Ultra and Inverse ETFs: The Downside of Doubling Up 28 comments
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It wasn’t long after ProShares launched the first inverse and leveraged exchange-traded funds back in 2006 that other fund sponsors followed suit. ProShares initially staked its claim to the familiar large-, mid-, and small- cap U.S. stock indexes, as well as a host of domestic industry sectors. Next came Rydex, which offered competing versions of inverse and leveraged funds built on the S&P 500, the S&P MidCap 400, and the Russell 2000 Index of U.S. small caps.
More recently, Deutsche Bank (DB) became the first firm to bring the inverse and leveraged exchange-traded note structure to the realm of gold trading. In late February, the DB Gold Double Short ETN (DZZ), Gold Double Long ETN (DGP), and Gold Short ETN (DGZ) debuted on the New York Stock Exchange’s automated Arca platform. These new products, which track an underlying index of gold futures, allow investors “to take a leveraged or short view on the price of gold,” Kevin Rich, a Deutsche Bank spokesman, explains.
But is that such a good thing? Ever since these innovative products debuted, investors—both professionals and do-it-yourselfers—have debated what role inverse and leveraged funds should play in an overall portfolio strategy. Some commentators think leveraged ETFs don’t belong in a retail investor’s account at all.
There is no doubt that they have been popular, and for good reason. Before the advent of inverse ETFs and ETNs, the only way an investor could profit from a decline in the price of a security was by opening a margin account with a broker and borrowing the shares—an often cumbersome process that carried enormous risks. “Shorting” a stock with a margin account can result in losses that far exceed the initial cost of borrowing the shares. By contrast, the maximum amount an investor can lose with an inverse ETF is the initial purchase price.
Leverage, of course, allows investors to obtain more exposure to an index with the same amount of capital, a double-edged sword that can leave a well-constructed portfolio in shreds, particularly during periods of excessive market volatility. As many investors know, 2008 has so far been one of the most volatile years on record for the benchmark S&P 500, with more than half of the trading days seeing market swings of more than 1 percent.
One of the problems is that retail investors often don’t understand what they’re buying. For instance, the leveraged ETFs and ETNs on the market are primarily designed to return double the daily performance of their underlying indexes. Many investors mistakenly believe that their leveraged funds will produce double the annual return of the underlying index. The difference can yield some surprising—and disappointing—results. For instance, if the Nasdaq Composite Index goes up 10 percent on Monday and then falls 10 percent on Tuesday, the total loss over those two days is 1 percent. The ProShares Ultra QQQ (QLD), however, will rack up a total two-day loss of 4 percent, not 2 percent, as many investors might suppose without a careful reading of the prospectus.
The other problem appears to be that leveraged ETFs tend to perform poorly when purchased at market peaks. Tristan Yates, a researcher and consultant who has studied them, constructed a model leveraged ETF portfolio and discovered that an investor who bought a leveraged ETF at the peak of the last bull market in 1999 still wouldn’t have fully recovered his losses by the end of 2006, more than three years after the beginning of the next bull run for stocks.
Because inverse and leveraged ETFs are so new, it can be hard to get a bead on how they will perform over the long term. ProShares and Rydex have for years offered traditional actively managed inverse and leveraged mutual funds; their ETF products were outgrowths of that business. Yates suggests looking at the long-term performance of those funds to get an idea of how the corresponding ETF will behave.
The old investing chestnut that says never buy what you don’t understand is excellent advice when it comes to inverse and leveraged ETFs and ETNs. While it can be tedious, reading and understanding the prospectus—and precisely how the fund achieves its returns—is essential before committing investment dollars. For most retail investors, inverse and leveraged ETFs will be most effective in supporting a more broad-based strategy that uses traditional index, sector, and international funds.
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This article has 28 comments:
Thx jegan ...
Here's a perfect example. Note that the chart shows that when the lines cross, the intersections occur at lower levels over time. If it were true that ultrashorts provided a true 2:1 return, then the intersections on these charts should always occur at the 0% line.
finance.yahoo.com/q/bc...
finance.yahoo.com/q/bc...
Lets say a normal stock was at 100; went up 10% one day, then down 10% the next:
100 * 1.1 = 110
110 * 0.9 = 99 ( A 1% loss, as explained above )
Now if you double the losses & gains:
100 * 1.2 = 120
120 * 0.8 = 96 ( A 4% loss as explained above )
If speculators, I dont believe in "investing", should learn how to correctly use stops, capital exposure and risk management...
If one buys and ETF at X and sells at X+Y they make Y. If the buy an ETF at X and sell at X-Y they lose Y. X & Y are not price but capital put at risk. This is the ONLY math that counts.
IMHO
If you think the added ummmhhff with these are fun try trading options on them, it adds a whole new meaning to them but if your truely trying to hedge a portfolio these options are PERFECT.
Who is on the other side of the trade that buys when I sell or sells when I buy? Do they use some sort of a put/call thing? I wish someone would explain this for me. It has been very profitable, but I would be embarassed if I had to explain it to my wife!
I found that below the surface of “Proshares” ultra products resides an unregulated black box full of derivative contracts, a chimera of creative imagination. I voted with my dollars and stopped using these instruments. I will be buying gold instead.
It's only on the surface that “Proshares ETF Ultra Short ETF's” appear to be the product of choice for navigating a bear market. With what other instrument can you double short an Index while receiving a three percent yield? Are “Proshares” too good to be true?
Normally you and I would be severely constrained to short an index because we would need to borrow the underlying shares, pay the dividends for those shares, and manage restrictive margin requirements. A Proshare ETF such as MZZ addresses every limitation to the problem of shorting the market or an index. You need very little cash to short the market or a sector, your holdings are recorded in your account as margin eligible long positions, and instead of paying a dividend you get paid a dividend. It sounded too good to be true so I read the prospectus. I had to read the prospectus many times and the net result was that it was useless.
Because, the “Proshares” prospectus provides very little decipherable information as to structure; I was forced to postulate. I would challenge Proshares to correct this posit by providing fact and making full disclosure.
Perhaps;
LLC #1 and LLC #2 have entered into reciprocal contracts to swap cash flows based on an index. Perhaps these LLC's are off balance sheet shell companies crafted for this specific purpose. These LLC corporations and the underlying contracts are black box entities not subject to disclosure. These LLC's are not regulated. Sales of shares are put into ETF form and sold into the market to generate a cash pool from which fees are collected and interest is derived and then swapped. These shares can only be redeemed in large blocks intentionally making them illiquid as to prevent a possible a run aka Bear Stearns. A third party brokerage firm, JP Morgan, gets tasked with assigning a net asset value to these contracts. These contracts are aggressively marketed on financial TV (CNBC lists Proshares in orange ticker!). Please remember the Enron commercials and the catchphrase “Why?” Perhaps LLC #1 provides a floating interest rate to LLC #2 while LLC #2 provides LLC #1 with an equity index return. The security trades on the exchange and we believe as investors that risk has been negated entirely through netting. The regulators are nowhere to be found, they don't understand that Ponzi may be at play. What exactly are S&P Midcap 400 Swaps? Please tell me as I can only guess.
MZZ – Proshare Double Short S&P Midcap. Holdings..
Security Description
Notional Value
Market Value
Shares/ Contracts
S&P MIDCAP 400 SWAPS
(396,543,080.19)
-
(497,045.72)
MID 400 E-MINI 20/06/08
(28,632,840.00)
-
(358.00)
Net Other Assets / Cash
-
212,627,636.57
212,627,636.57
This is why there's options. And, specifically, puts.
Thank you so much for your comments and analysis. You have really made me think! I don't know where to turn now.
As you said, their is no real descriptive info provided by ProShares. So it looks like a call to Congress may be the only way to address the issue and this might be too late to do anygood. I have a feeling that the regulators will neither respond or give a meaning full answer to this complex question. I am now considering leaving the SRS/FXP ballgame before I am left holding the bag!
If we only knew the full context of all the swaps that have been taking place in ETF's since they were created.
Thanks again for good article and comments William Edwards
re: Proshares posting counterparty note on their webpage, they have, under the Products tab in the right hand column, specifically stating that they have no Bear counterparty risk.
further, here's a link to some additional discussion wallstreetexaminer.com...