Arbitrage Opportunity in Ultra ETFs

Includes: SDS, SSO
by: Robert Zingale

Since 2006, ProShares has offered Ultra ETFs that have exposure to twice the daily exposure to certain underlying indexes. These ETFs can either be long or short the daily index. These ETFs are able to track the daily inverse by using financial instruments that allow them to use leverage.

ProShares Ultra S&P 500 (NYSEARCA:SSO) assets comprise of:

  • $2.436 billion in S&P 500 Swaps
  • $.392 billion in S&P 500 EMINI Futures
  • $2.351 billion in the underlying equity of the S&P 500 index
  • $.238 billion in cash

ProShares UltraShort S&P 500 (NYSEARCA:SDS) assets comprise of:

  • -$6.568 billion in S&P 500 Swaps
  • -$.519 billion in S&P 500 EMINI Futures
  • $3.543 billion in cash

The problem with these Ultra ETFs is that their long-term performance will diverge from the underlying performance of the index that they track. The reason for this divergence is the fund’s use of leverage and volatility in the underlying index. The leverage used in the funds successfully allows them to track the daily price movements of the indexes that they are supposed to track, but leverage will also play against them over multiple periods if the index is extremely volatile. The charts below illustrate the problem with these ETFs. The SSO tracks twice the daily movement of the S&P 500.

As the above charts demonstrate, SSO will successfully achieve 2X the daily price movements and 2X long-term price movements only when the underlying index has successive returns. If the index demonstrates any volatility, the returns of SSO will diverge from 2X the index.

Both the SDS and SSO have a downward bias due to volatility in the markets. The below chart illustrates the potential divergence given large market volatility.

Empirically, these indexes have displayed these divergences over the past several years. An investor can take advantage of the effects that volatility has on these ETFs by constructing a portfolio that would leave an investor with theoretically no daily volatility. As displayed earlier, SSO is approximately half invested long in swaps and futures and half in the underlying equity of the S&P 500 index. SDS is only short swaps and futures in the S&P 500 index.

An example of the arbitrage portfolio would consist of shorting $100 SSO, shorting $50 SDS, and buying $50 of the S&P 500 index. This would leave an investor with approximately a $50 short exposure of long S&P 500 swaps and futures, a $50 short exposure of short S&P 500 swaps and futures, a $50 short exposure of the equity of the S&P 500 index, and a $50 long exposure of the S&P 500 index. The short-short and short-long exposure of the swaps cancel each other out to be market neutral, and the short-long and long exposure to the equity of the S&P 500 cancel each to be market neutral as well.

Constructing this portfolio would leave an investor with small daily price changes but gains in the ending of the portfolio. Looking at the hypothetical situation above, an investor could expect to make (.5*5% + -1* 8.13% + -.5*-14.69%) or 1.715% plus the interest earned on the short margin.

Because this strategy involves $150 in short and $50 in long exposure, an investor can earn the risk free rate on the excess cash. This strategy essentially allows an investor to borrow free money to invest elsewhere.

The line graph below demonstrates the returns that this arbitrage portfolio has displayed over the past several years (Line graph shows adjusted closing prices). During 2007 this portfolio (purple line) performed poorly, because there was little volatility and only upward movements in the S&P 500 index. Once the markets became volatile in 2008, the portfolio turned positive and has returned upwards of 40% over the past 3 years.

Given the recent uncertainty in the financial markets, this portfolio may be attractive for an investor seeking returns that are not correlated with the market.

Disclosure: Author currently has no exposure in this strategy, but will likely in the near future