ProShares Ultra and UltraShort Sector ETFs: Does 2 = 2? 16 comments
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ProShares has offered a variety of "Ultra" and "UltraShort" sector ETFs for more than a year now. These funds are designed to track twice the return of the underlying index, and each corresponding long fund is created to match its corresponding short.
There is no doubt that these ProShares offerings have been the subject of a great deal of interest. They promise the rewards of leveraged sector returns without the headache of margin or portfolio construction, allowing profitable bets with less capital and less risk. This might not come for free, however, and many have investigated how closely these funds track their double-return target in terms of price. For more on that topic, I suggest this article directly from ProShares.
Instead of asking whether these funds track twice their underlying index, however, I've decided to investigate whether each pair of funds behaves as expected. That is, given two well-constructed index portfolios, the sum of the long fund's return and the short fund's return should equal zero. Though the behavior of the underlying derivatives might be expected to introduce some tracking error, we should expect to see only relatively small differences relating to the difference between price and NAV.
The following chart demonstrates the cumulative return difference between the long and short funds.
click to enlarge
The chart demonstrates that this is far from the case. In fact, nearly half of the sectors have seen over 20% deficits in this balance since June of last year.
Looking for explanations outside of portfolio construction leads to a believable alternative. Charting dollar volume differences shows that almost every single sector had greater dollar volumes on the short side. In some sectors like Materials and Real Estate, the difference in dollar flow over the past year has hit tens of billions. It seems likely that these funds are much more valuable as insurance for the down-side than as single-sector long bets. In other words, if investor are much more likely to bid on and bid up an UltraShort Sector insurance contract, imbalances such as these might be expected.
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This article has 16 comments:
Example; for all of 2007 the double long SPX ETF lagged SPY.
What I *am* investigating is why the daily NAV return for these fund pairs do not match. That is, the daily NAV return of UYG should be the negative of the daily NAV return of SKF.
2TallTurk, note that I readily accept tracking error from portfolio construction. These ProShares funds have done well considering that the difficulty of matching the magnitude of returns lately. I was merely investigating alternative reasons for the imbalance.
On day 1, let's say the index moves up 25%. ULX should move up 50% to 150, while USX loses 50% to close at 50. Now, on the second day let the underlying index lose 15%. That means that ULX loses 30% (45) to close at 105, and USX gains 30% to end at 65.
So, at the end of 2 days, ULX now has a return of +5%, while USX has a whopping -35% loss. So, even with perfect tracking, you do NOT get what you expect.
In other words, it makes a difference whether you lose x% and then gain y% than to gain y% and then lose x%. Therefore, your chart is not really telling us much of anything useful.
Whether you realize it or not, a 2X fund is an implicit momentum play, since it reloads every day. It will always force you to buy a little more at higher prices and a little less at lower prices. If the market goes up and down a lot over a year and then ends the year unchanged, you will lose a lot of money!
(1 + 2x) * (1 - 2x) = 1 - 4x^2
Still, if you get the direction right, the 2x should still put you ahead more than the 1x, but not twice as much. If you get the direction wrong, you are in a world of hurt. In a trading range, the above formulas show that the ultra bleeds you much faster than the straight.
This is true of both ultra and ultrashort.
I am not complaining that SRS was up more than 2 x .36, that is not the point. The real problem here is that the -.36 does not look correct for the index when compared to the average of the top 9 funds that make up the index were down -12.24% or an average of -1.36%. I don't have the average percentage gains of all of the funds that make up IYR and I realize an average of percentage numbers is not accurate, but it makes me wonder what happened.
But if you take 1.36 x 2 = 2.72% which is very close to actual amount that SRS increased at 2.76%! So did they lose the 1.0 factor or was the index flawed?
Does anyone know exactly how the manage to keep the two indexes as close as they do? Thanks, John
If you plot the long-minus-short portfolio 'shortfalls' against the realized volatilities of each index over the corresponding periods, you should see that sectors with the highest volatilities would have the largest shortfalls.