Is the Ultra Silver ETF a Dud?

 |  About: ProShares Ultra Silver ETF (AGQ), Includes: SIVR, SLV
by: Marc Gerstein

On, ETF commentator Don Dion described the Pro Shares Ultra Silver ETF (NYSEARCA:AGQ) as a “very bad actor” when it came to delivering on its promise to double the daily movements of silver. (Real Money subscribers can see the article by clicking here.) He correctly points out that tracking error (the difference between the net asset value $137.33 at Tuesday's open, and the market price, which opened at $144.41) is significant. From the point of view of any fund analyst, that would, indeed, be walloping thumbs down.

But what about traders, the ones who want to leverage up the daily movement in silver?

Before looking at that, let’s think about investment objectives in general. How reliable are they? Do target prices work? What about expected returns generated by the Nobel-prize winning Capital Asset Pricing Model or its successor, Arbitrage Pricing theory? If you’re an option trader, what do you think about the premium forecasts produced by Black Sholes (another Nobel Prize winner)? That’s such a mess, due to inability to forecast volatility, traders have twisted the formula inside out and wound up using the premium as an input to calculate “implied volatility.” What about market targets? We’re coming up now on mid-January so we’ve had our fill of strategists telling us where the S&P 500 or the Dow (assuming anybody still cares about that index) will be at year-end. Are you betting the farm on any of that?

The bottom line is that it’s hard, very, very, very hard, for any investor to achieve any sort of target. (That’s why we tend nowadays to evaluate performance based on outperform or underperform.)

In this spirit, leveraged ETFs tend to stand out as being unusually good at delivering, not necessarily their exact targets but instead, the general expectations investors have going in. Let’s look right now at AGQ. It’s really a very easy thing to do. I simply downloaded historical prices for it and the iShares Silver Trust (NYSEARCA:SLV) from Yahoo Finance into Excel, calculated daily percent price changes, computed an unofficial AGQ target by doubling the SLV numbers, and comparing the actual AGQ performances to the target levels. Doing this, it’s easy to see that AGQ traders have no cause for complaint. Its performance tracks very closely to the unofficial target.

The average “absolute” daily percentage movement in AGQ (meaning I’m looking only at the number, not whether it’s up or down, was 3.12% between 12/5/08 and 1/10/11. The average absolute daily percentage move in its target was 3.11%. This is an incredibly broad brush with which to paint, but if you want to see daily details, it’s easy enough to go on Yahoo Finance and replicate this quick study. Figure 1, a screen shot of the top of my spreadsheet, contains a preview of what you’ll see.

Figure 1

Click to enlarge

By the way, we all know leveraged ETFs shouldn’t be held for more than a day. But in case you’re curious as to what one would have achieved by holding AGQ all the way from its start, it produced a gain of 509.9%, versus 201.6% for SLV, more than double. Wow! That’s horrible. That’s way, way, way, way off base. I wonder how many AGQ holders are suing for the right to give back the excess money.

Again, I know AGQ is not designed to track a doubling of SLV. But I’m not wired into a detailed definition of silver. SLV is a tolerable proxy and it’s easy for anyone to track.

I don’t mean to be flippant about the risks here. They’re considerable. But let’s at least correctly identify them.

First and foremost is the direction of silver itself. So far, it’s had a heck of a run. If silver reverses course and you’re into AGQ, you’re going to get hammered. That’s important for all leveraged ETFs. You really need to be right about the direction of the underlying target. That’s a massive risk, one that may be getting short shrift here considering how good AGQ has been to most who’ve used it. Indeed, Mr. Dion cited some valid concerns regarding silver; alleged market manipulation by J.P. Morgan, and outsized demand due to Euro concerns. These are things anyone wishing to take any long stake in silver should consider.

Second is, of course, the uncertainty to which you expose yourself if you cheat and hold for more than a day (as many do). This particular set of facts worked out well. But don’t count on it repeating. Near-straight-line movements such as silver has experienced are rare. Normal zigs and zags can play havoc on longer-than-a-day holding period returns.

But I don’t think investors or traders are helped by piling on risks that don’t seem likely to hurt even if they materialize. The sort of tracking error Mr. Dion complains of seems to fall into this category. If he has reason to believe it will grow to larger, more troublesome proportions, to a degree that would impede a trader’s ability to achieve a more-or-less doubling of the daily movement of silver, he could and should articulate those concerns. But he doesn’t.

Traders are just looking to make money, not put on fund-geek uniforms and yell “Gotcha!”

Disclosure: I am long SLV.