[Editor's Note: Here at WCI we try to keep things as simple as possible, most of the time. Not today though. Today we're going to be discussing leveraged ETFs, a classic example of a product meant to be sold, not bought. This is a guest post from Chase R. Cawyer, MD, MBA, a financial advisor at Navigo Wealth Management in which he proposes a strategy to profit from the issues with leveraged ETFs. The publication of this strategy here should not be taken as an endorsement of the strategy, but simply a reflection that I found it interesting to think about myself and thought it would make for a good discussion. He is a paid advertiser on the site (although this is not a paid post.)]
Leveraged ETFs (Exchange Traded Funds) and Leveraged Inverse ETFs are a sucker’s bet, right? That’s mostly true when buying them as long positions. Leveraged ETFs inherently deteriorate in value due to their structure and inefficient daily resetting process and as WCI and many others have correctly mentioned, it is generally wise to avoid buying these products. But what about doing something else with them besides buying them? After all, inefficiencies often breed opportunities.
Beta Slippage
ProShares Ultra (SSO) is a leveraged ETF that seeks to return 2x that of the S&P500. As reiterated from their literature “The Ultra Proshares seeks a return that is 2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next.”
Chase Cawyer, MD, MBA
The performance problem with leveraged funds is that they deteriorate with what is called beta-slippage. To best illustrate, take a very volatile asset that is up 43% one day and down 30% the next. Compare it to a perfectly double leveraged ETF that should go up 86% one day and down 60% the next and see the end results:
Primary Asset: (1+0.43) x (1-0.30) = 1
“Perfectly” leveraged ETF: (1+0.86) x (1-0.60) = .74
As you can see the “perfectly” leveraged ETF has lost 25% of its value just due to beta-slippage. This is not some scam to take away your money, and nothing has changed in the principal asset, but simple mathematics has prevailed. Now this is an extreme example, but even if you adjust the percentage to something more realistic (2.5% up and 2% down) you will still see the impact of beta-slippage, especially over time.
For every positive there is a negative, and in the case of leveraged ETFs that is certainly true with the introduction of inverse leveraged ETFs. Instead of attempting to return 2x the S&P500 (SSO), traders can “invest” in Proshares UltraShort S&P500 ETF (SDS) and do the opposite. “The Short Proshares seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next.” Thus, when the market goes down 1% in a day, those invested in the fund hope to achieve a gain of 2% for their positions.
As previously mentioned, Leveraged ETFs, including the inverse versions, are not usually advisable funds to invest in. They reset every single day, and as we know all trades come at a cost to those who make them. Plus, beta slippage over the long-term distorts the risk/reward. See the following chart of the performance of SPY (green), SSO (blue) and SDS (red) from Nov 2010 to Nov 2011.
SSO / SDS Leveraged ETFs Pair 1 Year Chart from November 24, 2010 (Yahoo!)
As you can see, SSO did not return 2x the S&P 500 (SPY), not to mention SDS’ abysmal return compared to what it was intended to do. If asking if those poor returns are due to higher costs to make daily trades or due to beta-slippage, the answer is YES! And although these instruments are intended for day traders, investors can take advantage of them. If the value of leveraged ETFs inherently goes down, then investors can actually capture that value through short selling.
Short Selling Inverse ETFs
Now when most people hear the term short selling they scream risky proposition, but let me show you how it can work when done in an appropriate manner. For a brief recap short selling is defined by Investopedia “as the selling of a security that is not owned by the seller, or one that the seller has borrowed. Short selling is motivated by the belief that a security's price will decline, enabling it to be bought back at a lower price to make a profit.”
If you’re fully long in the stock market at all times you wouldn’t even think that shorting the 2x leveraged S&P 500 (SSO) would be a good idea. But, what is your reservation for shorting the inverse leveraged S&P 500 (SDS)? The double negative makes it a positive. In other words, being short an inverse fund in this case, means you are essentially long and own twice the S&P 500. You should be able to buy it back at a lower price at any point in the future because of the natural deterioration, correct?
For instance, if you shorted SDS at inception on May 31, 2008 you could have sold it (remember you’re shorting so think backwards) at 185.18 (adjusted close) and bought it back at 18.07 on May 31, 2016 for a total return of 925% (>110% annualized over those 9 years). Now before you start talking about how that number is too good to be true let me tell you it absolutely is. But the point is, if you understand the inefficiencies of inverse leveraged ETFs and know how to take advantage of those, then why wouldn’t you?
Dealing with Risk
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Shorting, leverage, inverse, huge potential returns…it all sounds too risky. It could be, but let’s take a look at how to take advantage of these inefficiencies more practically and safely.
First, shorting can only be done in a taxable investment account. In addition, all shorting gains are taxed as a short term capital gain thus your tax bracket matters. For example, using the 35% tax bracket you have to pay 35% of each year’s gains in taxes reducing that total return to 436% (48% annualized). As if we all needed another reason to show us why we should first invest in tax-deferred accounts.
Next, you likely wouldn’t want to go 100% equities because remember these funds are volatile. As a matter of fact, look at the start of the initial investment to the end of the bear market (June 2008 – Mar 9th, 2009). If you had shorted SDS, you were looking at a net loss of 150%!! So how do you decrease volatility? Asset Allocation. So maybe a nice 60/40 stock/bond split is the way to go. You don’t want to do just any ordinary bond fund, however. You want to use the same shorting strategy on a leveraged inverse ETF to capture that deterioration. Enter Ultrashort 20+ Year Treasury (TBT) as the fund of choice resulting in a 60/40 short mix of SDS/TBT. This matters because if invested 60/40 SDS/TBT during that same bear market stretch, while your SDS short was down over 150%, your TBT short was up almost 60% resulting in a still terrible but much more palatable 66% loss (compared to the S&P loss of 51%). Since the massive drawdown of our short positions was diminished, the net return over the entire 9 year time frame was actually improved to 495% (62% annualized).
Our results show that you would have been able to crank out some incredible gains over time, but we know how strong an emotion fear is. While the balanced portfolio did generate 62% annualized gains over the 9 year time frame, had you been watching the maximum drawdown of 66% you would have been fearful and questioning the validity of the strategy during that time. So how about exchanging some of the volatility for lower annualized returns? If you were to hold at least 50% of the portfolio in cash thus resulting in a 30/20/50 portfolio (SDS/TBT/Cash), you would have dramatically minimized the overall portfolio volatility while experiencing a total after tax return of 158%, or 19.7% annualized. This not only reduces our drawdowns significantly (a maximum of 33%); it reduces your stress level as well. It also addresses any margin call issues that might come into play if you were not sitting on much cash.
How does this more conservative 19.7% annualized return compare to a basic stock/bond portfolio mix during that same time frame? Very well! A buy/hold S&P 500 ETF (SPY) returned 7.1% after tax while a balanced portfolio (60% stock, 40% T-Bond) showed a higher 8.5% return. An even more conservative strategy holding 70% cash and being short 18%/12% SDS/TBT still outperforms the market with a net 10% annualized return on investment. So we have found an ability to handily beat the market by being long the S&P 500, long 20 year Treasury bonds, and holding 50-70% cash.
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When you short a leveraged ETF you are essentially going long a balanced portfolio of stocks and bonds, but then continuously capturing the value/money that deteriorates due to the inefficiencies of these positions. This type of shorting strategy can be incredibly volatile and obviously not for everyone, but with volatility (risk) comes rewards. You can move along that risk continuum as much as you like by including a lower cash allocation, which heightens the volatility, or a higher cash allocation, which dampens the volatility.
This strategy would generally be recommended with only a portion of an overall portfolio and the concept, along with other strategies that take advantage of market inefficiencies, can be utilized to create a more aggressive tilt to your portfolios. Our experience has shown that by also adjusting allocations dynamically based on the prevalent market environment you can even enhance returns further, especially in a bear market, while simultaneously reducing volatility; but that is an article for a future time. Although this strategic idea can appear somewhat complex, having an advisor experienced with this type of approach can take some stress off the table, but for those who manage their own investments the execution of this static approach is relatively straight forward. With a simple approach using large amounts of cash as a strategic allocation as described above, market beating returns with reasonable risk are certainly on the table. When looking at the current investment climate, and shaking your head at how many inept/terrible investment funds there are, a smart shorting strategy that takes advantage of inefficiencies can result in huge dividends.
[Editor's Note: I'm not sure I'm smart enough to point out all the potential issues with this strategy. Obviously I think going along with any of these investment products for the long-term is dumb. I've never owned a leveraged ETF and don't plan to start now, long or short. We have a written investment plan that we follow and it doesn't include schemes like this. A physician certainly doesn't NEED to use strategies like this to be financially successful. But I do like the idea of profiting from stupid investment products. However, there are a few things that are worth thinking about if you are considering adopting this sort of a strategy for a very small portion of your portfolio.
- If it is really all that smart, why isn't there a hedge fund already doing this? Well, it turns out there is. In fact, it was the best-performing hedge fund in 2015. That gives me a weird sense of performance chasing in my gut.
- This strategy is expensive. Not only are the expense ratios of these ETFs 10-20 times the cost of a good Vanguard ETF, but the continual buying and selling adds up too.
- The tax issue is not insignificant. What is your marginal tax rate? Mine is over 40%. Seems like a lot of risk to take to only keep half the gains.
- As a general rule, when a strategy is shown to be good (as this one apparently has in the recent past), it gets arbitraged away. I'm not sure exactly what that would look like for these leveraged ETFs, but perhaps it would manifest itself by making it harder to find shares to short (none to borrow on the market) or perhaps there would be a a negative premium on them.
- In a really impressive market (i.e. a trend that keeps going), your losses are infinite. When you short something, you HAVE to buy it at whatever price it is selling at later. That might be more money than you have. I could imagine a scenario where beta slippage decreased somehow and the market rapidly increased or decreased and wiped you out. Read this account of a guy who took a pretty good loss doing this 5 years ago.
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- Like any strategy, staying the course is challenging. Dr. Cawyer's recommendation to do so is to hold a bunch of cash, which is at best paying 1% right now. You think it's tough holding an 80/20 portfolio? Try one with a bunch of shorts and leveraged ETFs. If you're paying attention, you'll be pitched an apparently promising investment strategy at least once a month throughout your investing career. Bouncing from one to the next is the worst possible investing strategy. Investing is more behavioral than math. Even if you're the type who can tolerate a strategy like this without an advisor, will your spouse be able to if something happens to you? And if you need the advisor, add on another layer of fees.
Overall, there is some promise here, but I think the negatives are enough to keep me from implementing this with even 5% of my portfolio.]
What do you think? What issues do you see with this strategy? Is there a free lunch here? If not, are the potential returns worth the price of entry? What percentage of your portfolio would you use to implement something like this if you were convinced of its merits? Comment below!
What does your firm charge in fees when implementing this strategy for clients?
Hi Dr. Mom,
Thanks for the question and we don’t actually use this exact strategy. The post was intended to show the potential of the concept of shorting/investing in market inefficiencies. We use a more dynamic strategy that slightly adjusts allocations according to defined market environment. For that we charge 1.5% for the specific strategy that incorporates this concept and 1% for all others.
Thanks for the reply. Would the client pay these fees even in years your strategy lost them money?
As an RIA firm we have set fees regardless of performance. This keeps us from performance chasing and taking unnecessary risk in order to try and have a “positive” year merely to collect fees.
How do you balance being a physician and a financial advisor? They each can be very consuming full time jobs by themselves.
Time can be an issue, however something I am passionate about (and in line with the WCI site) is making sure physicians and others in the medical field do not get taken advantage of from the financial industry. Specifically in how we manage the relationship, we at Navigo have a team approach that handles the entire client relationship. I specifically look at the overall financial picture and its relationship to clients goals and needs, while other team members help keep with specific questions, adjustments that need to be made due to changing situations, and/or looking at the specific investment portion and strategies best suited for each individual client. If you have any other specific questions or concerns please don’t hesitate to email me [email protected] or you can keep posting them on here.
I believe a performance-fee only model aligns manager and client interests and presents the best business model for optimal performance.
I believe a performance-fee only arrangement aligns manager and client interests better than classic management fee models.
In performance fee models, the manager has the incentive to create a strategy that works and to follow it. The client’s job is to support the manager follow his strategy to the T.
I’m glad the performance-fee only arrangement works for you and your clients and it will be interesting to see if it starts to gain more traction and become more popular. From our perspective we think a set fee allows us to best serve our clients. When we do poorly we get a pay cut, yet still get paid for the services and comprehensive financial management we’re providing. When we do well we get a slight raise yet aren’t taking a large majority of our clients gains. Most importantly our interest are 100% aligned with our clients which is what all investment advisers with or without a fiduciary duty should be required to do.
Guess the purpose of this article is to prevent investors from buying more garbage sold by Wall Street. As evidenced by Wells Fargo gross fraud, the beat goes on in the financial industry. They will always devise products to line their products. When will anyone go to jail. The Wells Fargo CEO apologized. Guess he was blind to the fraud
They may get the message when we as a society stop buying what they’re selling.
Dr Cawyer’s strategy is sound if you can take the volatility, but I’m disappointed that neither he nor you remembered a key tenant about shorting: Your losses are unlimited, but your gains max out at 100%.
Shorting SDS at 185 and then buying it back at 18 would net you a 90-91% gain, not over 900%. To prove that, lets do the math:
You sell 100 shares at $185, collecting $18,500. However, you also have a liability of 100 shares, worth $18,500, so that cash is not available for you to use until you close out the position.
When you buy back the shares at $18, you pay $1,800 for them. Subtract that from $18,500, and your net profit is $16,700, or a 90-91% return on your initial amount at risk of $18,500.
>>I’m disappointed that neither he nor you remembered a key tenant about shorting: Your losses are unlimited, but your gains max out at 100%.<< Isn't that covered by WCI's point #5 above?
To limit your account’s downside, whether you go long or short, use stop losses.
Thank you for pointing out Aurelien because I should have made it more clear in the article. The returns we were using for the demonstration were compounded returns. In the illustration, each year the positions were re-bought (remember think opposite for shorting) and with the profits and principal shares were resold. For the stock/bond short the entire account was re balanced each year. Thus with power of compounding the returns where much higher then the 90% you mentioned. And remember with any type of shorting strategy all gains are taxed short term, so yearly rebalancing doesn’t create tax increases.
As for Johanna’s comment, your right losses are unlimited. This was alluded to with the comment about volatility (risk) being associated with reward, however it probably should have been more clear. For the reason of losses being unlimited with any naked short, we use a dynamic allocation that adjust to prevailing market conditions. This has worked very well for us during our time implementing the strategy and helps keep clients minds at ease.
I have been utilizing this strategy to capture the slippage in leveraged funds. However, when an individual attempts to do this, the first thing they will find out is that their broker will prohibit the short selling of these products. While the reason your broker will tell you they cannot allow you to short them is because the shares are not available to short, you can always look for deep in the money puts on each respective ETF and have a nearly synthetic short. The advantage of using the long put strategy on each is to limit the absolute maximum risk of capital used for purchase of the put position. A truly synthetic short would include the sale of the same strike call as the put you are buying, to help offset the small premium used to buy the long puts. I would discourage the use of the short call to capture the premium because then you do indeed have an unlimited maximum loss for that ETF. Instead, I try to execute both sides (3x bear and 3x bull) at nearly the same time. I try to find enough open interest and deep in the money puts that will have much less extrinsic value (premium) to avoid having to sell calls used in a truly synthetic short. Another rule I have is to be very careful when to put on the position because ideally, you are short both the 3x leveraged bear fund at the same time you are short the 3x leveraged bull fund. I hope I have not confused anyone, you wrote a good article and explanation, but I felt someone should state clearly that these ETF’s are not allowed to be shorted by any broker I know, so devising my long put strategy on each has greatly increased my overall return, regardless of market conditions. Additionally, for those who are nimble, having the long put position enables you to trade the underlying ETF at any point in time as if “married” to the put. This means being able to buy the underlying ETF with the complete protection of the put. However, we are now trading and your other long put is not truly hedged if the market moves against you, so I very rarely trade the underlying, only when I get multiple triggers on multiple time frames. Most importantly, the prospectuses are clear that these leveraged ETF’s are not meant to be held for more than a day, so you get in and get out, effectively reducing your overall costs. This strategy has allowed me to outperform the SP500 for four years now. I would be interested in incorporating the other types of leveraged ETF’s (as short sales only) if you want to contact me with more information and trade examples.
I agree with Aurelien W. The maximum potential profit from any short strategy is 100%. Unlike a traditional long strategy, which has a maximum potential loss of 100% and an unlimited potential profit, a short strategy has a maximum profit of 100% and unlimited potential losses. Which leads to the second major concern: that the broker forces you to cover your short position.
While I am always long on the S&P 500 long term, in the short term, I think we are due for a large correction. For a typical buy-and-hold investor, this would just be a bump in the road, but for a short seller, this could be disastrous. If the market crashes over 10%, the leveraged ETF could increase over 20% in value. The broker could then force you to cover your short play and buy back the ETF at the new, increased value. Unlike the traditional long play where you own the stock, you do not have the option to stay the course and wait for the index to recover.
I do think that the inefficiencies of the leveraged ETFs are very interesting and would be profitable to exploit, however, a simple sell-and-hold short strategy for the long term could be a very risky undertaking.
The only way a broker would force you to cover would be if you didnt take into account any kind of risk management and had a position sizing that would blow you up account for what is an entirely normal sized move of the underlying that happens almost every single year. That would be stupid. If you enter a position of such a nature you should run it through normal probabilities to assess your sizing and what would happen.
I currently have a short and the underlying would have to 20 times/2000% in less than a day for me to be anywhere close to forced to cover. You can also have stops and such, which are good but not perfect ways to manage positions.
Ok, and if all the original owners of the shares demand them back, which apparently happened to me today, limiting profit on the day. Sometimes why options are preferred for this, but they have their own labyrinth of issues.
All great points you brought up Plumber. As mentioned in the above comment, when you hold the same short position your return is capped at 100%, but when your trading or in our illustration rebalancing each year, you’re closing out your current short position and opening up new ones with your profits thus allowing compounding to help you gain over 100% return in the long term. Even more so a large correction and another bear market will surely happen (rather it’s this year or 10+ years from now is anyone’s guess), thus a dynamic strategy that takes this into account will perform much better during that time frame.
This article from Investopedia discusses the risk of being forced to cover your short position in a “short squeeze”.
http://www.investopedia.com/terms/s/shortcovering.asp
From the Seeking Alpha article you linked, Jim:
“Short Leveraged ETF Pairs?
This is a method for those concerned about which direction the market’s going to move. If you shorted virtually any asset class a few months back with the long-only ETF, you’d be in some pain right now. However, by shorting leveraged ETFs in pairs, you can often benefit from the value decay on both sides while remaining virtually market-neutral. This has been my primary strategy to date. The ideal situation here is that a market is roughly flat and you’ve made money on both sides of the trade, which is common.”
Thoughts on this? The thoughts of double shorting leveraged ETFs makes my brain hurt.
I think its more of a cute strategy and doesnt make a lot of sense, except in very specific instances.
Sounds good in theory, but I’m not ready to implement it with even 5% of my portfolio at this time. It sounds like a free lunch, and I don’t believe there are many of those.
I detest these leveraged products.
Look at the 5-year charts of Gold Miners 3x leveraged bull and bear funds.
1) Gold Miners Bull 3X: http://www.barchart.com/chart.php?sym=nugt&style=technical&template=&p=WO&d=X&sd=&ed=&size=M&log=0&t=BAR&v=0&g=1&evnt=1&late=1&o1=&o2=&o3=&sh=100&indicators=&addindicator=&submitted=1&fpage=&txtDate=#jump
2) Gold Miners Bear 3X: http://www.barchart.com/chart.php?sym=DUST&t=BAR&size=M&v=2&g=1&p=WO&d=X&qb=1&style=technical&template=
I wonder what long-term strategy one could implement here. These products, over the long run, in a word, suck. They have no place in a long term investors portfolio.
Leave these to day-trading losers.
I would’ve loved to have shorted the Bull in 2012….
Stay far away from these things, bro.
The math was oversimplified, the explanations a bit crude (works for our crowd though), but the example was terrible. The reason this can work is due to volatility drag (beta slippage), which all funds have the integer is usually 1 in all non leveraged funds. Throw and 2-3x factor in front of the volatility drag and it can be tough to overcome in the long term even with disregarding higher fees.
However, SSO is a terrible example. Had you bought SSO in 2009 and held to today you would have a return of 399% vs. 130% for SPY. Leveraged (especially 2x) funds can definitely be held longer term and sometimes even do exactly what theyre supposed to and more. However, the sp is huge, liquid, and trends. All markets have rewarded leverage in the past up to a certain point, and just around 2 seems to be the right number, and only sometimes 3x. No market has ever rewarded a leverage of 4x long term.
Now, if one were to consider doing such a thing you have to think about why this works the way it does and then find the appropriate vehicles that most match the issue. The reason it works is the compounding beta slippage problem, where losing 50% requires a 100% gain to breakeven. So obviously you want a very volatile underlying index, and you always have to know exactly what the underlying fund/index to be matched is of course. A trendless, sideways, volatile index that also has high holding costs to the underlying is basically exactly what you want. This usually means commodities, theyre volatile, have a futures market that is usually in contango (eroding value constantly). These are the better options to short leveraged etfs.
I think it was 2014 or 2015 where both the long and short gold leveraged funds lost a significant amount of value.
I dont think this is a bad strategy at all, however, a short little trend will always work as intended and you can get crushed if you’ve no position management. There are similar and imo even better ways to do things that take advantage of structural guaranteed decay that are a great way to get a tiny bit extra.
This blog has always taken the broad position of passive investing and low fees. Percentage of AUM fees are usually exorbitant, but most financial advisors continue to charge them. The only realistic way to justify such fees is to claim that active investing will generate higher returns and thereby justify the %AUM fees. This article attempts to do so, in spades.
You may consider asking your advisor whether he or she would be up for implementing a performance-fee only model.
Until that happens, the manager and client have misaligned interests, especially if the manager works at an established firm with no problem paying for overhead.
Back to basics: passive investment outperforms active investment after expenses. The only fee consistent with passive investing is a fee based upon quality of service and hours spent. %AUM fees are exorbitant for HNWI, and that methodology has no justification in the context of passive investing. Performance-fee only would be even less justifiable.
I wonder how you feel about a performance fee being charged only on the gains above a benchmark.
Fantastic for the client, provided the advisor sticks to passive investing, as he should. Free advice.
As someone who admits to being quite risk-tolerant, even I don’t have the stomach for leveraged ETFs. The beta slippage is too much for me.
I am a bond holder, I own great deal of whole life insurance and I have been investor (not a trader) in 2x leveraged funds since 2008. My observations are not scientific, but accurate. For the most part leveraged SPY 500 ETF captures all the upside, minus cost and at time a bit more then double the upside (how / why, I don’t know). If market looses > 5 %, then you loose around 9 %, not 10% or more. If market is flat or up by lets say 1%, you loose b/ 1 – 2.5%. Why, I shave no idea why. So, for the most part sp500 2 x leveraged fund is really really good for long term buy and hod (not 3 or 4 x leveraged).
I also buy UST /UBT, 2 x leveraged 5 -7 yr and long duration treasuries. My portfolio has been 25 % SSO and 75% UST/UBT. This portfolio is as comforting to me as my WLI’s. Max draw downs can be huge, up to 20% on monthly basis, but on annual basis this portfolio is steadier then 60 – 40 S/B fund. It by the way kicks 60/40 portfolios ass.
You can tax harvest as well if needed (plenty of options)
Draw back: This is based on 100’s of hours of research (free fem me to you all), fact is that all other leveraged funds are erratic with huge tacking discrepancies. Ideally, one would like to overweight bonds in leveraged portfolio (forget about the interest rate hike BS, no one can predict the future, and it is debt, not equities that make the world go around), add USA stocks, emerging market, gold and commodities. But besides sp500 and treasuries leveraged funds, this asset allocation does not track like it should.
Why not short? Because you will get killed. Over time. both stocks and bond will make money. Going long make sense. If you are the nervous type, then do adjust you entire portfolio to your comfort level.
This seems awfully complex
John Bogle and Warren Buffett both recommend simplicity with a straight up index fund.
I’m not sure there are many in the investment world who are smarter than those two. At least I haven’t met or heard of them…
See above
Not complex, but requires discipline
By leveraging I can get double the exposure, by reflecting leverage in my overall portfolio, I have less money at risk as well. Basically, getting the job done with other folks money, with small fee. But, you must have the right temperament and must be disciplined. For example, 2013 was a bad yr for my leveraged portfolio (25% us stocks / 75
5 treasuries), but I did not panic, and I did not start buying treasuries like crazy since they got killed, I did little tax harvesting and rebalanced the portfolio in dec 2013. Easy peazy, lemon squeezey.
Try selling a portfolio of leveraged ETFs for anywhere close to NAV during an extreme market downturn. My guess is that the ask will be NAV and the bid will be something like 5% below NAV at best. Leveraged ETFs should not even be in the conversation for individual investors
As Zaphod mentions, the example given is simplified to try to get the idea across of why these inefficiencies exist and how you can conceptually take advantage of them. Theoretically you are limited to a 100% gain if you short and walk away. However, because the positions continually decline over time, an active strategy would continually add to those positions by re-shorting them perpetually to maintain specific allocation levels. This is where the compounding effect takes hold.
Another thing to mention is the fact that leveraged inverse ETF’s, because they do inherently lose their value over time, have to do reverse stock splits routinely as prices inevitably approach single digits.
In reference to the risks with shorting and having to cover. Generally, if you have a balanced approach between equities and treasuries and keep plenty of cash on hand, then this should not be an issue. Regardless, because we are so concerned with managing risk and volatility, we employ a strategy that has a balanced and hedged approach. Our specific strategy has a dynamic allocation component that relies on an assessment of the long term and intermediate term trends for both equity and treasury markets. The equity and fixed income markets usually have negative correlations to each other which is great for a balanced portfolio. However, there are also times when their correlations sync up. That is why we assess both markets and are not afraid to hold cash as a strategic allocation when needed.
Our firm is also concerned about a significant bear market ahead, which is why a dynamic allocation approach to this strategy is so important. One component of our strategy that is not mentioned is taking advantage of the inefficiencies of volatility ETFs. Their beta slippage is significantly greater than those of leveraged equity and fixed income ETFs. Not surprisingly, volatility ETFs are very volatile and should not be considered as part of a passive strategy, which is why we would not mention it as an option in an article about passively taking advantage of these inefficiencies. With our active strategy however, we are able to throw those into the allocation mix alongside our short leveraged inverse ETFs. During Bullish markets, an allocation of inverse volatility ETF XIV is used, which captures significant beta slippage during contango periods. During Bearish markets, an allocation of volatility ETF VXX is used which captures the slippage during backwardation periods. This not only helps protect the portfolio during bear markets, but allows it to thrive. During uncertain periods where the markets are somewhere in between bull markets and bear markets, we simply leave volatility out of the allocation mix and capture the leveraged ETFs’ slippage value.
Obviously utilizing volatility ETFs can be a powerful addition to an investment strategy, but in order to do so successfully over time, you must have a specific discipline in place that removes emotions from the mix. It should not be done passively. That is an entirely different article for another time.
I agree with Zaphod that the choice of ETF in the example is a poor one for implementing this strategy. If I were to use shorting a leveraged index as my investment strategy, UVXY would be my choice. It is a highly volatile index with remarkably consistent decay over time.
I am currently short UVXY and was long XIV on the mon/tues after brexit. Closed XIV last week but still short UVXY. Im sure there was no way he could write about volatility without everyone just not even looking at the article, which has interesting points and value overall.
Volatility is much more difficult to quickly explain as its a derivative of like 3-4 orders, has a futures market where you should pay attention to contango/backwardation, etc…but overall, best play in the world structurally.
Interesting post. I find leveraged ETFs unattractive due to high fees. If a business reason arises to use leverage (either short or long) it’s much cheaper to trade futures. Thus, I would never buy leveraged ETFs.
That said, I would stay away from shorting the leveraged short ETFs, too. The calculations I sometimes see all have one thing in common: positive return then negative return back to starting point. By construction, that’s bad for this ETF.
The leveraged short ETF has momentum built in: it raises the short beta exposure after it made money. Thus, betting against this ETF works beautifully in sideways moving/quickly mean reverting markets. Precisely what we have observed over the last few years. If that were to change then the profit prospects of shorting the short ETFs will change too.
Example: four moves of -10% in the underlying index.
The index drops by 34.4% = (1-0.1)^4-1
The short ETF goes up by 46.4% = (1+0.1)^4-1
The 2x short ETF goes up by 107.4% = (1+0.2)^4-1
You would have lost a lot more than the index when shorting the ETFs. In fact, shorting the 2x ETF you would have been wiped out.
But just to be sure: there are times when betting on mean reversion rather than momentum makes sense. It worked well recently. But, in my view, there are better ways of milking mean reversion than this ETF play.
And that is why diversification is important. At the same time you would have seen equity moves like you are pointing out (2008 for example) you would have seen comparable opposite moves in treasuries for the most part. Together they help preserve a portolio during turbulent periods. It can work well for a passive investor over time, and it works beautifully for an active investor with the appropriate dynamic allocation.
just crazy to even discussing this vehicle that’s not appropriate nor understood for 99% of investors. More junk sold to the naieve public
One reason docs get taken advantage of is that they’ve never had discussions like these and don’t know to look for the downsides of more complex strategies touted as “can’t lose” strategies. I think a discussion like this is useful. Just because all you need to know about investing can fit on an index card (see what I did there) doesn’t mean that I should just publish the same index card worth of material every day.
Leveraged etc are no more dangerous, and in fact have added alpa if done appropriaterly. My other advise above is priceless, a gift to you all at no cost.
If you want expoe lets say 50% of your assets to stocks, then allocate 25% to leveraged (2x) account. The rest could be in bonds, or cash, etc.
Now, and never ever deviate from this, only use SSO, UBT AND UST ETF. SPLX for tax loss harvesting. You must use inverse / short leverage etc, You must never use leverage for emerging market, gold, commodities, reit or individual sectors.
Folks, this advise is based on 1oo’s of hours of research as well as real life portfolio. You would hav made money even 2008 (only difference, I used TLT SINCE ust/ubt were not available.
So, take it from fellow who loves WLI, 25 SSO / 75% UST/UBT, decade over decade you will kick the you know what out SP500 and 60/40 portfolio with possible larger drawdowns in b/ yrs, but usually less draw down every 12 months (yes, yes , yes). If you look at your entire portfolio along with leveraged component, you will be amazed as to how well you are doing, with even less volatility then 60/40 portfolio. I usually expose only 25% of my assets to stocks, rest mostly long term bonds (mostly treasuries)
I’ll buy TQQQ after corrections as its more volatile and has usually more upside in the retracement, been an excellent move this year. I like to switch to the non leveraged funds once the big move is over and then just sit back and wait….
We agree junk is sold to the public and in no way is this a “sales” pitch. This is not a core strategy for us and a great majority of our clients are not in any way shorting leveraged ETFs due to their risk tolerance or more importantly inability to understand what they are investing in. Our job as advisers is to simplify the investing process so clients can understanding it, in an “index card’ kind of way and be pleased with the relationship and results.
Sorry, it should read “You must never use inverse / short leverage etc, “
When someone is shorting a leveraged ETF, isn’t a high expense ratio (#2 at the end) to one’s advantage?
You are correct the expense ratio is included in the NAV (Book Value) thus is being accounted for in the daily return. More expense = less return to investors = better short position.
Problem is that for majority of the time , asset class is either static, side ways or moves higher by climbing wall of worry. So going long for most people is prudent strategy. Corrections on the other hand are USUALLY much sharper and occur in a rapid bursts. So, if you can time it then shorting leveraged etf’s will make you mega rich. However, based on conventional wisdom shorting leveraged ETF is a sure way to get once behind kicked.
Zaphos says “I’ll buy TQQQ after corrections”.
Yeah , right. Share with us when you believe it is time to short treasuries (people have lost fortune trying to short bonds and stocks since 2008)
TQQQ is the triple leverage QQQ, or NASDAQ index fund. I wouldnt short treasuries as even when the fed moves rates the market can take it lower, and agree it has seemed for years to many pundits that the bond bull must end and thats not a battle worth trying to fight.
I haven’t read all the comments, but I looked into shorting leveraged pairs a long time ago. One problem I encountered that I didn’t see in the article is that the fees are quite a bit higher than you think.
I don’t have time to type a full explanation right now, but basically most leveraged ETFs are “hard-to-borrow” over a long period (i.e., not intraday). For securities that are hard to borrow, you must pay a fee to borrow them (you have to borrow the stock in order to sell it and take your short position). You are basically borrowing the stock until you close the position. So if you’re holding a leveraged ETF over a long period of time, that hard to borrow fee is a massive drag on the return and makes it so that the strategy is not the slam dunk that you think it would be.
I think most people who do this in size use options, buying LEAPs or selling calls or any other crazy multi legged thing you might want to do. While there is certainly a cost to those as well, and their own wild issues to be concerned with, it alleviates a lot of those issues.
Currently wishing my UVXY short wasnt direct and had sold calls instead, broker was forced to buy in before it dropped another 10%. Cant be mad about a profit though.
There have been a few comments mentioned on here that allude to the disadvantage of short selling because of short selling having limited gains and unlimited losses. Normally that is correct and Chase agreed that was correct for shorts in general. However, when you short leveraged inverse ETFs, the understanding of short selling gets flipped on its head because remember we are shorting shorts. As a result, the underlying assets (S&P 500 and treasury bonds) are markets that can go up forever but only go down 100% theoretically. Although not realistic, the worst these positions could endure is 200% if the markets go down to 0 or 100%. Because the markets can theoretically go up to infinity, then the gains are unlimited.
How you might ask, since you are shorting a position that can only go to zero. If this was like shorting conventional investments that have a tendency to increase over time then that is correct. However, because of the beta slippage and structure costs, the inverse ETF’s get perpetually dragged down.
Even if you are a passive investor, re-balancing has to be a regular routine you implement in your portfolio. In the case of rebalancing these leveraged inverse ETFs, that would entail periodically re-shorting. Here’s an illustration that shows how that plays out:
You are short both the S&P 500 leveraged inverse ETF (SDS) and the leveraged inverse ETF (TBT) with $100,000 starting capital in each. After a period of time during which the markets are flat or going up, your account shows the shorts currently at $80,000 each. You have a 20% gain. Because you are appropriately re-balancing, you re-short with the same $200,000. After another similar period your portfolio shows the positions at $80,000 each again. You rebalance again and capture your 20% gain. You do that another 5 times, each time using the same money. You now have a 140% gain from the same capital. If you wanted to compound your growth, you would simply put the additional $40,000 in gains into what you are shorting each time and re-short at the higher amount. By doing so you would exactly replicate the compounding nature of long portfolios. And that can go on into perpetuity with unlimited gains.
Let’s look at what happens when markets become turbulent. The S&P 500 is down 20% during a period, and your SDS short is down 35%, which is adjusted for the slippage value gained. However because there is fear in the markets, treasuries are seen as a safe haven and gains accelerate there. Your TBT short is up 25%. You do have a loss initially overall, but the gains made in TBT prompt you to increase re-shorting of that vehicle while the losses in SDS prompt you to reduce your short positions in order to maintain your target balanced allocations. If it is a bad market that is here to stay for a few months or years, then the nature of the positions and rebalancing will keep you in good shape until markets get back to normal and your positions begin making substantial gains again.
During turbulent times, there is no doubt that doing a strategy like this passively will be down occassionally, but to assume it will get killed implies a lack of understanding of these vehicles, how they complement each other and the power in taking advantage of these deteriorating products. Please refer to our earlier comments that mention our ability to utilize volatility ETFs as well that provide even greater returns in bull markets and significant protection in bear markets. As mentioned before, a passive strategy for this concept, with ongoing rebalancing, can do well. A dynamic strategy, with a full understanding of the concept and vehicles, for this concept can and does do extremely well over time. It has to be re-noted though, it does have higher than average volatility, and this should be a consideration for a relatively small piece of an overall portfolio. We recommend that our clients put no more than 10-15% of their overall financial assets into our dynamically managed strategy.
A few additional responding comments.. UVXY is a volatility product. Like the volatility products we use, its beta slippage is significant. For passive investing, however, investors should steer clear of volatility ETFs. They can only be safely done with an active dynamic approach. Also, when choosing the ETFs to use, you must only choose extremely liquid products. This ensures the ability to move in and out when needed. Even during high volatilty periods, the spread does not get too crazy. And if it does, remember this is not a trading strategy. Positions are held for long periods of time, so during the extreme periods you are simply holding onto your positions. NAV shenanigans have little to no impact.
So, we are not shorting the market, but shorting the short leveraged etf’s?
Please give real lie scenarios, and reference any research or white paper if possible.
I am extremely conservative investor. However, have done very well by writing calls and buying leveraged ETF’s for yrs. Currently 70% bonds (25% leveraged), 20% leveraged Stocks, 10 % MLP bought in APRIL (leveraged funds/ AMZA/KYN).
Now, it is true that bond returns may not be as great as they have been (no one, and mean no one, even the fed doesn’t know). However, no way in hell I am going to increase my exposure by going heavier in stocks. I will rely on market tantrums to pick up cheap assets when market give me opportunity (like MLP’s this year / god send opportunity)
Additionally, I have a multiple whole life insurances with two mutual companies. Both of them told me that increased interest rates WILL BOOST performance of my WLI.
WCI
This is way to complex for my level of financial competence. Fortunately I’m FI and could care less. Working half time at 53 because I still like seeing patients. Going to go leverage my mountain bike for a while. Blue sky day. Cheers!
I don’t think any of the replies address the biggest reason why this is ill advised. Most explanations of why leveraged etfs are a bad idea show you how you can loose money when the stock goes up and down, but comes back to its starting value. What these explanations more rarely address is that there is a situation when daily reset can help your total return – when the market is constantly moving in 1 direction. For example if you bought a nasdaq etf qqq at the bottom of the 2009 crash you would have a 353% return today if you bought qld at its 2008 lows (a 2x daily leverage of qqq) you would have a return of 1600%. You will also do better than expected during a mono-directional drop. You don’t want to be on the opposite side of this.
allonblack1
You are mostly right’However, monthly some rest leveraged etf’s are very efficient and closely track the index . They include SSO (stocks), UST/UBT (treasuries). So if you want to allocate 60% to stocks, you can get the same result by allocating 30% to stocks. Same goes with treasuries ETF (I am 20% stocks and 70% treasuries leveraged). 5% gold and emerging market each, but not leveraged. Unfortunately leveraged gld/EM leveraged etf’s are very erratic.
I can state that even during historic stock bull run by sp500, poor performance by emerging markets / gld over past few yrs, with my portfolio I am capturing 97% of stock upside, and my maximum dew down was 3.5% when sp500 went down by > 14% couple of times in past few yrs.
I can’t wait for another large correction in stocks, thats when my portfolio will really shine.
SO, leverage is helping me by throwing less money at risky asset (stocks), and leverage is helping me by bying more of less risky asset (treasuries). I have been doing this since around 2007 (different variation due to available products). I wish I knew in 1970’s. what I know know.
Interesting idea ….
Rather than shorting SDS, why not get a PUT option?
SDS trades around 16.6 now
Dec PUT with a strike of 13 can be bought for 0.04 cents a contract
Buy 1000 puts for premium of 4000 Dollars
If SDS let’s say drops even 1 point in the next 2.5 months, that 0.04 cost per contract, should increase in value…. to ?0.35? Or 0.5? (Yes. This is a guess)
Assume it goes to 0.5
Sell your 1000 contracts for 50,000 dollars
Collect profit of 50000 – 4000 = 46,000
As it’s a short term gain, give 30-35% back to Uncle Sam and pocket the rest
It’s not an “investment” strategy but a possible trading strategy?
Is it a trading strategy? Sure. Is it a wise one? I have no idea, so I can’t endorse it. If you want to try it, let us know how it goes for you.
I did some more research on the topic of beta-slippage and shorting inverse ETFs. I came to the conclusion that there is no alpha from beta-slippage. That’s a complete myth! Moreover, there is no alpha from shorting the high-fee ETF because the fees to borrow the ETF and the disadvantageous tax treatment of the shorting profits will easily wipe out any gain.
Not sure what’s your policy about links to other sites, but here’s today’s post on my blog. Maybe you can allow that link because it’s not advertising but a direct response to your blog post. Thanks!
https://earlyretirementnow.com/2016/10/19/shorting-an-inverse-etf-is-a-bad-idea-or-why-beta-slippage-isnt-alpha/
Thanks for sharing.
EarlyRetirementNow,
I really enjoyed the technical nature and the thought/effort you put into looking at this strategy. Well done on your article. However, I would be interested to see if your conclusions were different when looking at inverse leveraged ETFs. In our example we never recommended shorting inverse ETFs (such as SH) for the reasons you mention in your article, such as short-term tax treatment and lack of alpha. As you correctly pointed out with SH the beta-slippage is not there thus would make very little sense in an investment portfolio. Your example of SH is a 1x inverse ETF of SPY while the example I show is SDS a leveraged (2x) inverse ETF of SPY. We currently use QID, a 2x inverse ETF of QQQ, and has worked extremely well for us and our clients in real market conditions over the last 2.5 years.