Edit- I was still working on this and published it to view it so a few of the numbers were not correct on the first publish and I moved around some of the links to make it easier to see. Please re-read this if you read it before 12:30 EST (9:30 PST) on the 14th.
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First I want to mention that all ETFs tend to underperform their ideal goal. For example, a single long ETF will often underperform the index it tracks, double long ETFs will tend to perform below 2x the index they track, and so on. The risks that all ETFs face can be found in the Proshares prospectus and include, most notably correlation risk (the risk that the ETF does not perfectly match the index), and counterparty risk, which is the risk that the party Proshares (or other ETF companies) do business with default on their payments. For example, if an ETF uses put options as a proxy for an index and the counterparty cannot pay as originally agreed the index may go down but the ETF loses the money on the puts. Similarly, if the ETF invests cash and interest is not paid as planned the ETF loses this amount. In normal markets such counterparty risk would seem remote but not in this market. In addition to risks, the ETFs companies charge fees. Without going into too much detail (again see the prospectus for more) these fees are taken out of the price of the ETF. To summarize all ETFs face the following notable costs/risks:
- Correlation Risk
- Counterparty Risk
- Fees
There are others too but these are the biggest ones. The key to note with all ETFs is that they are designed to track an index or inverse index on a given day ONLY. When held for more than one day they do a poorer job… and the fees compound as well.
In addition, distributions, and rebalancing, can have affects. It is important to know when an ETF plans to pay out distributions (the result is a lowering of the ETF price on that day I believe). Please read a bit more about this if interested. Now I want to specifically point out why inverse ETFs have additional risks, depending on market conditions.
Notice how the hypothetical index goes from 100 to 90 and then back to 100. The net affect is no change. So the inverse ETF should end up even as well right? Wrong. Even without fees and the risks mentioned above the inverse ETF loses even though the index returns to its starting price. This is true of both single and leveraged (2x) ETFs… though it is even more pronounced with leveraged ETFs because the affect is multiplied by rebalancing. Two things here: my understanding of why this is the case and what this means in terms of how to handle these things…
First, the reason for this. It occurs because of the fact that the ETFs reflect the percentage change of the index they track on a one-day basis only. On any given day the an inverse ETF should go up about 10% if the index goes down 10% and the double inverse should go up about 20%. However, when held for more than one day things get more complicated. It comes down to what I call “percentage asymmetry”. If an index goes from 100 to 90 it goes down 10%. So a single inverse ETF would go up 10%. So far so good. However, if the next day that index goes from 90 back to 100 it goes back up 10/90 or 11.1%. Since ETFs are calculated daily, this means that the inverse ETF goes down 11.1%… but it goes down 11.1% from 110… which is a loss of 12.2… not a return to 100 but a move to 97.8 (110-12.2). The point is that 11.1% loss from a higher number (110) loses more than 11.1% gain from a lower number (90) gains. On the flip side… if an index goes from 100 to 110 and then falls back to 100 the hypothetical inverse ETF would go from 100 to 90… then from 90 only back to 98.2 because 110/10 is a loss of 9.09% and a gain of 9.09% from 90 is 98.2 (after rounding).
Second: what this means. Essentially, inverse and double inverse ETFs do well in trending markets but the more volatile the market is the more they underpeform. The more volatility the more “percentage asymmetry” affects you get. Go to this official site and turn to page 20 to see a chart that shows this precisely. It means that inverse ETFs are absolutely NOT buy and hold vehicles except for periods when the market trends sharply down… and should be sold on any large daily or weekly move up. Please note that because the ETFs reflect inverse daily moves a move in the index from 100 to 75 in one day would cause the inverse 2X ETF to go up 50% (2x 25%)… but that a move from 75 back to 100 would then cause the 2x ETF, held more than one day, to go down 2x (25/75) or about 67%… from a higher level (a double ETF starting at 100 would move to 150 and then on the way back 150 x (1-2/3) = 50! You would lose 50% before fees and other risks on the double inverse ETF when the index ended flat! This is an extreme example but you get the point. Think about an ETF that has gone from 100 to 20 in this market… If you held the double inverse ETF from when it was at 100 and did not sell a simple 20 point move in the index from 20 to 30 in one day (or in a short number of days) would have a devastating affect on the inverse ETF and the further down an index has gone the smaller the absolute move needs to be to ravage the inverse ETF. Think about for eg UYG going from 5 to 7 in a few days… that’s a 40% move and can be close to a 80% move (it is if it happened on one day ... a bit less if it happened over several days) down in a double inverse ETF! The overwhelming point: short squeezes wreck these things, and highly volatile periods in the markets also pose financial problems to these things for those long the inverse ETFs.
So how to win here? Essentially here is my short list:
First of all, I much prefer to short the long ETFs generally speaking but there are exceptions that make inverse ETFs good plays for short trades (days to weeks).
Best times to buy short leveraged ETFs:
- Day trades that have significant downward movement
- Sharply down trends in the market, preferably after bull runs start to turn down. For example, May/June 08 after the Spring bear rally was a great time to use these. So was September/October 08. Double inverse ETFs compound so the ETF automatically buys more leveraged shares as it goes up... as long as the market continues down in a fairly straight line this compounds gains
- Buy and hold in volatile markets. These are not designed for this due to the fact that they are based on daily opposite percentage moves in indexes. Better hedges are shorting long ETFs and/or using put options
- Oversold markets! Short squeezes crush these things
- Highly volatile, sideways trending markets, such as the ascending triangle we have seen
- After oversold conditions, ie large dowtrends, when the market starts turning back up. SRS was at 240 or so not too long ago... a short squeeze or even sideways action made for a very nice short from that level.
- Upward trending markets
- Day Trades
Others may have different takes on this and feel free to comment if you have any similar or alternative perceptions of this. As I mentioned I am not an expert on this... I just see these things as tremendously powerful tools that are worth a deeper look. Definitely a bit of mixed Bizness...
Here are some good article references... particularly the investopedia article.
Seeking Alpha Leveraged ETF Value Traps
Investopedia ETFs
Also when buying an ETF it is nice to know what the intrinsic intraday value is.
Finding Intraday Values on ETFs
Best,
J
Here's another sweet song from from Beck.
Like Mixed Bizness it can't be embedded (copy write reasons perhaps) only the link...
"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice.
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