Why Short Sector ETFs Aren't So Smart - Part 2
By RealMoney Guest Contributor
12/23/2008 8:59 AM EST
URL: thestreet.com
This article is by Eric Oberg, who worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.
In Part 1 of this article, we looked at short index ETFs can go against you, even if you made the right call. Today we'll look at how volatility eats up the returns on short sector ETFs and why these instruments are not for professionals.
Very few people would decide to go long an index by shorting the short-sided index ETF -- they'd just go buy the long-sided ETF. These products purposefully segment the longs and the shorts, and that, by definition, creates illiquidity. (Although I have to admit, this is an ingenious idea for the fund manager -- if they just had one product where longs and shorts could meet, some of those would cancel each other out, and they'd have less assets under management than they get by herding the bulls and bears into different products.)
So if someone buys that short-sided ETF from a market maker, the market maker does not really have "the other side" to mitigate his risk, thus he either waits for someone to unwind a pre-existing position or he goes out and shorts the underlier. This puts pressure on the underlier, which creates more interest in being short. This, magnified by the leverage, magnifies the volatility, which magnifies the negative convexity, which eats into returns. Thus the "savvy trader" who thinks he or she is doing a "smart trade" is contributing to his or her own underperformance while still having the right idea -- the wrong execution of the right concept.
Now here is a key point: This short-volatility position is kind of a compounding issue. If you compound at low yields, it is only slightly noticeable. If you compound at high yields, it becomes meaningful. Only in this case, instead of yield, think volatility. The more volatility, the more these levered short ETFs get clipped.
So if I look at a broad index, such as the S&P 500, and then look at the returns of the two-times levered long and two-times levered short ETFs, the returns are more or less mirror images, with the two-times short fund only slightly underperforming. This is because the volatility of the S&P 500 on a daily basis is not extreme.
Another way of saying it is that these two-times long and short funds are small fish in a much bigger pond -- the water is so deep, these barely cause a ripple in the much larger market (not to mention that the intraday hedging can be done in a liquid futures market). The activity in these funds does not influence the broader market; the tail does not wag the dog.
But these smaller sub-index funds are much bigger fish in a much smaller pond. The tail does wag the dog, and there is not a deep futures market with which to hedge. And here is where you begin to see significant underperformance in these levered short-sector ETFs, likely because these funds are having an inordinate effect on their sectors -- and the volatility they help create leads to their own demise.
I took two recent trading days looking at the SKF (the ProShares Ultrashort Financial (SKF) , the two-times levered short financial sector ETF), and just at a high level looked at the dollar volume in the ETF traded that day, and compared it with the dollar volumes traded in some of the underliers. Note, that isn't to say that every dollar traded in the ETF translated directly into dollars traded in the underliers, but the results were pretty staggering.
The SKF closed Wednesday, Nov 19, at $222 and change. Daily volume has averaged 31.5 million shares (volume was actually slightly lower than that on the 19th). Now, this is not scientific (or indeed even accurate), but it just gives you a sense. At $222 and average volume of 31.5 million, that means (if every share sold at the close, which it didn't, but again this is just to illustrate a point) that the day's dollar volume in this short ETF was close to $7 billion. Since this is double levered, that is really close to $14 billion in volume in the sector. I understand that each trade represents a buyer and a seller of the risk, but bear with me here.
The same day, Goldman Sachs (GS) closed at $55, with roughly 30 million shares changing hands, representing 1.65 billion of dollar volume. Citigroup (C) closed at 6.40 with a (then) whopping 340 million shares changing hands, representing 2.2 billion in dollar volume traded. JPMorgan Chase (JPM) traded 90 million shares and closed at $28 and change, so roughly $2.5 billion to $2.6 billion in dollar volume. Merrill Lynch (MER) had about $1 billion in dollar volume. The volume created by the SKF swamps all of these.
On Dec 4, assuming average price of $135, the SKF traded 29,248,827 shares, representing just shy of $3.95 billion in dollar volume traded. Since this is a double-levered product, that represents just under $7.9 billion of volume in the underliers. Goldman Sachs traded 23,838,644 shares at an average price of around $68, giving us roughly $1.6 billion in volume. Goldman accounts for 2.59% of the index associated with SKF. That means that basically, $204,610,000 of the $7.9 billion in SKF was associated with Goldman Sachs, or roughly one-eighth of the day's volume in Goldman.
Again, these are rough calculations and just two random days, but I think you get a sense of the size of the fish relative to the size of the pond. There are by far more scientific ways to establish whether or not these influence the daily price discovery process -- but as a hint to those that may look into this, just start by looking at the sectors that do not have symmetric returns between the two-times long and two-times short ETFs, as those are the sectors where volatility has reigned. I must admit, there is a delicious irony in the fact that if indeed these ETFs have contributed to the extremes we have seen in these sectors, that those that caused the volatility have also paid their price.
So why do these products exist? Well, if you read the marketing literature, it says that these products "make it simple to execute sophisticated strategies, like shorting or magnifying your exposure to major indexes. No margin account. No margin calls. It's as simple as buying a stock." Basically, that is just another way of saying these ETFs are an easy way to get around the margin rules.
These products, contrary to popular belief, are not made for professionals; in fact if you talk to most institutional ETF desks on the Street, they will tell you they see very little activity from institutional investors in these products. That, in fact, makes sense, because an institution can find more efficient ways to be short or to be leveraged. Actually, anyone with a margin account can find more efficient ways to be short or leveraged (unless they are really ramping up their leverage by buying these on margin). The only reasons I could think of that someone would "invest" in these products would be because they a.) expressly lacked sophistication, b.) were trying to skirt the margin rules, or c.) were attempting to manipulate the markets.
To be sure, some institutional investors appear on the shareholder rolls of these products. (Would you be surprised if I told you Bernie Madoff shows up as a holder? He held 7,638 shares of SKF as of Sept. 30, 2008). But if I were an investor in a hedge fund that was short the market in such an inefficient manner, I'd either question their due diligence if they thought this was the best way to effect a trade, or I'd question their scruples if they were attempting to manipulate the market. Either way, I'd really question paying them "2 and 20" on top of the 95 basis points in fees that the ETF is taking out. If you have hedge fund investments that hold these securities, ask them for a return attribution.
According to a December 1995 piece in The Journal of Finance, an article by Mayhew, Sarin and Shastri, "Federal Regulation of Securities margins was mandated by Congress in October 1934 to promote market integrity and curb excessive volatility" [emphasis added] . So again, why do these products exist when they seemingly do neither?
If you wish to add leverage to your portfolio, you typically need to do so in a margin account, which means you need to meet suitability requirements and sign a hypothecation agreement. If you wishes to short a security, you need to establish a margin account, meet the suitability requirements, sign a hypothecation agreement, plus obtain a borrow. Yet these ETFs can be traded in a cash account, effectively sidestepping the margin requirements - remember, "It's as simple as buying a stock"!
Hmmm ... providing leverage and easy access to shorting the market ... that doesn't exactly sound like promoting market integrity and curbing excess volatility now, does it? The fact that so much expected return on these instruments gets eaten away by the volatility should tell you something about their efficacy.
The magnified volatility has also rendered moot many long standing market practices -- for instance, with these things it would be very difficult to reinstate the uptick rule, and they make it difficult to regulate naked short-selling, because "It's as simple as buying a stock." Furthermore, for those who follow technical analysis, cycles become much more compressed, and Fibonacci levels are no longer sacred because there is no speed governor when indiscriminate two-times and three-times levered index products are involved (and this counts in up markets just as much as in down markets) -- thus, "signals" really aren't signaling anything.
These levered and short sided ETFs are an endless series of paradoxes. They are set up to benefit from market moves, but the more volatility, the less accurate they are in achieving that objective. They market themselves as an easy way to provide sophisticated trading strategies, yet the true sophisticated investor can implement more effective trading strategies themselves. They do their job following daily moves, yet they make for a lousy long term hedge or trade. They offer the layman investor a chance to protect against volatility, yet they help contribute to and exacerbate that volatility because of their construct.
The double-levered short financials ETF is backed by -- you guessed it -- a swap with a financial. Despite having margin requirements to "promote market integrity and curb excessive volatility," these somehow have been allowed to proliferate in the market. And the biggest paradox of all is that you could have been spot-on accurate with your bearish call, yet still ended up in the red.
I realize some may say, "I hear you on that, but these just make it so easy for me to implement my strategy." OK, maybe so. But if you would have just been short the two-times long Ultra Real Estate instead of long the two-times-short UltraShort Real Estate since the beginning of the year, you'd have three times as much capital in your account right now. That's some price to pay for ease of use! At least the offering documentss state, "There is no guarantee [these products] will achieve their investment objective." You can say that again. |
