Double-Short Drawbacks

Late Sunday a reader left a question about this article which first ran on RealMoney and then was re-run on some sort of page at Fidelity's web site.

It is written by Eric Oberg and like several pieces he has written for RM it is an in depth dissection of the drawbacks of double short ETFs.

The big story is the day-to-day compounding that can either make holders very happy or make them regret ever buying shares. In the above link he cites an example of iShares Financial (IYF) being up 8% over some multi-month period while the ProShares Ultra Short Financials (SKF) being down 69%. By the way, I am not questioning the math at all.

My only involvement with SKF, or any double short sector fund, was a couple of articles for RM a few years ago spelling out a potential pair trade. The concept I put forth generally "worked" for a while but obviously would have unraveled as we got deeper into the crisis. The only portfolio action I ever took with any double short fund was with the double short S&P 500 (SDS). It did not perfectly track twice the inverse of the SPX but it generally went up over time as the market went down; on days where the market was down a lot it pretty much did what it was supposed to and I was quite happy with the result and the volatility dampening effect on the portfolio.

There are a couple of things I would point out in defense of these products. Clearly, anyone who thinks these funds have collectively malfunctioned has a point. While the objective is for the daily result the example above of plus 8% versus down 69% would be very disappointing, no argument. It is true though that in the same time period, longer really, everything (perhaps a little hyperbole) has malfunctioned one way or another. The spastic movement in equity prices, volatility, commodity prices, currencies, muni yields compared to treasuries and a half a dozen other things perhaps make this a less than ideal time to draw a conclusion.

I would note that in the year ended March 9, 2009, SDS was up 80% while the S&P 500 was down 50%. Obviously not exact (actually if you add the dividends it gets closer to 100%) but of course that is not the objective. Had I held it all the way through to March 9 I would have been thrilled with the result. The reason I stopped at March 9 is because the rally since then has knocked the stuffing out of SDS. The daily reset that occurs will be rough if the market goes up every day for such a long stretch.

Given that the funds worked "better," not perfectly, before things got so out of hand, I believe it is possible that these funds will work better when things normalize, and if they never do normalize then maybe the sector products should never be used. My willingness to use SDS in the future has not been hampered by this in the least.

Comments

[Stone Fox C...:]

Won't all these double shorts end up at $0 some day regardless of whether the market goes up or down?

Apr 14 12:07 PM

[Alan Young:]

Leveraged products work great during a trend. It's volatility that knocks the stuffing out of your results.

SPY YTD -4%, SDS YTD -5.5% --not too terrible; but

IYR -15%, SRS -38% (not a typo: the inverse fund and the index fund both down).

Useful products, to be sure, but NOT for long-term hedging!

Apr 14 12:23 PM

[Roger Nusbaum:]

the firms would say that they cannot go to zero. they do twice the inverse or twice the result (depending on a long or short product) on a daily basis.

So, can an index move 50% in either direction in one day? you're opinion on that would give you your answer.


On Apr 14 12:07 PM Stone Fox Capital wrote:

> Won't all these double shorts end up at $0 some day regardless of
> whether the market goes up or down?

Apr 14 01:39 PM

[Everyday Fi...:]

Based on typical market patterns and inevitable erosion, these generally aren't good buy and hold instruments (constantly deteriorating value on either side); however, if looking to near-term trade a trend with leveraged ETFs, might as well use the triple ETFs - why stop at 2x? I had done a Financials long/short hedged play which worked out great in March; details here.
everydayfinance.blogsp...

Apr 14 04:05 PM

[igggy:]

I can see why leveraged ETFs show odd results. But what about unleveraged inverse ETFs. They seem to have the same problem. Here is SH vs SPY:
finance.yahoo.com/q/bc...
SPY is down 40% but SH is up only 10% or so. I don't get it! There is too much daily slippage even without leverage.

Apr 14 04:50 PM

[wolf411:]

They probably won't end up at zero, but I believe that both the bull and the bear flavor of an ETF will *trend* toward zero in the long term. The higher the volatility, the faster the trend to zero. This implies that shorting equal amounts of both bull and bear flavor, should eventually result in an overall long term gain.

On Apr 14 12:07 PM Stone Fox Capital wrote:
> Won't all these double shorts end up at $0 some day regardless of
> whether the market goes up or down?

Apr 14 06:44 PM

[Gary Gallo:]

Thank You! Finally a sensible argument. Lets remember, higher leverage is always good becuse you can put less money in to make the same return. For example, ive been recommending 95% cash 5% FAS. A move near $25.00 from our purchase price would give us about a 35% return overall. If the market goes to hell in a hand-basket, we loss no more then 5%, thats guaranteed. These are the best thing since sliced bread. People have been doing the same thing with options for 400 years. Talk about not tracking correctly, try premium diminishing to 0. Even if your right but wrong on time. Handle 3X and 2X funds correctly with proper money management, they can be great.

Apr 14 07:23 PM

[carey_jim:]

The volatility of ETF's occurs because of the huge volume of trading in the ETF share itself, such as SRS.

When a very large number of owners of an ETF share, such as SRS (which went up 16% today), decide to take profits then the underlying buying and selling activity in the ETF account becomes distorted.

This happened to SRS last year when it lost about 40% of its value in a period of about four hours of trading even while the underlying value of its stocks was FALLING. (SRS is a double INVERSE fund.)

This process has not been discussed enough here or anywhere else, to my knowledge.

Should we blame government regulators for this lack of information?

The underlying math and risks are not that complicated but the average investor doesn't know anything about them. All s/he knows is that these ETF shares move ten to twenty percent a day and make excellent gambling vehicles.

But for the last twenty five years we've lived in an investment environment where people have expected to double their money every few years.

They expect to be able to do it now too. Without a commensurate DOWNSIDE RISK.

I don't mind keeping government out of this but I do mind the whining and blaming government when they lose their money.

Especially galling is the whining that has come from the banking sector and the shameless bailing out BY THE GOVERNMENT of the very people who HATED GOVERNMENT MEDDLING.

Now we are supposed to believe that Socialism DOES Work and apparently, at least for the last few weeks, the market is convinced!

Apr 14 08:57 PM

[squark62:]

hi roger,

i agree with your assessment of SDS vs other double short ETFs. i would put DXD next on the list of better behaved double shorts followed by QID. beyond that, it's "what's that roulette game called" with a hammer to be sure.

cheers!

Apr 15 01:51 AM

[yk00002:]

The 3x ETFs are excellently behaved. I find FAS and FAZ NAV to be tracking 3x the daily index change very well, with only small price errors over NAV.
If you don't understand the underlying mathematics you should not be trading these ETFs at all. The malfunction is yours. In general, holding any of these for a long amount of time will guarantee poor results. (perfectly explained by the math). If you do it do not complain.
Regarding going to zero: ever heard of reverse splits?

Apr 17 12:42 AM

[Chris B:]

Has anyone done a head-to-head forensic test on 2X or 3X ETF's versus an options strategy? I suspect the options pricing is much more efficient.

Apr 20 04:10 PM

[Zachary Sch...:]

I think the important thing to realize is that these ETF's mimic double the DAILY price movements of the underlying index. Due to the wonders of compounding interest, the long-term return can be quite different than expected even though the Daily movement is accurate (2x or negative 2x the index)

For instance, if a market drops 25% and rises 33% in two days (using an extreme example to make the point) the index would come out flat.

By comparison, the double ETF would drop 50% and then rise 66%. which actually results in a loss of 17% (remember the index was flat after the two days)

Also, the double inverse ETF would rise by 50% and then decline by 66%. That return would result in a loss of 50.5% - also compared to the market index being flat.

So you can see that extreme volatility make these tools less useful to hold, but very useful for quick directional trades.

For more information you can see my post on leveraged ETFs here: zachstocks.com/2009/02.../

Apr 20 04:20 PM

[bobbobwhite:]

All the endless quant detail talk of how and why these 2X ETN/ETF's do not exactly track their sectors do not matter to me! What matters is that I bought DTO and DEE on 10/3/08 and tripled my total purchase dollars until I sold them after they both went sideways a month ago. Aren't profits what we all want? When they stop making money at the rate I want, I sell them. Duh, case closed.

Apr 21 10:53 AM

[Freya:]

Either one would be a suitable inclusion into any portfolio. If you are a Buy and Hold personality on the long side, 10% of your portfolio in SDS would certainly have mitigated your losses.

On the other side, SPY would protect if you were shorting sectors and the Tide turned against you abruptly.

Good Insurance is hard to come by.

Apr 14 02:14 PM