The impact of silver’s incredible run-up over the last year has been felt throughout financial markets and in a wide variety of industries. Those investors with direct exposure have no doubt enjoyed the near-vertical ascent of the precious metal, as silver has outperformed virtually every asset class over the last several months. But not everyone has cheered the climb higher. The surge in prices has sent end users of the metal, such as film manufacturers, jewelers and solar panel companies, on a scramble to identify and procure cheaper alternatives. Mining firms have begun to adjust their hedging strategies, and some are no doubt experiencing significant regret after committing to sell significant portions of their output at rates far below the prevailing market price.
The silver rally has also highlighted a few interesting aspects of the ETF industry. Physically-backed exchange-traded funds offering exposure to silver bullion have emerged as a favorite vehicle for betting on the precious metal; SLV and SIVR have close to 400 million ounces of silver bullion between them. Many have pointed to demand for silver from exchange-traded products as a contributing factor to the silver boom. That has renewed discussions over the potential impact of ETPs on financial markets, with some evidence that the tail may now be wagging the dog.
The surge in silver that began in the middle of 2010 and has accelerated in the first several months of 2011 has also helped to illustrate the nuances of leveraged ETFs that have historically caused confusion among some investors and advisors.
Few strategies have performed better over the last nine months or so than an investment in the ProShares Ultra Silver (NYSEARCA:AGQ). That ETF seeks to deliver daily returns that correspond to 200% of the daily performance of silver bullion as measured by the U.S. dollar fixing price for delivery in London. Like many leveraged ETFs, AGQ resets exposure on a daily basis; the target 2x amplification figure is valid only for a single trading session. Those who buy and hold AGQ for a period longer or shorter than one day may not experience returns equivalent to 200% of the change in silver prices over that holding period.
In the wake of the unprecedented market volatility of late 2008 and early 2009, many investors came under the impression that leveraged ETFs were overly-sophisticated contraptions that only the most advanced investors could understand. Many publications also seemingly conveyed the notion that holding a leveraged ETF for longer than a single session was akin to investing suicide.
Much of the confusion around leveraged ETFs relates to the daily reset of exposure. The objective of many of these products is to deliver leveraged returns over a single day (it should be noted that there are a number of ETPs that seek to deliver monthly leveraged results). In order to accomplish this investment objective, exposure is reset on a daily basis. That means that the performance of a leveraged ETF over an extended period of time depends not only on the change in the related index or asset, but the path taken during the period in question.
When markets see-saw between gains and losses, leveraged ETFs are likely to deliver returns less than the daily leverage target multiplied by the change in the underlying index. The explanation is relatively straightforward; a 2x leveraged ETF increases exposure after winning sessions and decreases exposure after losing sessions. When gains are followed by losses and vice versa, leveraged ETFs are essentially making poorly-timed bets - putting more money on the table ahead of losses and taking money off ahead of gains. That’s what happened in the second half of 2008, when unprecedented volatility had an adverse impact on many leveraged ETFs.
As the eye-popping returns turned in by AGQ have demonstrated quite clearly, leveraged ETFs also have the potential to surge when the wind is at their backs. The wind, in this case, is trending markets. When the assets or indexes to which leveraged ETFs are linked either rise or fall consistently, leveraged ETFs can behave very differently.
On July 28 of last year, the iShares Silver Trust ((NYSEARCA:SLV)) closed at $17.16. Prior to Monday’s sell-off, SLV had climbed steadily higher, gaining close to 175% in about nine months. During that same period, AGQ is up a whopping 550% - or more than three times the performance of the physically-backed iShares product:
When silver went into a tailspin on Monday, AGQ lost more than $62 per share in a single session. When silver began its impressive run-up last July, this ETF was trading at about $55 per share. Those relative values highlight the potential for leveraged instruments to turn in huge performances in trending markets - as well as the nuances of compounding returns.
ZSL: Losses Insulated By Daily Leverage
It’s also interesting to note how the ProShares UltraShort Silver (NYSEARCA:ZSL), which seeks to deliver daily results that correspond to -200% of the change in silver, performed during this stretch. Given the precious metal’s meteoric rise, it’s probably no surprise that ZSL’s performance has been abysmal. But the relative severity of the collapse further illustrates the nuances of leveraged ETF performance in trending markets. During a stretch that saw silver prices climb by about 175%, ZSL was down “only” about 90%, or significantly less than the simple inverse of silver’s gain.
Again, this is the result of the daily reset feature. When silver gains, ZSL declines. Thanks to the daily reset feature exposure is reduced to the leveraged ETF after losing sessions - meaning that the effect of further losses is cut as well.
For those who picked up ZSL recently, Monday was a nice boost. The fund was up $2.26 per share, or about 16.6%. But that change is less than 0.2% of ZSL’s per share value when silver began its climb, again demonstrating how the “effective” leverage maintained can evolve over time.
Risk / Return
If silver markets had oscillated more frequently and severely over the last nine months, it’s very possible that the performance turned in by AGQ could be wildly different. And there is, of course, no guarantee that these returns will continue or that markets won’t begin to seesaw a bit more frequently. But it is important to understand that leveraged ETFs can potentially be powerful tools that make sense to hold for extended periods of time. Those who have held on to AGQ over the last nine months have essentially let their winnings ride, compounding returns along the way. And the results have been quite impressive - even after the bursting of the silver bubble on Monday.
Disclosure: No positions at time of writing.
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