Friday, September 17, 2010

Shorting a Bear Leveraged ETF: A Sure (But Impossible) Win

Some say that the stock market is like the casino...and I say they are right (in some cases)!  I can show you how you can be the house and have the odds stacked in your favour.  Just a small note: you can't actually execute this strategy...sorry!  Unfortunately, there's no free lunch.

Bear ETFs
In recent years, ETFs or Exchange Traded Funds have emerged as very popular instruments.  Traditionally, there were stocks and then there were mutual funds.  With stocks, it was possible to execute orders in a matter of seconds.  Literally, you could jump in and out of the same stock hundreds of times a day.  On the other end of the spectrum, you have mutual funds, which you buy from the company that runs that mutual fund.  If you wanted to buy or sell shares of that mutual fund, the transaction usually take a few days to show up on your account.

ETFs have bridged the gap between the two.  ETFs trade almost identically to company stock shares.  Orders can be executed in a matter of milliseconds and there are even options of ETFs.  However, as the name suggests, ETFs are funds, pooling investor's money to buy a number of securities, whether they be stock, options, swaps, etc.  Usually, ETFs will try to mimic the movement of a certain index (e.g. SPY with the S&P500).  To satisfy the market's demand for shorting stocks, bear ETFs have been created.  It mimics the underlying index, but inverses the return.  For example, SH is an inverse ETF of S&P500.  If S&P500 goes up 2% for a particular day, SH goes down 2%.

The Key Characteristic to Bear ETF - Imperfect Imitation
The normal index ETF, such as SPY, mimics the index almost perfectly.  If S&P500 goes up 2%, it goes up 2%.  If it goes down 1%, it goes down 1%.  Over the long term, the performance of SPY matches S&P500 pretty closely.  You can go to Yahoo Finance and plot SPY and ^GSPC (symbol for S&P500), and you will see that they essentially lie on top of each other.

For bear ETFs, they don't work as perfectly.  In the chart above, I've plotted ^GSPC and SH together.  In the ideal case, a bear ETF should have exactly the opposite performance as its underlying index.  The blue line is S&P500.  From 2006 until now, it has returned approximately -10%.  You would think that SH should return +10% because it is the inverse of S&P500.  However, it returned almost -30%!  What?  Isn't this a bear ETF?  Should it not make money if the underlying index falls?  Yes and yes.  The problem lies in the mechanics of a bear ETF.

Let's use a hypothetical case as an example.  Imagine that the American economy suddenly recovered, unemployment drops to 3%, and the market skyrockets.  S&P 500 moves from today's 1125 to 2360.  That is a 110% move.  Since SH is the inverse ETF, it should move the same amount but in the opposite direction. So, it should move -110%...but wait a minute, an ETF can't go negative, can it?  No, it cannot.  Therein lies the problem...or shall we say opportunity?

What actually happens with a bear ETF is that it inverses the daily performance of the underlying index.  All bear and leveraged ETFs behave in this way.  The fund company rebalances its portfolio daily such that the daily move mimics the move of the underlying index.  Look at the table below.  I have made up some data to illustrate this effect.  On the first column is the underlying index.  On the second is the daily moves in percentage.  The last column is the inverse ETF.  As you can see, even though the underlying ETF moves back to its original value of 100, the inverse ETF does not.  This is called time decay.  The more volatile the index is, the bigger effect time decay becomes.

Underlying Index
Move (%)
Inverse ETF

Leveraged Bear ETFs
In more recent times, leveraged ETFs have surfaced.  These ETFs simply multiply the daily movement of the underlying index by a multiple.  For example, the BGZ is an ETF that provides -3X of the daily move of the Russell 1000 index.  As you might imagine, the time decay effect is multiplied as well.  Since the direction of the stock market is generally up over the long term, bear leveraged ETFs are bound to lose its value, and very quickly.

From its inception in November 2008, BGZ has lost about 85% of its value.  If we look at the period from Feb 1, 2010 until Sep 17, 2010, the Russell 1000 index has returned just below 0%.  BGZ, on the other hand, lost almost 20% of its value.  In less than a year, the ETF has lost 20% of its value purely from time decay.

The Opportunity
As I was thinking about this just a few weeks ago, I wondered whether I could short a bear leveraged ETF.  It's almost a sure win.  All I need is for the stock market to remain steady, let alone going up, and I'd be making 20% + gains in a year.  Now, that's a market beating strategy!

I also thought about shorting ETF pairs, or basically the bull and the bear ETFs for the same underlying index.  For example, I would short both BGU and BGZ.  The reasoning behind it is that since the ETFs provide both 3x and -3x movements of the Russell 1000 index, the position would be a sure win in the short term because of time decay.  I got really excited and started talking to my close friends about it.  My cousin, who works in  TD bank's mid-office (ticker: TD) of its securities group, was skeptical, because if something was a sure thing, people would have taken advantage of it already.  In short, he was saying that I couldn't be so smart as to come up with this ingenious idea.

Too Good to be True
He was right!  Darn!  I googled some more on this and found that there had been some chatter on this topic on forums.  Most people were skeptical, but could not provide a real argument why this would not work.  Finally, I found out the real reason why this could not work.  It was not because the theory was flawed.  In fact, I was right on the money.  Most brokerages, I found out, would not allow shorting of leveraged ETFs, especially bear leveraged ETFs.  Even if they did, they would retain the right to call the shares back at any moment.  This leaves the investor vulnerable to huge losses.

An alternative to this strategy would be to buy put options on the bear leveraged ETFs.  However, these options were very expensive the farther out they were.  The market prices these accordingly because most people are aware of the time decay characteristic of bear leveraged ETFs.

Did You Just Waste Five Minutes of My Time?
So, what was the point of all this, if there was no way this theory could be executed?  For one, I was hoping I could share with you what goes on in my head from time to time.  I was quite excited about all this for about 18 hours, until I burst my own bubble, with the help of my cousin.  However, more importantly, I want to encourage all of you to try to think outside the box.  With tools like options and ETFs, there are quite a number of things that can be done that could not have been possible with traditional stock shares.  I'm not trying to get fancy or anything, but I try to keep my mind open for hidden gems that are waiting to be exploited.  Of course, this should all be done within our own moral code.

Before I close, I'd like to thank all of you who completed my short survey.  I've read all of your comments and appreciate them very much.  I will take note of your suggestions and try to address them in the future.

As you know, it's September, so school has started for me again.  I will try to keep up my writing as much as possible, amidst all of my readings and assignments.  Please keep me in your prayers!  God bless!