By Sebastien Buttet
In his 2002 annual letter to shareholders, Warren Buffett compared financial derivatives instruments (futures contracts, call and put options, credit-default swap, etc.) to financial weapons of mass destruction (FWMD). Leveraged ETFs are another kind of FWMD.
Leveraged ETFs allow investors to enjoy short-term juicy returns whether markets go up or down without the need to use margin accounts to sell the underlying security short. For example, investors who would like to position themselves to profit from a sudden market decline in the S&P 500 index can use two very different strategies:
- They can sell shares of the Proshares S&P 500 ETF (SPY) short using a margin account. Shorting is the practice of selling assets that have been borrowed with the intention of buying identical assets back at a later date. Investors profit from selling securities short when they are able to buy them back at a lower price.
- They can buy shares of the Proshares Ultra Short S&P 500 (SDS) which (according to its prospectus) seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P 500 Index.
The key word in the SDS prospectus is daily. While the Spyder ETF tracks the performance of the S&P 500 index quite accurately over long periods of time, the goals of the ultra-short ETF SDS are more modest: if during one trading session the S&P 500 declines by 1%, investors who are long SDS in their account should enjoy a return equal to 2 percent that same day.
Notice that the prospectus says nothing about the tightness of the relationship between SPY and SDS for periods of time longer than one day. And while it is tempting and perhaps convenient for (retail) investors to want to use SDS to place long-term bearish bets on the market, their financial returns will be quite modest (if not negative) if they keep holding SDS in their portfolio for extended periods of time. In fact, as we show below, investors who would have held SDS during the entire financial meltdown in 2008 would have lost money!
In Table 1 below, we compare the returns for SDS and SPY for a hypothetical investment over different time periods that would have been liquidated on 04/12/2011.
Tab 1. Comparison of SDS and SPY for different holding periods
|Returns for SPY||Returns for SDS||Portfolio: Short 2*SPY Short SDS|
|Intraday - 04/12/2011||-0.75%||1.53%||-0.03%|
Results are as expected and as described in the SDS prospectus. For short periods of time (a few days and even up to six months), returns on SDS are roughly equal to twice the inverse return on the S&P 500 index. For example, the S&P 500 index declined by 0.75% on April 12th, 2011 while the return on SDS that same day was 1.53%. Pretty close!
However, when holding periods are longer than one year, returns on SDS and SPY differ markedly. Between April 12, 2010 and April 12, 2011, the S&P 500 index returned about 10% to investors. If SDS and SPY would track each other closely over periods of time longer than a day, you would expect SDS to be down 20 % over the same time period. However, the Ultra Short ETF performed much worse and lost 28% of its value.
Things get even dicier when looking at three-year time period. Between April 12, 2008 and April 12, 2011, the S&P 500 index lost 1.43%. If returns on SDS and SPY were as described, you would expect SDS to be up 2.86% over the same time period. How did SDS perform? It lost about 69% of its value. Since a graph is worth 1000 words, we illustrate the 3-year performance for SDS and SPY below.
Now comes the important question. Can investors devise a strategy to benefit from the divergence between SPY and SDS over long periods of time? Although we caution that we did not perform full due diligence, we believe that the following short-short trade would be profitable over the long run: sell short say $1,000 worth of SDS and sell short $2,000 worth of SPY (the amounts $1,000 and $2,000 are for illustration only. The idea is to short twice as much SPY compared to SDS).
First, let us explain the rationale behind our trade. SDS does a poor job of tracking the S&P 500 index over the long run, so it should be sold, which in essence is equivalent to go long. To make the trade profitable regardless of the market's direction, the S&P 500 index must be sold to hedge the short position on SDS. And since SDS is supposed to return twice as much as SPY, we need to short twice as much SPY compared to SDS.
Next, we examine the returns for that particular trade over a three year time period. Between April 12, 2008 and April 12, 2011,
- SPY declined by 1.43%, implying that the short $2,000 position on SPY would have declined by about $29. In addition, investors need to pay dividends. Since SPY yields about 1.7%, this represents an additional $102 over a three-year period.
- SDS declined by 69% over the same time period. A short position on $1,000 would be up by $690.
To calculate the final payoff for the trade, we need to take into account the borrowing costs associated with the two short positions. Assuming that brokers lend at 5%, borrowing costs for shorting $3000 are equal to $150. So the total payoff for this trade would be $409 (=$690 - 102 - 29 -150). Not so bad for a directionless trade!