Benefit from Ultra ETFs' Tracking Error

Ultra ETFs have become very popular, but can destroy your portfolio if you are not careful. Most of these seek to ‘double’ the daily movement of the underlying security or sector. The important word in this description is ‘daily’ not ‘double’; these are not long-term investment vehicles! It seems like this should not present a problem, but simple math will explain how “tracking error” will erode your equity in a choppy market.

The figures below explain:

Use your calculator to divide 100 by 1.1=90.91

Multiply 90.91 x 1.05= 95.46

Divide 95.46 by 1.07=89.21

Multiply 89.21 x 1.12=99.92

Now do the same exercise, but double the amount of daily movement.

Your answer is 99.69.

In four market fluctuations of less than 20%, an investment in an Ultra ETF just lost .23% in ‘tracking error’. This little test explains why I like to ‘short’ Ultra ETFs.

In spite of the market movements, Ultra ETFs always get worth less. The wilder the market, the more the erosion, or ‘tracking error’. Imagine the thousands of transactions that occur in one day, the multiple fluctuations in price that are inherent in just one day. Now multiply that over many days or months.

These are NOT long-term investments. These are trading vehicles. If you are going long with any Ultra ETF, it should be held only for the short term, and hopefully while it is moving in one direction.

Even for a short-term position, why not short an Ultra ETF to take advantage of the ‘tracking error’? Take any advantage available, For example, to trade on the rise of the S&P500 you could buy the SSO Ultra ETF; this ETF seeks to double the daily movement of the S&P500. To take advantage of the tracking error, short the SH (Ultra Short S&P500). This Ultra ETF seeks to double the daily movement of the S&P500 inversely. As the 500 goes up, SH goes down twice as fast. You short sale it and buy back at later for less. The ‘tracking error’ will give you a little extra profit.

ETFs are great trading vehicles, but more importantly, some of the ETFs are great investment vehicles with a low average 0.08% expense fees. The alternative many investors use are mutual funds, these investment vehicles carry an average management fee of 2.2% A mutual fund cost 27 times the expense ratio of the average ETF. Is the cost worth the benefit? Can you manage your investments, cut costs, and improve your return? I believe you can, if you are cautious and always keep two rules in mind:

1. Return OF money.
2. Return ON money.

Every time I favor number ‘2’ over number ‘1’, in other words get greedy, I pay for it. SPY (S&P 500) should be any investor’s favorite. SPY tracks the index, pays 3%, and with elementary trading rules will return good results.

Comments

[dennybt:]

I think you're math ignorant.. If you lose 10% ya gotta gain 11.1111% to get back to even. Down 17% ... up 17% will always fall short. Reverse your calcs to up first then down, and you'll get the reverse answer. Aren't percentages funny. Ya can't add them together and get the right answer.

Jun 02 08:18 AM

[Luck-o-the-...:]

SDS is the ultra short S&P 500. The SH is just the inverse.

Jun 02 09:23 AM

[squark62:]

shorting shorts. why not buy SSO instead, 2X S&P 500? then you don't have to come up with the shares to short the short. can't short equities in retirement accounts and most individual investors don't have the capital to meet short requirements. just thinking out loud. :-)

Jun 02 10:27 AM

[Nikhil:]

SSO suffers from the same slippage as SDS, work the maths and you would see the same underperformance.

Jun 02 03:12 PM

[Baboon:]

Shorting SH as well as SDS for the long-term is a dangerous game. One can lose all his capital if SPY doubles in value.

Jun 02 07:44 PM

[Baboon:]

Correction: Shorting SDS is dangerous if SPY drops by over 50% in value.


On Jun 02 07:44 PM Baboon wrote:

> Shorting SH as well as SDS for the long-term is a dangerous game.
> One can lose all his capital if SPY doubles in value.

Jun 02 07:47 PM

[David Holli...:]

I understand what you are saying and agree with your point. The way I use these ETFs is to leg in to a position and buy more even if the ETF falls. This has worked quite well for me and can lead to rather spectacular results in a bear market recovery such as we are in now.

Jun 03 08:20 PM