While writing on the inefficiencies taking place at VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX) and iPath Dow Jones UBS Natural Gas ETN (NYSEARCA:GAZ-OLD), as well as discussing the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) I noticed something disturbing: There are traders that, having gotten stuck in these (and other) ETFs/ETNs at higher prices, refuse to get out in the hope that a later rebound might help them achieve breakeven. Also, some others deeply believe they are investing in something for the long term.
Given how some of these ETFs/ETNs work, that is incredibly dangerous. Due to several effects, these ETFs/ETNs can go down even if the underlying commodity goes up over the long term. Indeed, some of these ETFs/ETNs might even have an in-built tendency towards zero. And you don't want to overstay your welcome on something that might go towards zero no matter what the underlying does.
Indeed, in this regard you don't have to believe me. You just have to read the prospectus on these things. For the TVIX, one of the risk disclosures (page 28, PS-28) reads like this (bold not mine):
The long term expected value of your ETNs is zero. If you hold your ETNs as a long term investment, it is likely that you will lose all or a substantial portion of your investment.
So it's as clear as it can be, the long term expected value of these ETNs is ZERO - this means you cannot hold them for the long term. You have to take your losses, hope, here, is a sure killer.
Why does this happen?
There are two main effects that produce this outcome over the long term. One is the effect of contango on ETFs/ETNs that hedge or buy their exposure through the futures markets. I have already written an article that explains this.
The other effect, which happens on levered ETFs/ETNs (those that do 2x/3x/4x the daily movement of the underlying), comes from the compounding of the returns. A simple example where an index goes up 10% in a single day, and goes down 9.09% the next day ending up at the same level, would produce a loss of around 1.8% in a 2x levered ETF, this compounded over many days ends up eating away the value of the fund even if you bet on the correct direction.
The conclusion to be drawn here is that you should check your portfolio for any fund that meets these characteristics, and get rid of it. The characteristics are:
- The fund being levered;
Or the fund investing in a market that's in a deep contango;
Additionally, if you ever consider investing in any ETF/ETN meeting these characteristics and expect to need to hold it for a while, you should consider shorting the opposite ETF. For instance, let us say you wanted 3x levered exposure to natural gas on the long side. Instead of going long the VelocityShares 3x Long Natural Gas ETN (NYSEARCA:UGAZ), you should short the VelocityShares 3x Inverse Natural Gas ETN (NYSEARCA:DGAZ).
Disclosure: I am short GAZ-OLD.