Benefits Of Short Selling Inverse Leveraged ETFs

by: Cliff Smith

Comparisons are made between holding long positions of leveraged ETFs and shorting inverse leveraged ETFs of the same family.

The following cases are presented: 1) long SSO and short SDS versus SPY, 2) long SPXL and short SPXS versus SPY, and 3) long TMF and short TMV versus TLT.

Shorting an inverse leveraged ETF with periodic rebalancing significantly increases growth in bull markets compared to buying and holding a leveraged ETF or an unleveraged version of the ETF.

When combined with simple tactical methods such as moving averages or momentum, drawdown can be significantly reduced in short inverse leveraged ETFs, while maintaining high growth.

As I have developed simple hedge strategies such as the Tactical Hedge Strategy, THS, I have become intrigued with the idea of using short inverse leveraged ETFs instead of long leveraged ETFs. There does not seem to be much literature on short selling inverse leveraged ETFs with periodic rebalancing. (Since writing this article, I was informed by Harry Long that he had written a book on this subject, and wanted to be cited in this article). Some platforms do not allow you to short inverse leveraged ETFs. And you cannot short ETFs in nontaxable retirement accounts. So this article's information is only useful if you own a taxable account.

But the more I have looked into the benefits of shorting inverse leveraged ETFs like ProShares UltraShort S&P 500 ETF (NYSEARCA:SDS), Direxion Daily S&P 500 Bear 3X Shares ETF (NYSEARCA:SPXS), and Direxion Daily 30-Year Treasury Bear 3x Shares ETF (NYSEARCA:TMV), the more I like what I see. In this article, I will present some of the research I have performed comparing short inverse leveraged ETFs with long leveraged ETFs and their unleveraged counterparts.

I will start by looking at ProShares Ultra S&P 500 ETF (NYSEARCA:SSO) and SPDR S&P 500 Trust ETF (NYSEARCA:SPY), and comparing their performance versus shorting SDS. The data on SSO and SDS go back to mid-2006, so the back-testing includes the large bear equity market of 2008. SPY, of course, goes back much farther, but the calculations will be performed from mid-2006-present.

The figure shown below is a comparison of SSO and SPY in the June 20, 2006-present time frame. The green curve is SSO and the blue curve is SPY. The two bar graphs on the right are total return on the top and volatility on the bottom. Trading commission fees and interest costs for buying on margin are not included. The figure is from ETFreplay. Notice that during the bear equity market in 2008, SSO has a drawdown significantly greater than SPY, but has greater growth in the bull equity market (2009-present). The maximum drawdown for SSO is -84.7%, while SPY has a maximum drawdown of -55.2%. SSO has just now recovered from the drawdown, and its total return is equal to SPY at the present time, 89.2%.

But if we short SDS, we see an entirely different picture. The back-test results for a short SDS rebalanced monthly are compared to SPY's results from July 13, 2006 to the present. The ETFreplay results are shown below. The green curve is short SDS, and the blue curve is SPY. The total return is the bar chart on the top right, and volatility is the bar chart on the bottom right. The maximum drawdown is -78.3%, still much more than SPY. But the growth of a short SDS position rebalanced monthly is excellent during the bull run. The total return is 355.2%, compared to SPY's 89.4%. The benefits are significant in shorting SDS (and rebalancing) versus buying and holding SSO. Of course, if we combine a tactical strategy to this scenario, such as switching to SHY when a 5-month moving average is crossed, we can have the best of both worlds, minimum drawdown in bear equity markets and maximum growth in bull equity markets.

Similar benefits are seen between shorting SPXS versus holding a long Direxion Daily S&P 500 Bull 3X Shares ETF (NYSEARCA:SPXL) position. Presented below is a figure of SPXL (in green) versus SPY (in blue). The time frame is November 5, 2008-present, so some of the bear equity market is present. The maximum drawdown is very high (-71.3%), and the total return is 448.8% (CAGR = 34.3%). This compares to SPY with a maximum drawdown of -28.6% and a total return of 133.7%. The drawdown will be larger than these numbers if all of 2008 was included. Here, again, there is need of tactical methods to get out of SPXL in bear equity markets and into SHY. Or, one can combine SPXL with a long-term treasury ETF to reduce drawdown. That is the intent of the THS reported in the previous article.

If we short SPXS instead of going long SPXL, significant improvements are seen. The figure below compares a short SPXS position rebalanced monthly (in green) with SPY (in blue). The time frame is November 19, 2009-present. The short SPXS strategy has excellent growth (total return is 2583% and CAGR is 77.4%). The maximum drawdown is very large (-62.2%). Once again, it is important to utilize either simple tactical methods like a 5-month moving average or hedge strategies employing long-term treasures to reduce drawdown. But the growth rate in a bull equity market is sensational.

And finally, I present a comparison of a long Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA:TMF) position and a short TMV position. The long TMF position (in green) is compared with TLT (in blue) in the figure. Little benefit is seen in holding a long TMF position versus holding TLT in this 2009-present time frame. The total return of TMF is essentially equal to the total return of TLT, and the maximum drawdown of TMF is significantly higher than TLT (-53.3% versus -20.5%).

But using a short TMV position with monthly updating results in vastly improved growth. The figure for a short TMV position (in green) versus TLT (in blue) is shown below. In this case, the total return is 165.8%, while TLT is 35.5%. The maximum drawdown is -47.3% for short TMV versus -20.5% for TLT. Once again, a tactical strategy needs to be implemented to get out of the short TMV position in bear treasury markets.

In conclusion, it appears that shorting an inverse leveraged ETF gives improved growth over the unleveraged version of the equity or the leveraged version of the equity. To reduce drawdown and volatility, an investor must use some sort of tactical method to get out of the short position in bear markets.

Disclosure: I am/we are short SDS, TMV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.