Tuesday, February 10, 2009

Beware the short and ultrashort ETFs!

What's the difference between a long ETF and its short counterpart? Theoretically, the price chart of one should inversely mirror that of the other, but as you can see from the charts below that is definitely not the case here.

The first chart is of the USO, the US Oil Fund. (The chart of the US Gas Fund, the UNG, is similar.)

The fund peaked July 11, 2008 and has fallen more than 70% since. Wouldn't it have been nice to have had a crystal ball so that you could have seen this coming and then done the opposite like, say, buy the ultrashort oil and gas ETF?

Let's examine this scenario and see what would have happened. Here's a chart of the DUG, the double-short oil and gas ETF.

The DUG did rise after oil began to implode. It returned more than 140% from July 11 to its peak price reached on October 10, 2008 where it formed a one-day island reversal (an evening doji star in candlesticking). No matter how you look at it, this is a bearish sign. The price turned around and fell 68% since then, but so did the USO. In fact, the USO has only fallen 60% since that date!

So what gives? Shouldn't the DUG be trading through the roof instead of scraping the basement floor right now? That's what one would expect. To clear up this mystery I went to the Proshares website where they explained why their short and ultrashort funds don't always perform the way they should.

There are two reasons for this.

The first, they say, is that their funds are designed to return their stated returns on a daily basis only. Here's their explanation: “Leveraged and short funds can be valuable tools for investors who want to manage their exposure to various markets and market segments. But investors considering these funds should understand that they’re typically designed to provide a positive or negative multiple of an index on a daily basis and not for greater periods of time. As a result, fund returns will not likely be a simple multiple (e.g., 2x, -2x) of an index's return for time periods longer than one day.” No kidding!

The second reason they claim is due to market volatility: “Additionally, investors should recognize that the degree of volatility of the underlying index can have a dramatic effect on the longer-term performance. The greater the volatility, the greater the deviation will be of a fund’s longer-term performance from a simple multiple (e.g., 2x, -2x) of its index's longer-term return.“

In fact, it's this second reason that explains much of the discrepancy between the two charts. Let's look at the market volatility index, the VIX.

You can see that the VIX has had quite a profound influence on the behavior of the DUG—much more than even the oil and gas index that it's supposed to track! Actually, you could almost use the DUG as a proxy for the VIX—who would have thought?

Lessons learned
There's a couple things that I've learned from this exercise. The first, and most obvious, is not to blindly assume that just because a fund says that it tracks the inverse or double the inverse of an index means that over the long haul it actually will. Because of this, one should be very careful of using these instruments as hedges, especially in highly volatile markets.

You learn something new every day. Class dismissed.

1 comment:

Charlie said...

Thanks for this very enlightening article. I'm new to handling my own portfolio, learning a lot by reading many, many articles.

I had just recently 'discovered' these ETFs and at first thought, wow, this is great. But, not so great after all.

If I think it's time to short, I'll just short and watch it closely.