Unconventional ETF Profit Extraction: In 2 Years UDOW +134%, S&P Is Riskier And Only +43%

Oct.26.13 | About: ProShares UltraPro (UPRO)

You probably know how "unconventional energy extraction" (fracking) is revolutionizing the oil & gas industry and is rebalancing the US national import-export trade economics.

There is a parallel "unconventional profit extraction" opportunity available in Exchange Traded Funds (ETFs) that can reshape your retirement or other wealth-building plans.

You know the conventional appeal for Exchange Traded Fund investment:

The safety of diversification

The ease of investment

The clear, defined investment themes

The stability of holdings

The low price volatility

The simplicity of portfolio construction

The close-to-market pricing . . .

All fine for the piggy-bank, conventional "long-term" buy-hold-and-forget investing crowd, with other diversions on their mind and determined aversion to mental exertion. "Passive" investors, fearful of getting paid for taking any avoidable perceived risks.

In the field of study known as decision theory, an important, if not essential, piece of information is "the value of perfect information." The table below provides a history of what that has turned out to be, after the fact. They can be useful reference points, not target objectives.

ETFs, like any market-traded equities, provide ample opportunities for "active" investment, using the leverage of time-passage that is so grossly wasted by the "passive" establishment herd. Here are several examples of what major ETFs have been doing to "ostrich" investors with their heads in the sand, the clouds, or other places, while they ignore interim market movements:

Here's where those numbers came from

The calculations were done by downloading from Yahoo Finance the entire available history of prices for each of the ETFs. This is one time you can try it at home.

In Excel or any other worksheet analysis program, find the 252-day spans of highest [max] and lowest [min] ETF price, subtract min from max and divide that by min to get a decimal percent range for each day going forward through time. For SPDR S&P 500 ETF (NYSEARCA:SPY) my data started on 1/29/1993 and ran to 10/23/2013, or something better than 20 years. But since the calculations consume a year to get to the first usable point of data, there is only close to 19 3/4ths of a year left. For most pension-fund-consultant wonks, that ought to be long enough to find some useful notions.

The table shows what a simple arithmetic average of these 1 year long (252 market days) ranges have been (all 4,970 of them). Let's not forget about the fellow who drowned while trying to wade across a pond that was only two feet deep on average. I get this picture of what that price range history looks like over the 19+ years. It is One piece of "perfect information" in the challenge facing us.

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The next piece answers the question of "how much of that range actually clung onto the price at the end of that year?" To get the answer, for each 252-day period, divide the last day by the first and subtract 1 for the decimal percent gain or loss. Here we are interested in looking at typical one-year experiences, not trying to find out what the compound annual growth rate is, so a simple average suffices. (For the still curious, the geomean of all the 1+change values for SPY is 1.0645 or a +6 1/2% annual average price growth.)

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Well, if the average range for SPY has been 31.4% and the average gain is only 8.2%, what happened to the other +23% of price movement? It must have been a decline, at least from the high of that year. With "perfect information" known, that value loss need not have disappeared. So the (gross) value of perfect information in the case of SPY during this time was over 23% a year. That is almost three times (3x) the buy-and-hold value captured yearly on average.

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Looking at the other ETFs in the table, calculated the same way as SPY, we see even larger opportunities. But what is the cost of trying to capture them? Can it be done at all? Many say it can't. Many more say they don't want to be bothered to try. It is from the "many more" that "unconventional ETF profits" can be extracted.

Here is how we propose to go about it:

Precisely defined shorter-term active investing.

This is holding-time limited, specific gain objective targeted, disciplined commitment of capital when pre-defined conditions specific to qualifying stocks or ETFs are met, and only at such times. This is not bet-on-a-hunch, take-a-chance, feel-confident, trading.

Does that sound like a snake-oil pitch for "market timing"? It should, because it is, with very good justification, as we have tried to make clear in these prior articles and this.

We have ample evidence that market professionals have developed keen insights into the probable behavior of big-money fund manager clients and act in their own self-interest in ways that can be translated into effective price-range forecasts. So we propose to use their insights to select those points in price and outlook that produce high odds for profit success.

We can use our experience of daily monitoring the market-makers' [MMs] implied price forecasts for over a decade to learn in which issues they seem most adept, and under what conditions of imbalance between upside and downside expectations. Knowing the value of perfect information in various ETFs helps identify where the profit opportunities are most likely and largest in size. Here are some preliminary suggestions.

The time period chosen here is forced upon us by the desire to involve the ProShares Ultra Pro Dow 30 (NYSEARCA:UPRO) a (3x) leveraged-long ETF, which has been trading only in the time period indicated. It illustrates how well the notion of time-disciplined active investing practice produces profit opportunities that are far beyond any generally considered as possible by the mainstream investing establishment.

The effects of leverage on the "Diamonds" SPDR Dow Jones ETF (NYSEARCA:DIA) is seen in the ProShares Ultra Dow 30 ETF (NYSEARCA:DDM) at (2x) leverage, and UDOW at (3x).

The DIA's average 1-year price range is doubled in DDM and more than tripled in UDOW. Trend price growths are likewise multiplied, as is the disparity between trend gains and ranges.

Here is how the MMs have seen UDOW's prospects over the last 6 months, daily:

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The vertical lines are the ranges of price that MMs are willing to pay for protection against having happen, by means of taking hedging positions. The heavy dot in each line is the contemporary market price at the time of the implied forecasts. Colors indicate when those prices are at or near forecast extremes. A universal metric, the Range Index, tells what percentage of the forecast range lies below the current price. When price is below the range, as it occasionally is here, the RI becomes negative.

The market's cyclical nature in this time period is clearly reflected in the oscillations of the market pros' expectations. The behavior is emphasized by the (3x) leverage built into the ETF's structure. Given this kind of insight, it is clear that price volatility is far more than the "risk" bogeyman pretended by "Modern Portfolio Theory."

Astute attention to forecast proportions, and to expectations shifts, turns volatility into rewards often far exceeding the longer-term growth trends, "Alphas," so avidly sought by conventional investment practice.

Expanding the 6-month daily display into once-a-week excerpts of the daily data into a two year long scene provides a bit more perspective. The following picture reveals the recurring nature of the MMs' insights, even as trend growth is occurring.

Reassuringly, even market professionals do not have perfect projection credentials. The markets are subject to such a wide variety of influences, and ultimately reflect the thoughts and actions of humans under varying pressures. So perfection is not only impossible, but quickly becomes suspect, post-Madoff.

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It is important to keep in mind the differences between these pictorial records of forward-looking expectations, and the traditional investment "charts" that only look back in time at actual prices fixed in the past. "Technical" investment analysts like to believe that they can discern patterns in prices that have some recurrence in the future, but very little statistical study has been performed to substantiate that notion.

Instead, we have kept elaborate records of the implied forecasts at the time they were made, for over a decade daily, noting the actual subsequent price events over the next three months, and longer. These actuarial records provide odds for profitable results, and sizes of probable price changes, that are helpful in considering selection preferences and choices between candidates for investment portfolio holdings.

We offer one illustration here, contrasting the buy and hold result of an investment in the SPDR S&P 500 ETF with a time-disciplined active investment program in UDOW over the last two years. Here is what their price progress has appeared to be:

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The active investment discipline simply bought a position in UDOW only when its Range Index was essentially at zero, or at the bottom of its then current forecast range. The position was to be held no longer than 3 months (63 market days), unless the market price rose to or above the top of the forecast range, at which time it would be liquidated. The now available capital would wait for the next similar commitment opportunity, whether timed out or targeted out.

During these two years, there were twelve instances of Range Index qualification, but half of these occurred before a prior commitment had reached its point of liquidation, so only six investments could be experienced. All of these reached forecast-top sell targets, and no losses were incurred. Further, since buys typically occurred at times of market constriction, price drawdowns were rare, despite the ETF's structured leverage magnification. Average worst-case drawdowns were only -4%.

The gains of +24%,+11%,+13%,+13%,+16%, and +14% compounded into an aggregate gain of +134% over the two years. During the same period, a buy and hold of SPY rose in price by +43%. Given the (3x) leverage of UDOW, its slight superiority over 3x43 or 129% seems trivial until two other investment dimensions are considered.

First is the matter of risk, in the form of price drawdowns. The SPY continuing commitment exposed its capital to intermittent drawdowns averaging -7.5%, nearly double that of the UDOW experience. A loss potential that might have to be incurred in the event of some unexpected emergency at any point in the two years, instead of during only the half-year when the UDOW holdings were in place.

And then there is the matter of what could be done with the liberated UDOW capital during the roughly 3/4ths of the two years that it was not committed. How much more could it earn? This is where the value of time makes its mark very strongly. In annualized rate of return terms, there simply is no contest by the buy and hold approach.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.