ProShares UltraShort 20+ Year Treasury ETF: Market Insurance From an Inferior Fund?

Includes: TBT, TLT, UNG
by: Erik Gholtoghian

To invest successfully, one must not only understand the theory of investing but also the real world products and instruments available to accomplish practical goals.

Financial theory says that to beat the market, a portfolio must have the optimal combination of risky assets, chosen in a manner which somehow picks the best risky assets, and then blend this risk with the risk free asset(s). I say risk free assets in the plural because I have been considering the effects on portfolio standard deviation when different country risk free assets are used instead of the standard U.S. treasury. The discovery that there truly is more than one risk free asset in existence is no small observation, and it opened a large door of potentially uncorrelated or even negatively correlated assets to me. Risk free assets have interested me more than risky assets because of their relative scarcity and their correlation advantages for a leveraged portfolio. Using this thinking, I searched ETFs to find assets which could serve as alternative risk free assets. My result was I stumbled upon something in daily trading which seems to break the traditional rules of leverage and risk management.

Traditionally, I have used U.S. government bonds as my risk free asset, and my choice of product has been to use a high duration government bond ETF with the ticker symbol of TLT. I have used this fund instead of buying treasuries themselves because this fund offers options on the fund and as a retail investor I have no other way to trade options on U.S. treasuries. This allows me to use leverage with risk free assets. For quite some time I have been writing puts in this fund to gain a leveraged balancing with my other risky positions, and at the same time gain an advantage with the time value of money from selling options. But the problem that can on very rare occasions develop is that when the volatility index (VIX) shoots through the roof or markets go far one direction in a very short period of time, the excessive leverage used writing puts on treasuries can go heavily against me because they can on rare occasions "break correlation" so to speak.

In other words, because put writers are exposed to a potentially near unlimited loss, if the risk free assets break their negative correlation with the stock market and for some reason become totally positively correlated, even for just a short period of time, the risk free assets could actually topple a portfolio from huge losses. This would be extremely rare and is something of a black swan event, but an event that I have observed has been occurring more and more lately on a daily basis. My belief is that this behavior is a result from the U.S. government amassing a large debt. It has spooked many investors who fear that the dollar will no longer serve as a risk free asset. Another possible cause is the Chinese government. Because the Chinese government has started to let the Yuan float more freely with the dollar, it has pressured U.S. treasuries, and this weakness becomes visible on days when the U.S. stock market is down and also when U.S. treasuries are down.

Since the reality of the world is that risk free assets can to some extent be thought of as risky, how can one actually gain leveraged access to risk free assets, still have a time value advantage offered from writing options, and yet still not have unlimited exposure to a black swan event? Well, there are new products that have entered the markets over the past several years that are generally used by gamblers. The products are leveraged (2X, 2.5X, and 3X) funds. Most people just call them 2X funds. The problem with these funds is that in terms of a long term investment, they are inferior products because the fund managers use futures contracts in an effort to recreate synthetic 2X daily returns. Over time, these funds decay themselves, at least at the current time they do. Many commodity funds also suffer the same effect. For example, UNG is a ticker symbol for a natural gas fund which has suffered a similar consequence to leveraged funds. Even though the fund isn't leveraged, it has had similar decay due to fund managers relying on futures contracts to keep the net asset value adjusting on a daily basis. Over time the fund essentially loses the time value associated with those futures contracts, or swaps, or forwards, or whatever may be the case.

The theory is that these types of funds should only be used for short term purposes. When I worked as a proprietary trader, I found most day traders tended to prefer to use these funds because of the easy daily leverage offered. These traders all close their positions by market close each day, but in the longer term these funds can also be used for some rare hedging cases.

And this is where it gets interesting ...

The experimental asset I'm working with is TBT. It is a 2X inverse 20 year treasury fund, essentially a 2X inverse TLT. So as I said before, I tend to use risk free assets in my portfolio, especially when those assets can earn time value on the options I have written, but the problem that can arise is overexposure to these assets. In other words, using TLT I can earn leveraged risk free returns, but with limited upside potential due to the limits on put writing premiums. If treasuries were to explode upwards, I'd be happy, but I'd only get my small to medium premium basically immediately, and then I'd lose all the other potential gains that people who actually owned treasuries would have received.

Now, because TBT is a leveraged 2X fund, it by definition decays itself to death over a very long period of time. So, it already sort of has a time value advantage in it to the downside. So people who buy puts in this security literally are not paying any time value for the options they buy (as long as the options are cheap, which they seem to be). And amazingly, these puts are remarkably liquid, especially for such an exotic instrument. It seems option pricing models don't quite capture the dimensions of valuation I have just discussed, namely decay.

In conclusion, my theory is that instead of writing puts in treasuries themselves or in treasury ETFs one could buy puts in TBT to gain an even more risk free asset return, and with two huge advantages: (1) buying puts gives you limited risk, so even if a black swan event occurs, you cannot get hurt very much at all as opposed to the TLT put option writers who have to run for the hills and watch their portfolios burn to the ground; (2) buying puts provides unlimited insurance (risk free) protection. For example, if the stock market absolutely tanked and treasuries rose, your risk assets would fall dramatically, but puts you bought in TBT would rise exponentially, to extra-protect if you will. This effect is due to the pricing of volatility in options. I guess one could argue that buying calls in TLT would be just as effective, but the problem is that you pay a time value for those calls so you earn nothing if treasuries don't move in value. In contrast, TBT will decay over time, similar to an option itself. Meaning, even if treasuries do not rise, TBT put holders will likely still lose little to nothing because the fund itself will fall in value.

This is an experiment I will be working on over the next few months. I gained interest in this method because recently we had such a collapse in treasuries it caused a bit of unusual damage to my portfolio, so I had to think of a way to correct this design error for the future.

Disclosure: I am short TBT.