Hedging With Leveraged ETFs: A Real-Life Case Study

Includes: TZA
by: Marc Gerstein

Leveraged ETFs, many of which have been released by ProShares and Direxion, are designed to magnify the daily percentage change in the value of a particular benchmark. They’re available now for stock indexes, bond indexes, precious metals, etc. Trading volume has been nothing short of tremendous even now, several years after they debuted and under dramatically varied market conditions, suggesting investors find them useful.


Despite obvious acceptance in the investment community, leveraged ETFs have and occasionally continue to attract quite a bit of controversy. These products are not toys. Those who use them must take the trouble to understand what they are dealing with and if they don’t bad, and sometimes bizarre things can happen.

For starters, leverage amplifies volatility. If you buy a bullish (long) triple-leveraged stock market ETF and the market goes down, you suffer much more than you would have had you simply owned stocks. Such an ETF would be designed to deliver three times the market movement, so if the market dropped 3% in a day, your ETF would decline 9%. Hopefully, though, anyone working with leveraged ETFs is an adult who would understand this sort of risk.

A strange less-obvious source of risk relates to path dependency. If you hold a triple bullish leveraged stock market ETF over the course of a year, and the market rises 20%, a casual observer might anticipate a 60% gain. That might actually happen, but don’t count on it. These ETFs are targeted to the performance of a benchmark over the course of a single day. So the pattern of daily zigs and zags that could occur over the course of the year can make a huge difference. The ETF in this case might wind up rising more than 60%. That would be fine. But it’s also possible the ETF could rise much less, or even decline. The longer you hold a leveraged ETF beyond the daily targeting interval, the less predictable your outcome.

There’s an extra issue with leveraged short stock ETFs. If you look at a long-term price chart for just about any index, you’ll see that over time, the market has had a lot more up days than down days. Since leveraged shorts go down, a lot, on each of those up days, they will, over a very long period, trend toward, but never actually reach, zero (something like the notion of half-life some of us may have learned about in High School physics). Indeed, reverse stock splits have occurred in these ETFs and will probably remain a permanent feature.

It’s these three risks that cause some commentators to mount soapboxes and scream “dangerous,” “toxic,” etc. That’s unfortunate since all three risks can be managed by those who take the time to understand leveraged ETFs and use them in reasonable ways. Suggestions that nobody should use them make as much sense as suggesting nobody should drive since automobiles can be death traps to those who try to operate them without bothering to learn how. (Heck, I’ve been licensed to drive an automobile since the mid-1960s, and back when I was in school, a New York City taxi, but even now, I wouldn’t dare try to operate a motorcycle or tractor trailer. You need to know what you’re doing, with vehicles, with leveraged ETFs, with lots of things.)

A Dose of Reality – A Hedge Strategy

I’ve written about leveraged ETFs quite a bit in the past on Seeking Alpha, including one 2009 article entitled “What Happens When You Hold Leveraged ETFs for More Than One Day?” That was a hypothetical study; an extensive hypothetical study, but a hypothetical one nonetheless. Today, I’d like to follow up with a real-life real-money case study. You’ll see, here, screenshots tracking the performance of one of my portfolios, one that includes a hedge based on a leveraged short ETF, compared with the Russell 2000, as tracked by FolioInvesting.com, my on-line broker. I’ll show you the good, the bad, and the ugly.

The stocks I own in this portfolio consist of those in the Model Portfolio of my low-priced-stocks newsletter. These are reasonably trade-able (i.e. non-pink-sheet), fundamentally sound, based on my model and analysis, stocks priced below $3.00. This is, by nature, an extremely volatile group: In the Model Portfolio’s first year of operation, its actual Beta relative to the Russell 2000 was 2.83 (a beta of 1.00 would have indicated a level of volatility exactly equal to that of the index). I had, from day one, anticipated ugly periods in the market (such as the one we’ve been experiencing lately), and having resolved that it would be too burdensome to try to constantly trade in and out of stocks like these based on market-timing judgments, I decided to stay in the stocks all the time and hedge by allocating 10% of this portfolio to the Direxion Russell 2000 3X Bear ETF (NYSEARCA:TZA). This was not a simple buy and hold. Every time I refreshed the stock list, I bought or sold as much of TZA as necessary to bring its weight in my portfolio back to 10% (meaning I was regularly averaging my purchase price up or down depending on what happened in the market). The regular rebalancing is an important element of the strategy since a rigid buy and hold will, for leveraged ETFs, likely lead to very bad outcomes. (NOTE: I also implemented a leveraged-ETF strategy for an income portfolio, but this was done just recently and I don’t yet have enough real-world data to present.)

It’s important to understand, here, that this is a hedge. As such, I had no expectation of getting something for nothing. In other words, I harbored no fantasies about being able to see my portfolio rise in bear markets. I only expected to mute volatility to a more comfortable level and hopefully not give up too much upside.

Don’t underestimate the importance of such a goal. The level of volatility one experiences can have a huge impact on one’s willingness to stick with a portfolio through hard times. Overly severe downswings are bad not only in the dollar losses they produce but also in the way they cause investors to lose their nerve and bail out, often at the worst possible time. (When we jump ship in bear markets, we all like to think we’ll know when to get back in, but seriously, how good are we really? How many investors who ended 2008 with all or most of their assets in cash got back in after March 2009 quickly enough to really enjoy the recovery? I’m not asking how many bragged that they did; I’m asking how many really did! When you get into small stocks, the earliest stages of recoveries are especially potent.) Having my 10% TZA hedge goes a long way toward bolstering my willingness to stay exposed to low-priced stocks notwithstanding ongoing market difficulties.

Hedges are like insurance policies. They are designed to protect you against disaster, but at a cost. You pay a premium to get a policy of insurance. To get downside protection in the market, you “pay” by forfeiting the opportunity to profit as handsomely as you could in good times. If you’re going to do any kind of hedging, with leveraged ETFs or any other vehicle, you must understand and accept this. I accept it for my low-priced stocks because my experience with this corner of the market tells me that in good times, I can expect performance substantially better than the Russell 2000; enough so to make it worthwhile to tolerate the losses a 10% stake in TZA will deliver during market rallies. If you use leveraged ETFs, don’t fantasize about being a perfect daily market timer. Instead, assess the likely impact of movements that go against you and determine whether you can live with them.

The Results

I’ll start with the good, or at least the good aspect of the hedge. (No matter how “good” I’ve done lately with TZA, I’d much rather have seen a strong market produce losses in TZA and profits elsewhere!)

Figure 1 shows the performance, as computed and presented by FolioInvesting.com, of my portfolio, compared with the Russell 2000, from 7/15/11 through 8/18/11.

Figure 1

Obviously, I felt a lot of a pain lately, just like many others. But so far during the current crisis, I outperformed the Russell 2000 by 10 percentage points.

Now let’s backtrack and examine, in Figure 2, what may have been one of the worst periods during which to hold TZA; the period from 7/15/10 (the inception of the newsletter) through 2/15/11, the onset of the Middle Eastern crisis and the instability that has persisted more often than not since then.

Figure 2

As you can see, the Russell 2000 rose 29.22% during these seven months. Because of daily zigs and zags, we won’t expect TZA, the triple short ETF, to decline 87.66% (29.22% multiplied by three). But if you look up real-world price data (which is easy to do on Yahoo Finance), you’ll see the actual start-to-end decline was 14%. That’s not what my position experienced – remember, I was averaging up and down as I went along – but you can see something the leveraged ETF fear-mongers didn’t tell you about; that oddities of holding for more than a day can work for you just as easily as they can work against you.

Now, I’m going to show you a truly dismal portfolio episode, the period between 2/15/11 and 6/15/11.

Figure 3

I got hit by a double-whammy.

First, the longer-than-a-day pricing oddities of TZA didn’t kill me, but they resulted in a lesser benefit than I wish I had received. With the Russell 2000 down 4.95%, the casual observer might have hoped for a gain of 14.85%. Actually, though TZA gained only 5.8% during the period, with my own results again impacted by interim position rebalancings.

Second, low-priced stocks significantly underperformed the Russell 2000. The newsletter Model Portfolio, absent any hedge, dropped 15.7%, versus 4.95% for the index. I am experimenting with a price index that measures the low-priced sector only (as distinct from the Russell 2000’s emphasis on small-cap in general) and that index fell 17.22% during this period But that’s little consolation for the fact that TZA didn’t give me as much help as I wished it would have delivered.

The hedge really dragged during the next month. Figure 4 shows what happened between 6/15/11 and 7/15/11.

Figure 4

The Russell 2000 rose 6.33%, and the start-to-end price change for TZA (which I experienced in its entirety since this was just a single month, meaning the position was not rebalanced in the interim), was minus 23%. But the Model Portfolio stocks were quite strong that month, enough so to allow the overall portfolio to exactly match the Russell 2000 despite the drag from TZA.

Figure 5 puts all this together by showing you the full time period all at once.

Figure 5

For the record, the un-hedged Model Portfolio performance was plus 59.23%.

What Can We Learn

Hedging Involves Cost-Benefit Tradeoffs, Not A free Lunch: As you can see, my hedge was expensive during this overall period. I gave up a lot of upside. Was it worth it? That’s a matter of opinion. I cannot emphasize this enough. Neither I nor anyone else (except, I assume, members of your family and others who depend on your financial decisions) can tell you what sort of cost-benefit, risk-reward choices to make. I’ve shared some of mine with you in order to offer a hopefully objective, demagoguery-free, peek into the world of leveraged ETFs. But ultimately, once you understand the facts and probabilities, you have to make your own choices.

Don’t Ignore Human Emotion: In a pure numbers sense, my hedge cannot be said to have worked. But as those in Behavioral Finance have been trying to teach us, there can be a lot more to this stuff than just numbers. As noted above, I’m not shocked by what we’re seeing in the market. I had noted some financial-market dislocations right from the beginning as I told my subscribers of my 10% TZA hedge. I’m also aware of how vulnerable this segment of the market is to recession. To be perfectly honest, I don’t think I’d have the stomach to take on many of these low-priced stocks under current conditions but for the hedge. And as you can see, despite the TZA drag, I’m still way better off than I’d have been had I chickened out and simply held a Russell 2000 ETF.

Don’t Be In A Rush To Close The Book: This is, of course, an ongoing story, and the benefits of the hedge just started to manifest big in the past month. Earlier in 2011, it helped, but just a bit. Many chapters are yet to be written. So always preserve an open-ended quality as you draw conclusions.

Think Of TZA As Having A Life Of Its Own: I know all about the daily targeting, path dependence, oddities beyond a day, etc. When ProShares introduced leveraged ETFs to the world back in 2006, I was intrigued and immediately poured through the prospectuses and started analyzing, writing (back then I wrote on Reuters.com) and trading these things. Frankly, I have to tell you that unless you truly are a day trader, you’ll be a heck of a lot better off not getting bogged down in daily targets and deviations and instead, learning to view these securities as having lives of their own. Suffice it to say that TZA is a security I hold if I want a high-volatility position that’s likely much more often than not to move counter to the Russell 2000. Period! If I leave it at that and stop trying to out-think the room, I can make much more sensible decisions.

Be Real About Expectations And Results: Does TZA always deliver exactly as expected? Of course not! But what does? Companies have earnings disappointments all the time, those can and have hurt a lot more than the disappointments I’ve experienced with TZA. And by the way, if you bought oil stocks or ETFs last spring, how closely is your performance matching expectations? If you want perfect targeting, stick to CDs and the like. If you’re going to be in stocks (or commodities or fixed income or currencies), you have to live with the fact that results often vary from expectations (there’s a reason why earnings surprise and revisions spawned a something of a cottage industry). All things considered, my experiences is that leveraged ETFs, despite all the “oddities,” typically deliver results that are a lot closer to expectation than I’ve seen in most other portions of the market.

Have A Well-Thought-Out Strategy: Recall from the discussion above that I didn’t simply jump into TZA because it seemed like a cool idea. I thought about how it’s likely to relate to the rest of my portfolio (i.e. the likely relationship between my low-priced stocks and the Russell 2000), and how things might pan out for me if the market moves against a TZA hedge. This is vital. Always understand (for everything, not just leveraged ETFs) the potential consequences of being wrong and assess your ability to live with it. This is the stock market: Being wrong is a fact of life! Notice that for the most part, this article is a study of erroneous timing and its consequences, rather than a puff piece on brilliant market forecasting.

In conclusion, I cannot and wouldn’t presume to tell you to use or avoid leveraged ETFs. My hope is that you are now able (perhaps with the help of the early-2009 article I cited above and other articles I wrote on Seeking Alpha back then, which are easily searchable on Seeking Alpha) to make thoughtful decisions, grounded in reality, as to what works or doesn’t work for you.

Disclosure: I am long TZA.