A potentially good idea gone bad - Short-structured ETFs
This analysis is prompted by the intense, but partially-knowledgeable comment-response of another Seeking Alpha reader to my recent article advocating the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) as a defensive investment. This article in reply is not to provoke emotional combat, but to further one of the valuable, perhaps nearly unique advantages of the SA website - mutual education by contrasting discussions.
One of my great educational advantages came at a University whose business school reputation deservedly was earned by the employment of a case discussion method. There, ampitheatre-style classrooms with curved,elevated seating provided face-to-face contact between students carefully admitted to provide a blend of responses between my kind of neophyte academic exposure and more mature real-world business experienced folks. There is a strong similarity here at SA-U.
The reader offered his detailed familiarity with the biotechnology industry, certainly far more extensive than mine, as multiple reasons for his belief that biotech investments in general, and IBB in particular, are currently grossly overpriced.
Good; that is the essence of what makes a market; difference of opinion. More than a few SA readers are aware that one of my central interests is in how markets work and what drives them.
The opportunity here is to get a better look at what makes short-structured ETFs tick, and the implications of the way investors and speculators react to them. Misunderstandings appear to abound in the investing public about these instruments. The trigger for the continuation of discussion in this vein is the commenter's disclosure that he is long the ProShares UltraShort Nasdaq Biotech ETF (NASDAQ:BIS), and that he has been successful with a strategy of short-term shorting of biotech investments.
If a biotech short is good, can a Short-Biotech-ETF be better?
And if a straight short is good, mustn't a leveraged one be still better?
How is a short-structured ETF created, anyway? Aren't they just holding short positions in the same stocks an ETF that tracks the same index would hold? And if the ETF is leveraged, or geared, say 2x as much, is it just short twice that many shares?
Any investor that has ever personally shorted a stock has learned what a compliance, tax, record-keeping, and collateralizing nightmare would be ahead of an ETF fund sponsor that attempted to create a levered short ETF by the presumptions of the above paragraphs.
No, the actual practice is outlined here.
When this explanation has been read, several considerations present themselves because of the involvement of derivative securities in the process.
The simplest illustration has to do with ETFs that track indexes that themselves are traded on futures exchanges. Those markets exist because there are investor/speculator participants who have differing notions about what is likely to happen to the calculated price of the index in the future. The balance between their notions, multiplied by the capital commitments brought to the futures exchange to express their ideas are already embedded in the future exchange's quoted price of that index's futures contract. This is the very same contract that may be being held (long or short) by the ETF.
Depending upon whatever else (like swap contracts) may be held by the ETF, there is already an overlay of speculative judgment that may differ from the simple weighted average of the stock exchange quoted prices of the component stocks making up the index.
And to further complicate things, futures contracts, unlike stocks, have expiration dates. When they expire, for previously expressed positions/commitments to continue, they must be "rolled over" into one or more contracts with expirations further out in time.
Judgments by futures markets participants quite often differ in their balance between optimism and pessimism from one contract expiration date to others. Those differences across time may take on a progressive nature, a nature which itself may change direction from one calendar date (in the present) to another.
Life in derivatives is not simple, and like in theoretical thermodynamics, it gets worse. Especially when leverage is introduced onto the playbill.
Leveraged ETFs have a contemplated holding period of only one day. Or less. To try to create something more is like the generation of a wedding contract between two individuals in love that guarantees a long life free of ever having any disagreements.
So the marriage of an investor's capital with a leveraged ETF share has a partial-day honeymoon that is rebalanced at the close of market every day by adjusting the impact of the futures or swaps contracts back to the relationships which existed at the beginning of the just-ended day. At least, something like that is what is intended and attempted.
We are not going to get into some complicated mathematical explanation. Just accept that it exists for ETF securities that tend to most frequently have an at least slight upward bias through time. Where the ETF instrument involved is so structured as to benefit in its price change from declines in the price of the underlying index it is intended to track, a serious negative impact bias develops on the ETF's price across time.
Still with me? If not, don't be embarrassed to go back and reread the last few paragraphs.
The long and short of it (pun intended) is that short-structured ETFs are in an unfair fight with their long-leveraged twins. For the shorts to win, they have to do it quickly. Otherwise, the rebalancing disadvantage soon overcomes them, even in a sideways market, and the long side of the family gets the better of the arbitrage.
There are some very sophisticated Seeking Alpha contributors who practice this form of profitable entertainment regularly, skillfully, and perhaps nearly continually. I am often impressed by their abilities in knowing when and how to participate.
The SA commenter responsible for precipitating this article made known his awareness of the critical role time plays in the practice. So the following picture of how his present long position in BIS would have traveled had he had it from its life inception (the red line) is not a put-down. Instead, the infrequency of rises in that line, and their short duration, is a testament to how critical the entry and exit decisions are. We hope, for his sake, that they will fulfill his expectations.
Coming from the other side of the proposition, the entry and exit tasks for long investors in IBB or the similar SPDR Biotech ETF (NYSEARCA:XBI) are not nearly so critical.
Our standard portfolio management procedure is to pick investments that currently have the best-ranked odds for substantial price improvement in the next 3 months, as demonstrated by prior instances of forecasts for that investment. Forecasts which had, in the past 3-5 years, the same balance between upside and downside coming price-change prospects as does the current forecast.
Our choices between investment candidates are often sensitive to their present prices, as well as their current outlooks. Our champions are almost always ones of the moment, not of an era.
But they are strongly odds-influenced. That leaves us strongly disinclined to a long position in BIS. Now, maybe a long-term short position... if we could find a lender who might provide us with the collateral shares, and not want them back just at the worst (for us, not him) possible moment...
Money can be made in markets by betting "against the house." But the old saying of "the markets can stay irrational longer than the investor can stay solvent" takes on some proportion when one looks at the holders of IBB and BIS. The largest holders in each case are institutions, where for BIS there are 4, with $4.2 million committed in total. For IBB there are 327, which have committed $4,670 million.
But remember, all those 19 million IBB shares owned by the institutions were sold by someone. Only time will tell which will be the victors and which the victims in the present situation. Such is risk in the investing world.
We attempt to manage that risk in two ways. First by finding the best-informed, highly motivated, continually involved players in the game, and by getting them, through their own self-protecting actions, to tell us what they think can happen to coming prices, vetted by how well their judgments on the specific issue have held up in the past. Currently IBB has been a winning candidate, slightly favored at the moment over XBI. And second, by limiting our patience to just-adequate holding time investments which, if not sufficient to achieve a reasonable target, get shut down to be recommitted, along with the liquidated capital, to the results of search for a better alternative.
The structural limitations of, and market realities facing, leveraged short ETFs make it highly unlikely that we will favor that kind of instrument. But there is an exception. Suppose there was a short ETF that went up when the market went up...? (like SVXY, but that's another story).
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.