Double and Triple ETFs Decay Their Value Faster, By Design

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Includes: DXD, EEV, ERY, FAZ, SKF, UYG
by: Elaine Southard

Over time the inherent inequality between the same percent up, and then down, relentlessly erodes the value of a given starting investment. Every retailer knows this lesson.

On a \$1000-ticket item a 40% mark-up moves the price to \$1400, yet when later put on sale a 40% discount moves the price to \$840. An equal percent up and down yet the retailer is at a \$160 loss on his original \$1000. Many a small business has folded because of not attending to this mathematical truth in their financial planning.

Over and over, this, in principle, is what is happening. With doubled and tripled percent moves, this disparity is greatly magnified. So we, in my amateur’s opinion, must treat all double and triple ETFs as if we are paying a premium on a wasting asset, because for all practical purposes they are decaying, somewhat like an option would decay. This happens regardless of whether it is a double up ETF or double down ETF, because the effect comes from the function of mathematics, not what market item is being measured. However, the frequency of computing the new value does matter.

Want proof? Below is 20%, oscillating, to demonstrate what would happen to a small investor. The same thing is happening, yet less obviously, when the up and down percents are lesser and inconsistent.

By back checking your date of purchase with the underlying price of the market item/package being tracked, and comparing to your dollar value now -when it touches that same price point, you can witness the erosion in value of the ETF. A huge up day can of course show a good gain, yet the erosion sets in again.

The bigger the percent swing, the faster the dollar-value erodes. A triple erodes even faster than a double, a double faster than a single. So in a sense the triple exacts a higher premium. Notice that at 20% - \$1000 up and down was a \$40 loss, where at 40% - \$1000 up and down was a \$160 loss. 20% doubled is 40%, \$40 doubled is \$80, yet the loss on 40% up and down is \$160, or 4 times the loss (\$40 x 4). That gives a rough sense of the mathematical impact on triple versus double ETFs.

(my example is rounded for reporting convenience)

\$1000 invested goes 20% up (\$1000 base times 1.2 [120%])

then goes 20% down (new base times .8 [80%])

\$1000 to start:

• up \$120 0, down \$960
• up 1152, down 922
• up 1106, down 885
• up 1062, down 849
• up 1019, down 815
• up 978, down 783
• up 939, down 751
• up 902, down 721
• up 866, down 693
• up 831, down 665
• up 798, down 638
• up 766, down 613
• up735, down 588
• up 706, dow n 565, etc.

Just 14 up and down cycles, ending on \$565/\$1000 = 56.5 % remaining or a 43.5% loss. Of course an even 20% up and 20% down, repeating, will never happen. But, this proves that Down is the Prevailing Trend of every double and triple ETF.

Sometimes the underlying market item goes up more than one day, or down more than one day, yet any chart can let you count the number of zigs and zags up and down. Please notice that with this the volume is also irrelevant. A small volume day moves the percent up or down as easily as a large volume day. Multiple days up, then multiple days down does slow this trend down some, yet over two or three months it does happen.

Sometimes if the item goes up 20% and down 10% and up 20% and down 10% of course you do gain, but it is like bucking the tide. Like in Las Vegas, the odds are relentlessly with the house. The designers of these instruments, in my opinion, in all likelihood knew this going in.

My investments in DXD and SKF that never did as well as I expected, caused me to start thinking about an old maxim of mine. Do the math. It can disprove an obvious conclusion. I finally did.

I have been late in applying this to my own tiny holdings in UYG, EEV, ERY, and FAZ so I am looking for even a near break-even exit point ASAP. I made the mistake of thinking I could hold them long term. Because I now understand that the longer I wait, the further in the distance my break-even point is likely to move. I will start fresh, with a clearer understanding of how these products move.

If everyone who woke up to this pulled out of double and triple ETFs at once, the underlying market item components might get hammered with selling. Ouch. For example: at close February 5, 2009, SKF had traded a volume of 33,798,785, and FAZ 24,250,289. The same way short seller covering can move a market, I would bet ETFs, exited by too many investors at once, would move a market as well. Or would they?

I wonder how many hedge funds are hanging onto ETFs as investments?

Do treat these ETF’s like some pros are now counseling, as short term trading tools. Take your profits sooner rather than later. Then, at a better entry point, get back in and do it again. Mathematically, these are definitely NOT long term investment instruments. So Be Aware. And tell a friend.

Disclosure: Long FAZ, EEV, ERY.

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