Much has been written abut the deteriorating nature of daily leveraged ETFs. In this post, I am going to point the reader to some additional resources to understand these vehicles, and present my approach on how to reap profits from the existence of these ticking time bombs. During the course of this post, I will refer to three pair of leveraged ETFs as examples when implementing this strategy; FAZ/FAS, which is a 3X bear/bull leveraged financial services sector ETF, TQQQ/SQQQ, which is a 3X leveraged bull/bear pair correlated to the NASDAQ-100, and TNA/TZA, the 3X leveraged ETFs associated with the Russell 2000 index.
In general, the public does not have a clear understanding of how these funds work, even though the fact that they are not suitable for long term investments is disclosed in their prospectuses. Many have the impression that if they purchases shares of a 2X leveraged S&P fund, and the S&P goes up 20% in one year, their shares will increase by 40% in that time, which generally speaking, is not the case. I have explained this to some knowledgeable and sophisticated investors, and even they took a while to convince.
The underlying vehicles inside these ETFs are complex derivatives, options, swaps, etc., much of the same instruments that brought us the great real estate crash and financial collapse of the past few years. Why does the SEC allow these products to be sold to the general public that may lack the knowledge to fully comprehend them? Is it coincidence that these funds came into widespread being right after the removal of the shorting uptick rule that had been in place for ~70 years? Why did they allow the exotic collateralized debt junk a few years ago? These leveraged ETFs allow clients to apply leverage without using margin, and the inverse funds allow investors to be short the market in cash accounts, such as IRAs, again avoiding the requirement for margin.
Due to the daily rebalancing requirement of the fund, also known as the constant value trap, the fund has a high statistical probability of declining in value as time progresses.
In terms of Calculus, the limit as time approaches infinity of all daily leveraged ETFs is zero. Here is Direxion explaining why their own funds are not suitable longer term investments: http://etfsmag.com/images/Understanding_Exchange_Traded_Funds.pdf
For example, FAZ (3X the inverse of the financial services sector), which closed it's first day of trading on November 19, 2008 at a split adjusted $1,293 per share, is now worth ~$15 per share. In other words, FAZ has declined in value an average of ~18% per month, and has lost almost 99% of it's value in it's lifetime of less than two years. FAS, which started life at $34.58 on the same day, is now ~$20. The funds occasionally reverse split the shares to keep the share price from getting too low.
The leveraged bear funds have a tendency to erode even faster than the leveraged bull ETFs. I won't explain why here, but refer you this article written by a group of professors that goes into detailed statistical analysis of the impact of daily rebalancing on these funds, differential equation by differential equation. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344133
What is important, is that to minimize risk of predicting market direction, the mix of bull/bear shorts should be what I will call market neutral-plus, slightly more short the bearish leveraged ETFs than the bullish ones, perhaps in ratio of approximately 55(short bear funds)/45(short bull funds). The reasons for this are twofold; the degradation in bearish funds tends to be slightly greater, and there is a limit to how the low the market can sink, and no theoretical limit to upside potential. The roughly net neutral strategy will also reduce volatility in the portfolio.
In the investment community, us nerds like to joke that all these funds should trade under the ticker symbol POS, for Piece of "Something". There are thousands of investors who are implementing shorting strategies for these funds, their postings are all over the Internet. Here are a couple more posts I will point you to.
Let's look at the performance of the three ETF pairs in past six months (March 1, 2010 through August 31, 2010). For the sake of simplicity, we will use a market neutral implementation, assuming a portfolio of 50-50 bull/bear positions.
FAS lost 28.1% and FAZ lost 5.2% in the past 6 months, so an investor who had been short an equal amount of both would have received ~16.7% increase in 6 months with a neutral double short position. TNA dropped 21.8%, while TZA dropped 17%, a net return of ~19.4% in six months to the equally short investor. TQQQ and SQQQ lost ~14.5% and 8% respectively, yielding ~11.3% to the double short investor. The more leveraged the fund, the greater the volatility of the underlying sector, and the greater the market condition volatility, the higher the return tends to be.
The further one strays from the market neutral-plus implementation, by employing active management, the more risk being taken. By active management, I mean attempting to time the initiating of short positions and the various cover buys in an attempt to increase return. This active management could increase returns, or screw things up and reduce returns or generate losses. The point of this overall approach is to minimize trying to forecast the direction of the market, so straying too far from the neutral-plus model begins to defeats that purchase.
What would Warren Buffet say about this? He would turn over in his grave, and he's not even dead yet. This is not value investing, there is no point in comparing apples with elephants. There is no societal value add from these activities, this is not about being a shareholder in a company. If will make you feel better, you can become a shareholder in one these value destruction ETF funds and watch your money dissipate.
What are some of the difficulties in implementing this strategy? First, you have to get the shares to short. Given the large number of clients that are aggressively shorting these funds, they are not always readily available for shorting. Also, your broker can "call away" your shares, forcing you to buy to cover when they claim they no longer have them available for borrowing, which I have had happen to me a couple of times. Also, there are corner cases where this strategy will not work, when a market goes extensively in one direction with very low volatility. However, the probability of that occurring is very low.
There are many variations of this double short methodology, but they all have at their core the long-term unsuitability of these leveraged ETFs as investments, and the implementation of shorting as opposed to owning these ETFs. I have begun to implement this strategy in a couple of portfolios. I do not recommend that you try this at home, have someone who does this for living and keeps a close eye on the market do this for you. These instruments are volatile, with wide intraday swings. This is for someone who is an experienced trader, who knows how to step into and out of positions to construct a portfolio. I am seeking some additional clients who want a managed portfolio that includes implementing this strategy. (How's that for shameless self promotion). If this is of interest to you, please email me at email@example.com.