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Monday, January 26, 2009

UltraShort ETFs - they work if you follow the rules

Bashing the ProShares UltraShort ETFs seems to be a favorite blog topic these days but it has also incited a few defenders of these ETFs to respond.

To review, those who dislike these ETFs have pointed to the fact that they do not seem to have come anywhere near delivering the expected result of double the inverse of the underlying index. Indeed, they might not have shown any gain at all even if the underlying index lost significant value.

Evaluating the arguments --

Let's take a look at the following scenario: buy an UltraShort ETF when the corresponding long index ETF falls below its 200-day simple moving average.

We looked at four pairs of ETFs as described in the following tables. The Start Date corresponds to when the index ETF fell below its 200-day MA. Standard Deviation is included as a measure of volatility.

This first table shows the results using ETFs that correspond to two major market averages.

Start Date1/9/08
End Date1/16/09
Initial Price47.7537.01137.8747.48
Recent Price28.9058.9583.1181.11
Percent change-39.48%59.28%-39.72%70.83%
Standard Deviation7.3011.5719.2813.83

This next table shows the results of using ETFs that track two individual sectors: real estate and financials.

Start Date6/18/07
End Date1/16/09
Initial Price76.3077.93109.2775.94
Recent Price32.2259.3233.86158.78
Percent change-57.77%-18.61-75.4182.84
Standard Deviation12.6321.6920.6827.35

The outcome --

What we found was that one of the sector UltraShorts, SRS, the UltraShort Real Estate ETF, did indeed perform horribly over the long haul. The other ETFs we examined didn't do too badly. They may have lagged the hoped for 2X inverse of the underlying index but they did way better than the underlying indexes did as stocks plunged this year.

At this point it is important to reiterate what ProShares says about these ETFs: they are meant to double the inverse of the underlying index on a daily basis, not over extended periods of time.

Others have written how compounding over time can affect these kinds of leveraged ETFs so I won't go into detail here; suffice to say that they are correct and that it tends to keep the gains less than the expected 2X.

Use the right tool for the right job --

What is important to point out is that indulging in these ETFs is essentially a commitment to, at the least, market timing or even active trading. This by itself implies that the intent is probably not long-term hedging.

So if you are willing to actively trade the UltraShort ETFs, then they will work quite well. This does not necessarily mean day trading. Handsome gains were had in SKF, for example, if an investor bought this ETF each time it fell back to around its 200-day MA, held it for a few weeks or months and sold each time it spiked. For most folks, of course, this is easier said than done but if you were good at determining stops, it was still quite possible.

What is more noticeable (and useful) from the data presented above is that a bearish investor, betting against a major market average like the S&P 500 or the NASDAQ 100, could indeed have held the corresponding UltraShort ETF and realized a quite reasonable gain over the course of the last 12 months.

Sour grapes?

So in my opinion, it seems that those who are railing against these ETFs are not using them as they were intended and are judging them by criteria they were not intended to be judged by. In addition, this attitude that the UltraShorts are awful investments is very much a result of what end date is used. A few months ago, when SRS on two occasions rose to over $175, I don't think anyone would have been complaining about this ETF. Furthermore, it is clear that the volatility of this ETF is very high and wild price swings are to be expected. Lesson: be careful, pay attention and take profits when you can. Otherwise, don't complain.

Major market averages do pay off --

Playing individual sectors, especially the highly volatile financial and real estate sectors, may yield unpredictable results.

In a cyclical bear market, however, using the UltraShorts that correspond to the major market averages has actually worked out quite well, even if holding these ETFs for longer periods than recommended. I have provided the details for the S&P 500 and the NASDAQ 100 but the results are the same for the Dow 30 Industrials (comparing DIA and DXD) and the Russell 2000 (comparing IWM and TWM).

The rules of the game --

It seems there are four rules for using the ProShares UltraShorts:
  1. Pay attention. When an ETF jumps 20 or 30 points in a day, it is probably a good idea to take some profits.
  2. Some of the most volatile sector ETFs should only be used as trading vehicles over shorter periods of time. This should be evaluated on a case by case basis. Also, see rule #1.
  3. The ETFs that correspond to major market averages (referred to by ProShares as "short market cap" ETFs) can be considered "dual purpose": use them for longer bets on cyclic bear markets or as trading vehicles if you are nimble enough.
  4. Have an exit strategy. Set a point at which "enough is enough" and have the discipline to take profits. Don't assume a 2X return over longer periods of time.
Are there any other rules you think should be added?

Disclosure: small positions in SDS and QID

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