Seeking Alpha
Peter F. Way, Blockdesk (708 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
Profile| Send Message| ()  

Our usual approach in most of our Seeking Alpha articles is to provide the do-it-yourself (d-i-y) individual investor with the means of comparing a set of (usually related) alternative investment choices on a common denominator basis. We try in each case to give a full presentation of the market strengths and weaknesses of importance so that the investor can quickly see the market-appraisal tradeoffs involved and tailor choices to fit his/her individual preferences. We stay focused on the impact on market prices of securities from the actions of big-money fund investment organizations and eschew the offered opinions of economists, academics, and sell-side street analysts.

This time we depart from that approach to follow the more usual investment-letter approach of recommending a single "best" (by my standards, so you should pay attention) investment choice of the moment. But we do this only after extensive evaluation and observation over sufficient time to have satisfied ourselves that we really do understand what is at hand, and have come to a rare conclusion that this choice is truly something special, not just an ordinary tout to fill subscription space.

The ETF in question is ProShares Short (Inverse) Vix Short-Term Futures ETF (SVXY).

For those not fully familiar with SVXY specifically, its focus is on the price progress of derivative financial instruments that are awkward to invest in directly. Awkward because of their continuing need to adjust holdings to balance risk exposures with return prospects. At the direct investment level, this is a very sophisticated game requiring constant daily attention and excellent information updating resources. The next few paragraphs may tell more than a casual investor wants to know about how it works and why.

The ETF is structured to take advantage of the occasionally sudden, wide-ranging reactions of an index maintained by the Chicago Board Options Exchange that measures the uncertainty for coming prices of the S&P 500 stock index. Those varying levels of uncertainty are present in the appraisals of market-making investment professionals (MMs) as they hedge the at-risk capital they must commit daily in order to do their jobs. That index is the VIX, or Volatility Index, which cannot be invested in directly, in the way the SPDR S&P500 ETF (SPY) serves investors who want to position investments in the S&P 500 index.

Instead, the futures markets provide transaction capabilities in futures contracts on the VIX. These derivative contracts have limited lives defined by their expiration dates, for the purposes of this discussion, on a monthly basis. The Futures markets elaborate on the CBOE VIX Index by providing both a short-term (one month focus) and a mid-term (few months) VIX Futures Index. The ETF SVXY tracks the Short-Term VIX Futures Index by making daily adjustments between the near month expiration contract and the next month.

The difference in prices between futures of different expirations becomes a key to the dynamics of SVXY price behavior in a peculiarly beneficial way. The SVXY is structured to invert its pricing, compared to the price changes of the VIX indexes, so it is a "short" ETF. Because of the mathematics of daily adjustments performed on leveraged ETFs, and particularly short ETFs, there can be a negative bias induced and this effect persists in the way the short-term (long position) VIX Futures Index is maintained.

The nature of the VIX Index, whether from the CBOE or the short-term VIX Futures Index, is that VIX prices rise when market uncertainty increases (often this is a product of decreases in the general prices of stocks) and VIX prices decline when markets are strong and fears of price declines are repressed. This is how the VIX gets the "fear index" label. But the important point is that SVXY is the short of an inverse price function, or the negative of a negative, a security whose price action parallels, in direction the S&P 500's moves.

The important point about the impact of the futures market VIX Futures ST Index as a price-driver is that it puts an accelerant into the price fire, equivalent to the leverage structured into other effective leveraged long ETFs like the ProShares UltraPro S&P 500 (UPRO). That leveraged effect appears to be even stronger and more pervasive for SVXY than for the 3x-leveraged UPRO when our market-maker implied price range forecast information is utilized as an entry and exit tool for investments.

Leverage cuts both ways, of course, so having reliable guidance as to when to act in making shorter-term investments is essential. Regular readers know that our application of intelligent behavioral analysis to the self-protective hedging actions of Market-Makers provides useful insights into their expectations of coming price change limits. The balance between their views of upside vs. downside prospects has been quite helpful for UPRO, as illustrated by subsequent 3-4 month price changes in the table below, ranked by those upside-to-downside proportions:

(click to enlarge)

This table at the blue-line row takes an every-day purchase of UPRO 1120 times in the last 4 ½ years and shows how its price would have increased over the following 16 weeks (80 market days). The blue-line average annual rate of all 1,120 experiences was +41% when each was held the full 80 days and had larger annual rates of gain in shorter holdings.

The table is constructed to aid in looking for desirable points in time to make buys by cumulating experiences from extreme reward-to-risk balances at the top and bottom. For example, when upside prospects from MM forecasts were at least 3 times as large as downsides (on 174 days) those gains expanded in 80 day-holds to an average annual rate of +103%.

The same presentation for SVXY shows an even stronger performance with more than twice the rate of gain on average for all days of +98% and a selective performance when upside prospects were 3 times the downsides, of a +256% rate of gain. But for SVXY we only have a history of 422 days overall, or just 57 days at the 3:1 level, since that is as long as this ETF has been in existence.

(click to enlarge)

If we compare UPRO over the same exact time period we have a more fair contrast where the average growth rate of all the most recent days was up to the 80-day +68%, but still only 2/3rds of SVXY's +98% at the same point. And the 3 : 1 prospect performance favored SVXY by 2 ½ to 1, +256% vs. +103%.

(click to enlarge)

But the longer history on UPRO reminds us that it is likely that less bountiful market times may be ahead at some point, and it may be wise to avoid high leverage issues when problems present themselves. So it would be desirable to have some sense of warning of their coming.

That may be possible by looking to see what proportion of the days' results were profitable, and under what upside/downside forecast balance conditions problems were most present. For that we revert to the longer-dated history of UPRO, this time looking at what percent of RI-indicated buys were profitable at the subsequent dates:

(click to enlarge)

Well, this may give more encouragement than caution. The best takeaway may be, since SVXY and UPRO have such similar price direction characteristics, is to ignore any less-than a month drawdowns and wait for the 3-4 month holds (65-80 market days) where chances of trouble have been only one in 15 to 20.

Another sense of the SVXY situation at present is to see how the ETFs forecasts have been trending daily in the past six months, and how long it has typically taken to reach their sell targets of the top of the forecast range. First, the recent forecast trends, SVXY, then UPRO.

(click to enlarge)

(used with permission)

(click to enlarge)

Now, a look at how well the market-makers have done in their appraisals of each in the past 5 years, or as long as information was available to work from. We use a test of buy on close of day after RI indication; sell at first market close => forecast day top of range, or at end of 3 months, whichever comes first. The current forecasts in the left-hand columns tell how to distinguish SVXY from UPRO:

(click to enlarge)

(click to enlarge)

The red flag on SVXY's sample size is a reminder that the combination of shorter history and favorable (low) price relative to expectations (RI = 33) allows fewer instances than the 20-25 we usually prefer to work from. But it is not down in the less than ten to twelve range where their credibility is questionable.

At this level of RI, SVXY's experiences have been universally profitable (100/100 = 15/15) and the average time to close out positions has been a mere 23 market days, only two days more than a month. Compounding the average simple percent gains of +18%+ at that rate produces big 3-digit annual rates. In reality, present-level opportunities have only appeared 15 times in 1 3/4ths years, so the calculation may be accurate, but the practical frequency may be some less. Still, it's a pretty attractive wealth-building capacity.

UPRO is no discard, either. But now at its elevated RI level, a choice between the two is apparent. Back two weeks ago, before the Fed's QE taper-trimming announcement, with a RI at 45, its upside might have been marginally better, but its win odds could have been less, with about the same drawdown exposure of its prior experiences.

Our earlier SA article but a month and a half ago showed a Block Trader Forecast chart for SVXY with a top expectation of $139, just where it is now. The comments there on SVXY's future performance still hold. Only time will tell whether SVXY will lose some of its luster, but at present it has some rather unique conditions producing very attractive, frequently-timed investment prospects.

Source: The Now And Continuing Future Star-Performing ETF