The staggering decline in the stock market in 2008 and early 2009 has led to many people re-evaluating their views on investing. They have now steered away from the traditional strategy of buying and holding diversified mutual funds for the long term. A portfolio fully invested in small, medium-sized, and large companies, with both domestic and international exposure, likely experienced a peak-to-trough loss in the 35 to 50 percent range.
Not surprisingly, in response to the events of 2008, an increasing number of people have sought to profit when the market goes down. In addition, some people harbor a conviction that a certain sector will perform particularly well or poorly. This line of thinking is a major departure from conventional wisdom, and a series of financial instruments have been recently created to meet this demand. However, I want to spotlight the dangers of certain investment vehicles, in an effort for others not to act on the same mistaken beliefs I held.
Many Exchange Traded Funds (ETFs) have been created recently that apply leverage and shorting capabilities to a given index, like the S&P 500 for example. If the S&P 500 drops 5% tomorrow, an ultra-long fund tied to the index will fall 10%, a short fund will rise 5%, and an ultra-short fund will rise 10%. Most ultra funds have double leverage, but ETFs now exist that are levered by a factor of 3. As you can imagine, the downside risk is quite large if you guess wrong.
These funds have an additional property, however, that is quite startling. Over time, ETFs that are ultra-long, short, and ultra-short are guaranteed to lose value if the underlying index remains the same. This is far from an intuitive concept, and one that few people are aware of, but it will cause investors to lose money with these ETFs in all but the very best of circumstances.
As a quick demonstration, let's say an index has a value of 100. It increases by 25% to 125 on Day 1, and decreases by 20% back to 100 on Day 2. You would think that the other ETFs based on this index would also have a value of 100 at the end of Day 2. However, you can run the calculations and will find that the ultra-long fund would be worth 90, the short fund would be worth 90, and the ultra-short fund would be worth 70. In this example, you would actually lose between 10 and 30 percent of your investment even though the index was flat over that time period:
Initial Value | Day 1 | Day 2 | |||
| Underlying Index | 100 | +25% | 125 | -20% | 100 |
| Ultra-Long Fund | 100 | +50% | 150 | -40% | 90 |
| Short Fund | 100 | -25% | 75 | +20% | 90 |
| Ultra-Short Fund | 100 | -50% | 50 | +40% | 70 |
What could possibly explain this disparity? The ETFs are designed to produce daily returns relative to the index, not long-term returns. The effects of compounding, particularly in a volatile market environment, cause these specialized ETFs to decay over time.
As a final demonstration of this, consider the Dow Jones U.S. Real Estate Index. From January 2, 2008 thru January 2, 2009, this index declined 41.7% because of the major weaknesses in housing and commercial real estate. If you predicted this decline perfectly, and sought to profit from this insight, you may have purchased the ultra-short ETF tied to this index. Yet instead of making a great deal of money, you would have actually lost a staggering 47.9% of your investment!
In short, don’t touch any of these short or levered ETFs unless you envision a noticeable movement occurring over the span of a few days. The longer you hold these instruments, the odds of making a profit are reduced dramatically. Even hedging with these ETFs is not a great idea because of their erosion. My thoughts are to use extreme caution, or more simply, to stay away.
What if you played these ETF's only on the short side. Shorting the Ultra-Short Fund as a means to go long and shorting the Ultra-Long Fund as a means to go short?
ReplyDeleteGreat question and two years back I modeled out different scenarios with this strategy. Statistically this could produce very solid investment returns if you are correct. Another approach is to hedge your bets by shorting the Ultra-Long AND Ultra-Short funds tied to the same underlying index. Because leveraged ETFs tend to decay over time, this would seem like a prudent long-term play.
ReplyDeleteA problem is if the underlying index moves in the same direction for an extended period of time. Compounding effects would cause either the Ultra-Long or Ultra-Short ETF to rise substantially, enough to make your short position very problematic.
More importantly, I don't believe there is a mechanism to short these leveraged ETFs, which would make this concept impractical. Shorting these leveraged ETFs would be mathematically appealing under most circumstances, but an inability to do so further merits staying away from these investment vehicles.