Leveraged ETFs Are Not So Bad: The SPXU Case

| About: ProShares UltraPro (SPXU)

Summary

Leveraged ETF drift theory.

One-year drifts of S&P 500 leveraged ETFs.

Hedging with SPXU.

I published on Monday a monthly follow-up on leveraged ETF decay. Today's article is focused on S&P 500 leveraged ETFs, especially on ProShares UltraPro Short S&P 500 (NYSEARCA:SPXU), and shows that hedging a stock portfolio with SPXU has been cheap for one year.

What people usually call "decay" for leveraged ETFs is beta slippage. The target of leveraged ETFs is specified by their daily return. A 2x leveraged ETF aims at returning every day twice the daily return of the non-leveraged underlying asset. Imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:

(1 + 0.25) x (1 - 0.2) = 1

The perfect 2x leveraged ETF has lost 10%:

(1 + 0.5) x (1 - 0.4) = 0.9

This is beta slippage. It is not a scam but a normal behavior due to rebalancing the fund's holdings every day to reach the daily target (holdings are mostly futures and swap contracts). Beta slippage is complicated because it is path dependent and cannot be calculated from aggregate statistical data. It doesn't always result in a decay: for a trending asset, beta-slippage can be positive. Imagine an asset going up 10% two days in a row. On the second day, the asset has gone up 21%:

(1 + 0.1) * (1 + 0.1) = 1.21

The perfect 2x leveraged ETF is up 44%, more than twice 21%:

(1 + 0.2) * (1 + 0.2) = 1.44

Something strange at first sight, but perfectly logical when looking at the math: in this case, the inverse 2x leveraged ETF has also a positive beta-slippage:

(1 - 0.2) * (1 - 0.2) = 0.64

It has lost 36%, which is better than losing twice 21%. It is the result of compounding leveraged negative returns: the value cannot go negative, so the loss is asymptotic.

That's enough with math, now let's look at the return and beta-slippage of S&P 500 ETFs on a trailing year (data on 2/13/2017):

Ticker

Lever

Return%

Lev.x SPY return

ETF Drift%

Trade Drift%

SPY

1

29.32

29.32

0.00

0.00

SSO

2

62.60

58.64

3.96

1.98

UPRO

3

103.65

87.96

15.69

5.23

SH

-1

-23.69

-29.32

5.63

5.63

SDS

-2

-42.32

-58.64

16.32

8.16

SPXU

-3

-56.75

-87.96

31.21

10.40

ETF Drift is the difference between the ETF return and SPY return multiplied by the leveraging factor (lever). Trade Drift is ETF Drift divided by the absolute value of lever. Trade Drift is the drift relative to the amount of SPY giving an equivalent exposure. Drifts are mostly beta slippage, and also account for tracking errors and ETF fees.

As we can see, all S&P 500 ETFs, long or inverse, have a positive drift for one year. It is the result of a steady trend with little volatility in the stock market. A note of caution is necessary: if a market downturn happens and volatility comes back, beta-slippage may become a heavy drag. However, when negative drift happens, it is less harmful on S&P 500 leveraged ETFs than for more volatile underlying assets (precious metals, sector indexes).

Consequence for hedging:

On this period, I have been using SPXU to hedge a part of my trading account (the Market Neutral Portfolio). SPXU is obviously in heavy loss on one year, but it has the best positive beta-slippage of the S&P 500 ETF series: 10.40% in Trade Drift. It doesn't mean that hedging a stock portfolio with SPXU has resulted in a 10.40% positive drift on the hedged equity value because the hedging position needs to be rebalanced to keep a more or less constant exposure, and rebalancing cuts the drift.

The real drift resulting from the hedging position depends on rebalancing dates: once a week, once every two weeks, or beyond a threshold from ideal size, etc... It's also path dependent. The real drift may have been slightly positive or slightly negative depending on rebalancing dates but was very likely significantly cheaper than following the same tactic with a short position in SPY (with borrowing and margin rates), in futures (the e-mini S&P 500 contract had a rolling cost a part of the year), or with options (which also incur a time decay and rolling costs). In 2016 my Market Neutral Portfolio has returned about 18.9% (non-audited calculation), whereas SPY with dividends returned 14%. It means that the full-hedged version (100% market neutral) would have returned about 5% with zero market exposure, the risk being the aggregate idiosyncratic risk of a 25-stock portfolio based on quantitative fundamental models. Hedging at 100% may not be the best solution regarding an investor's objectives and risk tolerance. Other hedging tactics are possible, for example based on the market risk indicator MTS10.

SPXU is included in my monthly Leveraged ETFs Decay Dashboard. You can follow me if you want to be notified of its drift every month.

Past performance is not a guarantee of future results. Market Neutral Portfolio is not a part of my service on SeekingAlpha. Read my profile or send a private message for more information.

Disclosure: I am/we are long SPXU.

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.

Additional disclosure: Long SPXU for hedging purposes. My holdings are net long stocks.

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