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Hedging With Leveraged ETFs 0 comments
There are plenty of ways for your portfolio to profit when the market goes down--you can go short, buy puts, sell naked calls. But what if the market moves against you and you're not hedged? Considering using one of the 2x or 3x leveraged ETFs to balance out your portfolio? While these funds can help smooth out volatility in your portfolio, it's probably not as straight ahead as you might imagine.
One of the first statements is that the fund seeks to track 2x or 3x the daily (inverse) performance of a given sector or index. However, there are several factors that will limit the long-term performance of these funds.
ProShares has a page dedicated to the effects of rebalancing their portfolios on a daily basis. This can be beneficial if the market moves in a straight line for an extended period of time, but if there's a long period of consolidation, this will quickly eat away at the fund's Net Asset Value.
Example: A fund goes up 10% one day and down 10% the next day. In a portfolio of traditional stocks, this would have a net return of -1%. Now let's leverage that fund up to 2x: the fund is up 20% and down 20% the next day for a total return of -4%. Over a few years, this situation will happen plenty of times, severely eroding your initial investment.
Since leveraged ETFs hold a portion of their assets in swaps or options, this exposes the entire fund to the same things that typically effect those derivatives. When volatility explodes, like it did last October, this will cause the inverse funds to rise sharply. Just take a look at this chart of the SKF double short financials against the XLF 1x long Financials:
At the peak, the SKF was up 111% while the XLF was only down 18%. How does this make sense? The volatility index went from 20 to 80 in the same time frame shown on this chart. That caused the SKF to sharply outperform the actual drop in the financial index.
Unlike a sector index fund that gets balanced once a year, you're paying a fund manager to constantly rebalance the assets of your ETF. The management fee alone will cause a traditional ETF to under perform a sector, but in an actively managed fund, this decay of investment capital is even more pronounced.
While this is not a complete list of head-winds that face a leveraged ETF, there are plenty of other articles that document their under performance.
So what's the safest and easiest way to make money with leveraged ETFs? The easiest way is to short a pair of bull and bear leveraged funds. Direxion introduced a group of 3x funds in November of 2008 as the markets were crashing. Here is a chart of the BGU Large Cap 3x against the BGZ Inverse Large Cap 3x from their inception to date:
As you can you can see, the long fund is about even while the short fund is down 80%. That means if you shorted both of these funds when they were introduced, you'd be up 80% right now; however, you'd need enough capital for the 20% draw down that occurred less than a month after the fund's inception.
Sound too risky for you? Consider buying long term puts on both of these funds. That way you can't lose any more money than what you spent to purchase the put and you're almost guaranteed to make a killing on at least one leg of your spread. This is essentially the equivalent of buying a straddle on one of the funds, but you're improving your odds because you can expect both funds to decline. If you are lucky, you can hit both legs of your position as seen in this next chart of the SSO 2x Long S&P 500 against the SDS 2x inverse S&P 500, which are down 50% and 46% respectively:
Theoretically, this should work with any pair of leveraged ETFs, but make sure the daily volume of the funds you choose is at least 1 million shares, otherwise there might not be sufficient liquidity for the fund to accurately reflect the daily performance of the sector that it's tracking, which could possibly cause significant variations in the returns of this strategy.
The following lists are not complete, but they provide a starting point for pairs of funds to consider shorting or purchasing puts on. For an up-to-date list, check out the ProShares or Direxion websites.
List of 2x Leveraged ETF
(Listed as Bull / Bear)
List of 3x Leveraged ETF
(Listed as Bull / Bear)
Please Note:
This strategy will also work with commodity ETFs as long as they purchase futures on the given commodity, especially with new regulation from the CFTC expected to turn many commodity ETFs into closed-end funds.
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Oct 17, 2009
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