Maybe Leveraged ETFs Aren't So Hated After All

Includes: DIG, DOY, DUG, UOY
by: Marc Gerstein

Not surprisingly, my recent defense of leveraged ETFs attracted opposing views but one comment was especially intriguing:

I'm smiling while I write this, but it seems as though you've taken on the task of the debater doing the best they can with an assigned fundamentally weak case.

Actually, I’m smiling too because the observation about “the tasks of the debater,” hits the nail right on the head, and I’m loving every minute of it. I can’t recall if my Seeking Alpha bio mentioned that I’m a (now-non-practicing) attorney who, in my younger days, specialized in litigation. I remember having constantly needled my earliest mentor about the criminal cases we had, about how he could sleep at night defending the guilty (oh yes, they were as guilty as guilty can be). He explained how everybody, even the worst folks, were entitled to a defense and that someday I’d get it. Hey George, are you reading? I get it!

Arguing for the defense here is a pleasure because this time, I really do believe in my “client.” As to the fundamentals, my earlier article can speak for itself and each reader can and will make his or her own decision on the merits. But I’m becoming even more intrigued by the “politics” around this whole issue.

These securities are being mercilessly pounded by, commentators notwithstanding, favorable experiences on the part of investors who have been successfully using these products, and a level of marketplace acceptance that suggests such positive experiences are more prevalent than just a few anecdotes.

The most useful item of evidence in support of the acceptance of leveraged ETFs is the trading volume, whether measured as shares traded or dollars traded. It’s huge.

I’m not going to bore you with the details. Just look at charts. Instead, I’ll jump right to the next step (I’m not sure that’s correct debating technique, but it served me well in court); whether we can infer from the large volume that users are making intelligent decisions, as opposed to running with an ignorant sucker mob.

I can’t offer direct evidence unless I get names, track these people down, interview them about their results, and, of course, ask them to document their claims of success. But I do see some circumstantial evidence which, contrary to the assumption of many television- and movie-scriptwriters, is very much admissible and often even more credible than direct evidence.

Let’s compare a pair of leveraged ETFs that offer up and down plays on oil prices, ProsShares Ultra Oil & Gas (NYSEARCA:DIG) and ProShares Utra Short Oil & Gas (NYSEARCA:DUG), with alternatives: MacroShares $100 Oil Up (UOY) and MacroShares $100 Oil Down (DOY).

The MacoShares products are a topic unto themselves and have been beaten up by commentators even more than has been the case with leveraged ETFs. I actually tried the predecessor to DOY once (as to “predecessor,” it’s a long story; if you don’t know, don’t ask!) and did fine with my singe attempt. But frankly, these products are so weird even I’m not going to try to defend them. (I should have known what was to come when, shortly before the first ones came out, a MacroMarkets official told me about how they patented the MacroShares accounting system!)

While the MacroShares products don’t use leverage, they are arguably comparable to DIG and DUG in that both offer investors simple equity plays on oil prices that spare them the need to deal with the issues connected to options and futures. (Actually, it’s easy to play the upside with individual stocks. It’s the down play that attracts notice, with the up ETF plays appealing as part of the matched pairs.)

The data I’ll show will be for the down plays, DUG and DOY, these being the ones that really offer something unique in the context of ordinary equity trading.

Table 1 shows the average daily volume for each security from inception through 1/26/09.

Table 1

Obviously, DUG (the leveraged product) is considerably more popular. But let’s drill down a bit more.

Table 2 shows a trend, the average daily volume during each product’s first 60 trading days, and each one’s average for the last 60 trading days.

Table 2

DUG, the leveraged product, started much more gingerly. But look at the trading interest it gained as time went on. By way of contrast, DOY, the MacroShares offering, started OK but lost ground as time passed.

Actually, though, DUG has been around longer than DOY. Perhaps investor sentiment toward a down oil play was different in DUG’s earliest days. Table 3 addresses that. The first-60-day number it presents for DUG is not the first 60 days of its own trading, but the first 60 days of DOY’s availability.

Table 3

OK. Sentiment toward a down oil play was relevant. When we control for this, we see that average daily volume for DUG also declined. But look at the magnitude of decline for each. Average daily volume for DUG slid about 13%, an unspectacular degree that’s in line with what we see all the time. But DOY’s volume plummeted 87 percent.

While DOY and DUG are both parts of trading pairs so to speak, the formality of DOY’s pairing with UOY is much tighter. It’s not just a matter of reciprocal goals. DOY and UOY are designed to see-saw, as one goes up, the other is supposed to go down by a like amount. (As previously noted, the accounting system is patented!) Table 4 extends Table 3 to show data for both pairs.

Table 4

No matter how we slice it, the result is the same. The popularity (measured by trading volume) of the leveraged funds has increased or held up while that of the MacroShares declined.

Let’s finish up with a couple of pictures. Figure 1 shows a chart of daily volume for DUG. Figure 2 does likewise for DOY.

Figure 1

Figure 2

Are there substantive reasons why the market is treating these securities differently? Yes, there certainly are!

Although the investment play is generally comparable (a way to short oil by making plain-vanilla long purchases of equity shares), the structures of these ETFs are light years apart, a topic well chronicled on Seeking Alpha (click here for the results of a search on “macroshares”) and elsewhere. And if we really want to split hairs with the differences in investment plays via use of leverage in one instance, that should, according to the views of many commentators, work against DUG (with its hated leverage) and in favor of DOY.

So we see that the market is noticing and reacting to fundamental differences in the product, clearly preferring one over the other. This supports the view that we are not dealing with an ignorant mob, but an investment community that notices differences and is making presumably thoughtful choices.

By the way, you may find it interesting to browse volume trends among the many different leveraged products. Investors are picking and choosing here, too.

I focused on oil and the contrast with MacroShares because this is the one instance where we get alternative ways to make similar short plays within the context of long-only equity trades.

But we also see that investors are making plenty of choices within the leveraged fund universe. Volume for ultra short oil is high. So, too, is volume for ultra short S&P 500. Volume for ultra short Russell 2000 or ultra short telecomm is much leaner. Ultra short real estate is hugely popular. Ditto ultra short financials. As for Rydex’s double short S&P 500 midcap, wake me when someone cares.

In sum, members of the jury of the court of investment-community opinion, I submit that we see by a preponderance of evidence adduced here that (1) leveraged products in general are popular, (2) that said popularity is not uniform across the board, (3) that said popularity is the result of thoughtful choices, and (4) while my defense of leveraged ETFs puts me in the minority among those who write on the topic, I seem to have considerable company in the investment community at large.

There is, still, the potential sucker question. Are all these thoughtful decisions just plain stupid? (i.e. Did they think but get it wrong anyway?) Are investors in the habit of continuing to do something useless at best and damaging at worst even after they’ve been chided by critics and seen the results in their own brokerage accounts? That’s for another day. (Like I said, I’m enjoying this debate!)