Breakthroughs, and the Leveraged ETF Saga Continues
While I wanted to write a blog post tonight, I got startedﾃつre-toolingﾃつa strategy that has been in development for quite some time. The strategy was very promising but it wasﾃつhaving problems when it encountered months like January and October of 2008. Tonight I found a solution, and it appears to be robust. Below is the equity curve over the last 9 years.
Keep in mind this strategy will be traded onﾃつ2xﾃつleveraged vehicles, but what is represented here is a chart of the strategy applied to the SPX. (Double the results for the leveraged vehicles).
Not being one to bleat my own horn without at least offering something for someone else to benefit from, I am linking to an article from Trading Markets. This article continues the discussion on the problems with the leveraged ETFs. These notorious ETFs even have seasoned veterans (The Fly) swearing to quit them, and then coming back for more. The following article is one of the best I’ve read on the subject.
Long story short, if you are a trader, these can be excellent vehicles. I consider them money trees. I finished positive for the year last year trading them almost exclusively. However, if you are not a trader, or to be more specific, not a swing trader, the article will explain why you should steer clear of the leveraged ETFs.
What Can We Learn from the 2008 Leveraged ETF Collapse? Part 1
Leveraged ETFs are like caffeinated crack, as you are fully aware……Actually, I think it’s more accurate to say that the prospects of leveraged profits are like caffeinated crack to some.
Yes, if you have an edge which lasts a few days or so before coming to fruition, these diETFs are better than crack (I’ve never tried crack, by the way.)
your not bullshitting anyone. It’s ok if you did.
What? You’ve never “been” with a woman?
Wood-
Saw your pic in WST, btw. You don’t look like a crackhead.
Nice article.
Woody,
I caught an email alert about yet another analysis of leveraged iETFs on RealMoney.com they put out today. I don’t hang out in that ghetto anymore, but you might have a hook-up.
(It didn’t look like the conclusion was going to be anything new, but as long as you’re testing a new strategy…)
Sorry, didn’t see that Juice had posted this at Fly’s. But in case you missed:
Oberg: The Perils of the ProShares Ultra Shorts
By RealMoney Guest Contributor
1/13/2009 1:25 PM EST
URL: http://www.thestreet.com/p/rmoney/etf/10457651.html
Editorﾃ｢竄ｬ邃｢s note: This column is by Eric Oberg, who worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.
One of these days in your travels, a guy is going to show you a brand-new deck of cards on which the seal is not yet broken. Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear. But, son, do not accept this bet, because as sure as you stand there, youﾃ｢竄ｬ邃｢re going to wind up with an ear full of cider.
ﾃ｢竄ｬ窶 Sky Masterson in Guys and Dolls
I was amazed at how much discussion my piece and subsequent Q&A on levered, short-sided ETFs generated, particularly for a holiday launch. We received a number of comments at RealMoney and TheStreet.com about how this helped to explain the perplexing (under)performance of these securities ﾃ｢竄ｬ窶 and the chat rooms were abuzz.
For the chat-roomers, let me clear up one thing ﾃ｢竄ｬ窶 contrary to speculation, I am not a disgruntled loser in these things; I have never bought or sold a ﾃ｢竄ｬﾅ澱earﾃ｢竄ｬﾂ or ﾃ｢竄ｬﾅ澱ullﾃ｢竄ｬﾂ levered ETF. Their construct has fatal flaws, and you can do what these set out to accomplish much more efficiently in a margin account.
In reference to the quote at the top, you will not catch me uttering, ﾃ｢竄ｬﾅ泥addy, Iﾃ｢竄ｬ邃｢ve got cider in my ear,ﾃ｢竄ｬﾂ as Sky Masterson did after being hoodwinked into a bet as to whether he could get Sgt. Sarah Brown of the Save-a-Soul mission to accompany him on a dinner date to Havana, Cuba. Yet many professionals, who have been deemed ﾃ｢竄ｬﾅ都mart money,ﾃ｢竄ｬﾂ may feel like invoking that very line as they towel their ears dry.
There were a couple of interesting news articles that hit Monday that sadly highlight how some of the smart money has been gaffed by these. I mentioned that these products are really marketing gimmicks and not created for professionals, so I was stunned when I saw some professionals get suckered in.
Barronﾃ｢竄ｬ邃｢s current edition of ﾃ｢竄ｬﾅ典he Roundtableﾃ｢竄ｬﾂ has a review of the 2008 professionalsﾃ｢竄ｬ邃｢ picks. At the beginning of 2008, Marc Faber made the prescient call of being short China. He recommended two ways to do so: short the iShares FTSE/Xinhua 25 Index (FXI) ETF (which was down 46.7% ﾃ｢竄ｬ窶 nice call) or to buy the ProShares UltraShort FTSE/Xinhua China 25 (FXP) (the double short on the same index which the FXI is long). The FXP ended up being down 57.2% ﾃ｢竄ｬﾂｦ whoops! We saw the same thing with the ProShares UltraShort Real Estate (SRS) ﾃ｢竄ｬ窶 the 2 times levered ultra short fund ended up doing worse than being long the very index that was down ~40%. Wrong execution of the right idea.
The second article of interest was in the morningﾃ｢竄ｬ邃｢s Financial Times. This was an article on the hedge fund Harbinger, and how it had thrown up ﾃ｢竄ｬﾅ鍍he gateﾃ｢竄ｬﾂ and restricted redemptions. The article went on to describe how Harbinger got the subprime call right, and through six months of 2008 was up more than 40%, yet closed the year with a 27% loss.
A lot of the chat rooms associated with these levered ETFs pointed to Harbingerﾃ｢竄ｬ邃｢s ownership of the ProShares UltraShort Financials (SKF) ETF as a validation of these securities as a smart buy (Harbinger owned 3.5 million shares as of Sept 30, 2008, according to the 13-F filings). I wonder now, in light of the second-half performance, how Harbinger feels about the efficacy of this position vs. employing the capital elsewhere.
On the message boards, several people said, ﾃ｢竄ｬﾅ徹berg just doesnﾃ｢竄ｬ邃｢t know how to trade these things ﾃ｢竄ｬ窶 you have to know how to ride the bumps.ﾃ｢竄ｬﾂ That is simply a naﾃδｯve intellectual position to take. Maybe I could have chosen a measurement point that reflected outstanding performance (note: my dates were entirely coincidental ﾃ｢竄ｬﾂｦ I just started examining these things right around Thanksgiving), but it really doesnﾃ｢竄ｬ邃｢t matter. An efficacious trade or hedge should perform more or less in line with expectations, regardless of the point in time of measurement. If you cannot measure it at any point in time and have it perform as would be expected, then you are in an inefficient positional expression of a view. If you cannot admit that, then you are rationalizing. When you rationalize a position, nine times out of 10 you will lose money.
I stated in the original piece that there are only three reasons someone would buy these:
1. they are uninformed (and indeed, the Journal of Finance research piece I referenced, which was co-authored by someone at the SEC, showed that reduction in margin requirements leads to increase in uninformed traders),
2. they are trying to circumvent the margin rules, or
3. they are attempting to manipulate the markets.
The fact that professional investors could get caught up in these is just mind-boggling to me. Letﾃ｢竄ｬ邃｢s give them the benefit of the doubt, and assume that they are not attempting market manipulation ﾃ｢竄ｬ窶 Iﾃ｢竄ｬ邃｢ll leave that up to the regulatory bodies to sniff out. (As a parenthetical aside, I will also choose not to debate whether a fundﾃ｢竄ｬ邃｢s potential pro rata contribution measuring anywhere from 10% to 40% of a stockﾃ｢竄ｬ邃｢s daily volume is meaningful or not (it isﾃ｢竄ｬﾂｦ).) Letﾃ｢竄ｬ邃｢s also assume that these larger ﾃ｢竄ｬﾅ都ophisticatedﾃ｢竄ｬﾂ investors do not need to circumvent the margin rules, as they should have some access to capital, somewhere, if they truly are legitimate and deserving of their ﾃ｢竄ｬﾅ2 and 20.ﾃ｢竄ｬﾂ So maybe that just means they are uninformed.
Leaving aside the oxymoronic concept of aggressively shorting a passive basket of stocks ﾃ｢竄ｬ窶 I mean, cﾃ｢竄ｬ邃｢mon, if you are so convicted that you want to lever a short, how about a little selectivity? ﾃ｢竄ｬ窶 letﾃ｢竄ｬ邃｢s see if they could have figured this out, and indeed whether an ordinary retail investor could have figured out the dramatic failure of these instruments in advance.
My guess is, unfortunately, they must not have read the offering docs; it just viscerally sounds so good ﾃ｢竄ｬ窶 ﾃ｢竄ｬﾅ展ow, a product that easily allows me to be 2 times short an index!ﾃ｢竄ｬﾂ Yes, even the ﾃ｢竄ｬﾅ都ophisticatesﾃ｢竄ｬﾂ can fall prey to gimmicks. But even still, what if they had read the offering docs?
I have just finished re-reading the 165-page prospectus for one of these funds. It is my opinion that in no way, shape or form have they adequately disclosed the volatility risk ﾃ｢竄ｬ窶 in fact, they have a longer passage for risk associated with foreign investments than they do this concept of volatility eating away at returns outlined in my prior pieces. The ﾃ｢竄ｬﾅ鉄tatement of Additional Informationﾃ｢竄ｬﾂ goes into a little more detail, but is still insufficient to explain the miserable failure of these as a term trade or hedge.
I believe the purveyors of these products were careless, reckless and perhaps even grossly negligent in disclosing the risks. Either they were a) completely clueless as to how dramatically these could underperform due to volatility (in the prospectus, they use 15% volatility and show underperformance of 70 to 220 basis points ﾃ｢竄ｬﾂｦ in the 68-page ﾃ｢竄ｬﾅ鉄tatement of Additional Information,ﾃ｢竄ｬﾂ they show volatility of up to 40% and underperformance of ~900bps, with the index down 40% ﾃ｢竄ｬﾂｦ nowhere remotely close to the underperformance we have seen), or b) they knew that performance looked horrendous at high volatilities but chose not to disclose. Given they show the tremendous potential outperformance of these if volatility is very low, my guess is they knew exactly what it would look like in the type of volatility environment we have seen, thus making ﾃ｢竄ｬﾅ澱)ﾃ｢竄ｬﾂ more likely ﾃ｢竄ｬﾂｦ but, then again, if they knew of this risk, theyﾃ｢竄ｬ邃｢d disclose it more thoroughly, right? To be fair, I have no idea which is the case, but this raises my eyebrows a bit.
Furthermore, the purveyors simply highlight that these seek to replicate (plus or minus 1 time or 2 times) the daily returns, and that they ﾃ｢竄ｬﾅ電o not seek to achieve their stated investment objective over a period of time greater than one dayﾃ｢竄ｬﾂ ﾃ｢竄ｬﾂｦ despite presumably knowing full well people do not view mutual funds as one-day holds. Indeed, investors are sent a prospectus when they execute a trade, meaning that there is at least three daysﾃ｢竄ｬ邃｢ price risk before they even get the prospectus, and that alone is enough to cause damage.
In my mind, that is kind of like advertizing on the side of a cigarette box, ﾃ｢竄ｬﾅ哲ot smoking these may have health benefitsﾃ｢竄ｬﾂ instead of ﾃ｢竄ｬﾅ鉄moking these may be hazardous to your health.ﾃ｢竄ｬﾂ Both are true, but one does not fully disclose the risks of using the product. Maybe the cover of the prospectus should just say, ﾃ｢竄ｬﾅ典his product probably wonﾃ｢竄ｬ邃｢t do what you think itﾃ｢竄ｬ邃｢ll do.ﾃ｢竄ｬﾂ
As I said ﾃ｢竄ｬ窶 viscerally, these sound quite appealing. But their performance is more painful than a random walk. Nothing hurts more than being right but at the same time losing money ﾃ｢竄ｬ窶 I mean, Marc Faber and Harbinger must be horrified to see their names forever in print next to these gimmicks (at least the individual investor can remain anonymous). The sad thing is that anyone with a margin account can create a far, far more efficacious position to reflect bearish views. And for these professionals, there really is no plausible excuse but laziness.
For those who argue, ﾃ｢竄ｬﾅ添es, but Iﾃ｢竄ｬ邃｢ve made so much money trading theseﾃ｢竄ｬﾂ ﾃ｢竄ｬ窶 Iﾃ｢竄ｬ邃｢ll tell you what: I will start an ETF based on an index linked to a random number generator. Whenever it is up and you are in the money, you can sell it and tell everyone in the chat room of your genius in knowing how to ﾃ｢竄ｬﾅ途ide the bumps.ﾃ｢竄ｬﾂ But for everyone else: If someone shows you a brand new deck of cards, on which the seal is not yet brokenﾃ｢竄ｬﾂｦ
Any details on this money tree of yours forthcoming?
Clearly the ultra ETFs are not for long holding periods - that much has been clear from the beginning. For short holding periods, they seem to perform well. The new 3x ETFs are interesting in the same way - but really only for day trading.
Cuervo, I’m considering writing up something that will cover at least one part of the breakthrough.
I have been playing around with Larry Connors book, “Short Term Trading Strategies That Work” on diETFs (after removing currency, gold, and the short internation plays) since the beginning of this year. Extremely optimized for 2008, the three long strategies (RSI2, Cum-RSI2, and Double 7s) are seeing a combined 400% return for the year, so these strategies are very promising.
I am now trying to de-tune the optimization so it is more robust and can work under different market conditions by optimizing for 2007 and then walk-forward for first and second half of 2008, separately. It will be interesting to see how the final performance numbers work out — even at 1/4 of the extremely optimized result, it would be my best strategy combination for a volatile marketplace.
Mike, I do not have the book yet, but it is on my list. I am actually ordering today Ralph Vince’s The Handbook of Portfolio Mathematics. The reason why I am getting the book is I think it will help me to optimize capital allocation between systems. For example, how will we know when RSI2 stops working? How will we know when another strategy begins out-performing? What is the optimum size to use to trade these strategies.
I’m hoping Vince’s book will help with all that.
I’d be thrilled if you would update us as to what you uncover in your de-tuning.