Investor Jujitsu Part 1: The Volatility Dividend

by: Kiran Pande

Executive summary:

  • Daily leveraging of an index quickly erodes value due to volatility decay and excessive fees.
  • Volatility decay and fees are reversed when ETFs are sold short.
  • A short pair trade captures these effects and allows investors to be market-neutral.
  • Shorting Financial ETF pairs like (NYSEARCA:FAS) + (NYSEARCA:FAZ) creates explosive returns with limited potential for loss.
  • Perpetual volatility creates a "volatility dividend" via short pairs.


In Japanese, Jujitsu signifies the art of using an opponent's force against him instead of using one's own force. In the 21st century of equity investing, there exist several sneaky ways in which other investors' mistakes can be predicted and used against them for profit. Part 1 explores what is perhaps the sneakiest investor Jujitsu technique: shorting leveraged ETF pairs to create a steady, synthetic dividend.

The Underlying Mathematics

Sometimes called "beta decay" or "systematic slippage," volatility decay is probably the most severe side-effect of investing in leveraged ETFs. If a 3x levered ETF like Direxion Daily S&P 500 Bull 3X Shares (NYSEARCA:SPXL) sees volatility over time, its long-term returns will likely be less than 3x those of its underlying index, the S&P 500. Under those circumstances, the opposite will be true of Direxion Daily S&P 500 Bear 3X Shares (NYSEARCA:SPXS), which would likely incur more than 3x the S&P 500's returns in losses. Models that map the returns of these ETFs will indicate that there is massive loss of alpha over time. Consider the following scenario, in which 4 theoretical, levered ETFs are compared to an underlying index when that index sees alternating days of +2.00% and -2.00% over the course of 90 days...

Source: none (calculated via formula)

It should be noted that 5x and 10x levered ETFs do not exist (and for good reason), but they are meant to exaggerate the effect for the purpose of illustration. That being said, the cause of this effect is purely mathematical, and its effects are easy enough to understand. Pretend you have $100,000 on day one and it appreciates by 1.00%. You have $101,000 on day two. Now, pretend that you're curious how much depreciation is needed to set you back to your original $100,000. The answer is not -1.00%; it's -0.990099%, because your frame of reference has changed. Investors tend to view things in a relative sense rather than an absolute sense (in other words, the market quickly forgets that yesterday's 1.00% gain is more than erased by a 1.00% loss today on an absolute basis, despite being identical on a relative basis). Thus, if the market decides to correct itself by equal magnitude, you'll be left with less money than you started with. The compounding effects of this miscalculation create volatility decay. Since markets rarely move in a straight line, the effects of volatility decay are frequently masked by asymmetrical price movement like rallies or sell-offs.

If you are wondering why volatility decay ETFs that might take advantage of this do not exist, you have to consider several factors. First, all ETFs are largely a matter of satisfying a niche demand. If no demand exists for a niche such as volatility decay (due to a lack of widespread understanding of the effect), no sponsor will be willing to conceive an ETF. Second, the strategy relies on the assumption that owners of leveraged ETFs do not know that decay is occurring. If every leveraged ETF owner was fully aware that their returns were being quickly eroded, they would certainly not be owners of such positions for very long. I would love to see such an ETF, but it does not exist yet.

Ally #1: Short Selling Reverses Volatility Decay

If we can't buy an ETF, there has to be a way of engineering a means of capturing volatility decay on our own. Especially in dealing with highly leveraged ETFs, it's important to remember that the maximum gain of a short position is always 100% (no ticker can dip below $0.00). Remember also that volatility decay acts against investors in both levered ETFs and inverse-levered ETFs. With that in mind, shorting an ETF effectively reverses the effects of volatility decay in both cases, locking in significant additional gains during periods of volatility. Here are the same ETFs as shown above, but sold short this time...

Source: none (calculated via formula)

Given enough time, each of these ETF positions will approach an asymptote of 200.00, just as the ETF positions in the prior chart will approach an asymptote of 0.00. Believe it or not, even the underlying index (such as the S&P 500) will eventually creep perpetually closer to 0.00.

Covering The Short Position In Intervals

The second chart above assumes that we sold a share of each ETF short at the start of day one and bought to cover at the end of day 90, capping possible gains at 100%. Covering and borrowing fresh shares to sell short at regular intervals allows us to pursue the possibility of gains over 100%, and accelerates gains substantially. Think of it as accumulating cash gains like dividends and reinvesting them anew. Here is what that chart would look like if each short position was covered and sold short with proceeds every 10 days...

Source: none (calculated via formula)

This closely resembles the logistical and visual nature of reinvesting traditional dividends. Beware, however, that this is a strategy that is exceedingly difficult to pull off, as liquidity, capital requirements, and significant risk come into play (these are discussed later). However, this is a good illustration of how diminishing returns can be turned into accelerating returns. If we could execute this strategy with an existing 3x levered ETF, we would haul in a 90-day gain of 17.28%, all while the market perceives only alternating changes of 2.00%.

Ally #2: Reversed ETF Fees

Once we sell short, the various fees levied on levered ETFs are also recruited by our team, quietly adding to gains (since their detrimental effects on NAV become reversed in a short position). Levered ETF fees are among the highest around due to the need for levering (borrowing), daily return precision, and managers with an intimate knowledge of financial engineering. Each of these needs make fees difficult to predict, but frequently high enough to have a noticeable effect on performance. It is not unheard of to see a leveraged ETF with fees amounting to 1.00% annually. That 1.00% in loss becomes 1.00% gain in a short position. These fees have the direct effect of subtracting alpha from a long position and adding alpha to a short position.

Historical Performance

The history of leveraged ETFs is somewhat limited, but the few years we can observe suggest the strategy would have been overwhelmingly successful. The following chart shows the performance of $100 beginning on November 19th, 2008 (the date of inception for Direxion's S&P 500 Bull and Bear 3X Leveraged ETFs, SPXL and SPXS)...

Source: Yahoo Finance, adjusted historical data

This, of course, ignores the cost of borrowing shares of SPXS to sell short. However, it's fairly certain that no practical level of borrowing cost would have erased a 5-year gain of 1,725.83% or eroded this gain to anywhere near SPXL's gain of 636.07%, which is already quite robust compared to the SPDR S&P 500 Trust (NYSEARCA:SPY). Levered ETFs are consistently frowned upon by their own sponsors and investment professionals alike for long-term gains, yet it cannot be denied that a simple holding of SPXL was a great decision over the last 5 years in hindsight (owing to an abnormal bull market). Note how similar the past 5 years appear when compared to the theoretical chart found in the prior section; this is no coincidence.

But what happens to the bear ETFs? If we observe what would have happened to a long position in SPXS and a short position in SPXL, the strategy is reiterated...

Source: Yahoo Finance, adjusted historical data

While it may seem insignificant to see the final values $3.65 and $1.37 when they were once $100, it's important to note that SPXL sold short outperformed SPXS at every point during the last 5 years due to the capturing of volatility decay and fees. If we encounter a situation in which our future expectation is negative for the market, SPXL sold short will be the better choice by far. Thus, the considerable risk assumed by 3x bull investors was handsomely rewarded, while 3x bear investors were punished disastrously. How is a reasonable investor to handle these choices without essentially placing an all-in bet on the market's next 5 years?

Ally #3: Market Or Sector Neutrality

Therein lies the important question that we have ignored thus far... where do we see the market going? It's simply a matter of opinion. If we see a bright future for the S&P 500, we want to create a short position in an inverse-levered ETF. This, in effect, will allow us to capture several times the S&P 500's gains; the only difference is that volatility decay is now on our team. If we see the market going sour, we'll want to short a levered ETF (not inverse), allowing us to capture the S&P 500's losses with volatility decay working in our favor again. Both of these options are illustrated in the prior sections, but obviously imply extreme and unreasonable risk.

Meanwhile, a third option is to remain market neutral and still capture volatility decay. This can be accomplished via a pairs trade that includes short positions in both the bull and the bear levered ETF iterations, such as SPXL and SPXS. Employing this strategy requires us to rebalance (buy to cover and sell short again with proceeds) at regular intervals, resetting each ETF to be evenly weighted every time. This strategy would look like this if executed beginning in November, 2008 at the inception of both ETFs...

Source: Yahoo Finance, adjusted historical data

SPY outperformed by a significant margin, but do not forget that the S&P 500 tends to return only about 9% annually; 150% in just over 5 years is so far removed from this figure that it's likely we're looking at a period of time that isn't representative of the market's historical long-term returns. In other words, it would be prudent to assume that the next 5 years will not look like the last 5 years. Whether the market appreciates or declines over the next 5 years, the chances of a repeat are astronomically unlikely. As such, the pursuit of more conservative gains is an intelligent endeavor.

On the other hand, the above short pair preserved capital faithfully and recorded its most aggressive gains during periods of volatility in which SPY frequently saw major losses. A return of 55.10% in just over 5 years is quite in line with what we statistically expect of the S&P 500, but with much less deviation. Furthermore, this is a pair of ETFs that tracks relatively stable, large-cap assets in the form of the S&P 500, which is arguably much less volatile than most other underlying indexes. As far as volatility is concerned, this short pair is one of the most conservative.

If we want to get more aggressive, a short pair consisting of Direxion Daily Financial Bull 3X ETF and Direxion Daily Financial Bear 3X ETF should do the trick. Over the same period of time and conditions, this pair would have produced the following result...

Source: Yahoo Finance, adjusted historical data

The strategy would have crushed the market, owing to the fact that financials tend to see high levels of volatility on a frequent basis, and happened to be rebounding from dismal sentiment after the recession. Notice how when the market sees frequent up-and-down movement, the short pair quickly shoots up, yet is largely unaffected by the overall direction the market moves. If there is an expectation of volatility in 2014, a short pair may be perfect. Don't expect a 5-year gain of 249.42% going forward, but also do not underestimate the market's tendency to be scarred by events such as the recession that will continue to facilitate considerable volatility in the financial sector.

Major Limitations

There are several major limitations that could leave the above strategies dead in the water. For an investor to consider short pairs, he/she needs a relatively large stash of capital from the outset. The act of rebalancing is the combination of 4 transactions (2 buy-to-covers and 2 sell-shorts), meaning transaction costs may become significant if starting capital is not adequate. Assuming a conservative retail cost of $8 per trade, we're looking at an annual commission of $384.

A second limitation is the cost of borrowing shares to sell short. A study published in 2012 reports that the cost of borrowing leveraged ETFs to sell short ranges anywhere from 1.40% to 8.90% annually. This varies significantly depending on the ETFs borrowed and prevailing interest rates, but clearly this cost has the potential to detract significantly from returns. Upon receiving a quote for the cost of borrowing shares, be sure to consider the long-term cost it will imply (easily calculated). Do not be afraid to abandon what is otherwise an attractive strategy if prevailing interest rates rise considerably.

Finally, short sellers must constantly monitor the liquidity of the chosen ETFs. Given that shorting an inverse ETF is quite a novel transaction, it may become difficult to locate a broker willing to lend shares at all. If more investors begin to employ the strategy, this may become a major issue.

It's also worth noting that while most leveraged ETFs do not pay consistent traditional dividends, any such dividends will need to be paid to the lender. Thus, while the various alpha-drivers above switch from being detrimental in a long position to beneficial in a short position, traditional dividends are an alpha-driver that will do just the opposite. Short sellers must be well aware of each leveraged ETF's distribution policy and history to avoid unexpected dividend payments.

Final Thoughts - "Profit is sweet, even if it comes from deception." - Sophocles

This Jujitsu trick boils down to a quiet arbitrage strategy: investors who hold long positions in leveraged ETFs will bleed alpha as major price movement occurs. What's important is that these investors usually don't know that this is occurring, so they will continue to hold their ETFs despite warnings from their issuers, allowing their loss to be our gain. Furthermore, since most indexes are constantly pervaded by some level of volatility, loss of capital will seldom occur. ETFs that track an index which experiences heightened levels of volatility, or sectors (like financials) for which volatility is constantly high, will incur consistently aggressive returns from high levels of volatility decay. What is produced by shorting these is a synthetic dividend.

As soon as an in-the-money short pair is bought to cover at regular intervals, the difference between the original cost basis and subsequent buy-to-cover purchase price is captured as a cash profit (dividend). The magnitude of this dividend is entirely dependent on the level of volatility that was incurred over the course of the position. Unless the underlying index moves quickly and consistently in a single direction (losses or gains), volatility will produce a steady dividend. If not, the usage of opposing levered ETFs will serve to mitigate the capital losses of rapid consecutive movement. For example, if an underlying index incurs 5 consecutive days of 3% loss (which is far beyond what has ever occurred in recorded history, including the Great Depression), the index will incur a total loss of 14.13%, the 3x bear ETF will incur a total loss of 37.60%, and the 3x short pair will incur a total loss of only 8.13%. This isn't based on history; it's simple mathematics, or investor Jujitsu as I prefer to call it.

2014, which has been called "The Year Of Volatility" by some of the best minds in economics, may perhaps be the best time to employ this strategy. Some investors have attempted to capture volatility through the VIX index via ETNs like iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), yet these derivative products ironically suffer from the disadvantage of being volatile in themselves. As investors search for defensive strategies to weather the inevitable market correction, this strategy is one that will fly under the radar and reward perceptive investors.

If this strategy has a place in your portfolio, I encourage you consider it for 2014. If not, be cognizant of the fact that levered ETFs, and even basic indexes, will always suffer from volatility decay. If you hold a long position in levered ETFs for extended periods of time, understand that other investors are quietly using investor Jujitsu to force your seemingly aggressive ETFs into submission.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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