:]

On Feb 13 08:19 PM omooc wrote:
Then decide where you think where the market is going on day 2, and get out by the close.

> Barron's has covered the problem of reverse 2x ETFs on several occasions.
> While I understand the end result (not SDS; Barron's used other ETFs),
> I am at a loss to understand the internal logic why reverse 2x does
> not work over an extended period of time (say, a month). For intra-day
> validity, does that mean one should close out at the end of each
> day? Then what?

Feb 13 08:27 PM

[Jonas Elmer...:]

You're Kidding: Sorry to hear that you lost money last year. I'm happy to discuss the virtues (or detractors) of SDS, but is the name calling and profanity really necessary? We're all grown-ups here.

Best in breed means that of all the ultrashort funds out there, SDS is the least volatile. While that may seem hard to fathom after losing 33% in such a short time, just take a look at some of the other ultrashort ETFs (like SKF). Their distortion is wildly greater than SDS.

Like I said in the article, SDS isn't a set it and forget it stock pick... you have to watch this one, or at the very least place a stop loss.

My subscribers are up around 3% right now on the position in about a month while the S&P has dropped just over 1.5%.

Feb 15 11:26 AM