Thursday, December 11, 2008

The Ultra ETFs Should Not Be Used For Long Term Holding. How to Make Money With Them

Ultra (2X) long or short ETFs have proliferated in recent years, and several have appeared in recent months, including 3X funds. There are now ETFs that give you double exposure on pretty much any segment of the market: gold miners and bullion, oil, financials, S&P500, Dow, etc.

These ultra ETFs are great if the market goes up or down and has no volatility in terms of ups and down days. In fact, theoretically, you'd make money buy buying both the long and the short ETFs as a paired trade. The reason is very simple. If you invest say $10,000 in both a long and short ETF, and the underlying index goes up by 1% every day for 10 days, the long version will be worth $x and the short ETF holdings will be worth $. In total, you'd have $x for your investment of $20,000. This is because your wins compound and get bigger and bigger, and your losses get smaller and smaller. After 1 day you have earned and lost $200 on each of the ETFs. On the 2nd day, however, you gain $204 on the long ETF but you only lose $96 on the short ETF. The gain is larger because it is now applied on a larger principal ($10,20), and the loss is smaller because it is applied on a smaller principal ($98,00). And so on.

The same thing happens if the market only drops, in this case, the short ETFs keeps getting exponentially bigger and bigger. Here are some of the initial points:

After 60 days you would have a total of $35,203.00, a gain of 76% over the initial $20,000.00 invested.

This charts shows what would happens in this scenario:

Clearly, taking a position on both the long and the short ERTF pays off, regardless of market direction. It is in a sense a timeless straddle. The only loss is due to MER, but there are also gains due to dividends and interests earned on the various derivatives used to achieve the 2X returns.

Now, what happens however, if there is great volatility, and the market goes up and down. Take a look at this extreme scenario, where the market goes up 1% one day, then down 1% the next, and then alternate doing this for 60 days.

At the end of 60 days you would have a total of $19,769.99, a small loss of 1.15%. Here is the chart, you can barely see the decline:

But is this what happens in practice? In the vast majority of cases, no. In fact, for the long run, it's almost guaranteed that this will not happen and capital will be lost. I wrote a piece of software that analyzes all these funds. It has ran over millions of data points.

Here are the various performances of the paired ETFs:

(please click on chart to enlarge)

The ETF issuers claim that this poor performance is due to daily resets and compounding. Daily resets are necessary so that the exposure of each fund remains at 2X or 3X on both the long and short side. This is not the issue, after each day the performance should still track 2X or 3X the underlying index. Compounding does have an effect if the fund keeps oscillating up and down every day, but, as seen above, this effect is small and nowhere near the large losses seen in practice.


Based on the data and performance, a probable winning strategy with these ETFs is to short the pair of ETFs: short both the long and the short ETF. If you had done this with all the above ETFs, not counting the gains of DTO and DXO, you would have gained an average of 18%.

DTO and DXO are too new and have been on a trending environment (oil declining). It is likely only a matter of time until its performance degrades, just like all the others.

These ETFs are great for trading in and out if you get the market direction right, just as placing bets on red and black are at a Casino roulette is.

Just like a casino, you know what happens when someone keeps playing for a long time. The house always wins.

Charts of paired trades since inception (please click on images to enlarge):


You can see that SDS managed a gain of about 36%, while SSO had a very big loss of around 63%.

















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1 comment:

Anonymous said...

Elucidating...thanks for sharing.



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