I knew these products were too good to be true. I don’t know why some short ETFs have been halted today (ProShares is mum), whether it is just overwhelming volume or that their shorting strategy has been impaired by the ban, but in addition to counterparty risk, this is just one more example of how options are superior.
Today is also a stress-test for brokerages. If yours is under performing today, better look for a more robust alternative, because this is only the beginning.
My understanding is that these ETFs do not actually engage in plain-vanilla short selling, but use options, futures, forward contracts and swap agreements in order to perfectly track their respective indexes. The ProShares ETFs that I have been watching lately have been doing a good job of operating exactly as advertised, providing twice the inverse of the indexes on a daily basis. I expect them to continue to do so, and believe that their vital risks are still counterparty defaults and government meddling in the derivatives markets.
Page 7 of the ProShares prospectus (PDF) has a rundown of strategies employed by its short funds.
MarketWatch reports that ProShares ETFs have seen massive volume this week, especially SKF, the double short financial ETF, which benefited from earlier naked shorting restrictions.
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This is one heck of a rally. Dow futures are up 347 points on top of a 600 point rise from the intraday low yesterday afternoon. This is a gift for shorts using means other than plain short sales, since it sets us up for a spectacular failure, financials included.
Trading was suspended in London this week for some vehicles issued by ETF Securities, because the funds relied on counterparty arrangements with AIG (Reuters). The dirty little open secret of levered and short ETFs, and many others, is that they rely on swaps to get that near-perfect tracking of their underlying indexes.
“LONDON, Sept 16 (Reuters) – Some banks and brokerages ceased making markets in commodity securities backed by matching contracts from troubled insurer American International Group Inc … on Monday afternoon, ETF Securities said on Tuesday.
The affected securities are known as exchange traded commodities (ETCs).
ETF Securities said on its website it was “actively working on possible ways of providing investors with liquidity” — including arranging suitable collateral for market-makers.
As of this evening, ETF Securities was reporting that it was an apparent beneficiary of AIG’s nationalization:
AIG confirmed that last night there was an announcement by the Federal Reserve Board, that the Federal Reserve Bank of New York is providing a two-year, $85 billion secured revolving credit facility to AIG that will ensure the company can meet its liquidity needs.
AIG has continued to honour all of its obligations under our agreements with them, including processing all creations and redemptions in the usual manner and paying all redemptions due on time.
Like money market funds breaking the buck, this is one more risk that few investors have ever thought possible. Popular issuer ProShares spells it out in their prospectus (my underlining):
Swap Agreements Swap agreements are two-party contracts entered into primarily by institutional investors for a specified period ranging from a day to more than one year. In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments. The gross returns to be exchanged or “swapped” between the parties are calculated with respect to a “notional amount,” e.g., the return on or increase in value of a particular dollar amount invested in a “basket” of securities representing a particular index. The Funds are subject to credit or performance risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
Now, swaps are not the only assets of these ETFs, so they may not go to zero in a counterparty default, but we don’t know exactly what fraction of a given fund is at risk. Nor do we know who the counterparties are in all of the ETFs. ProShares keeps their counterparties a secret, though they did assure us this week that Lehman and AIG were not among them.
Back to analog
Seeing as all major investment banks are on the ropes, it may be time to think about other ways to go short, such as old-fashioned short selling or buying puts. I’m a fan of LEAPS puts for a number of reasons, including the greater default protections of the options market.
Jury-rigs
It is worth mentioning that there are some work-arounds possible with levered ETFs that mitigate counterparty risk: shorting a levered long ETF or buying puts on a short ETF that you are long. Or you could allocate a small amount of capital to calls on a levered short ETF to limit your losses in case of default.
Why not more disclosure?
If ProShares or other issuers are implementing measures to eliminate counterparty risk, they should be forthright about it, otherwise we have to fear the worst. Is there more than one swap counterparty per fund? Just how much of each fund relies on uncollateralized swaps? How often is collateral rebalanced? If it is done daily, I would be OK with that. No biggie to lose out on one day’s gains, even a big day — I just don’t want to lose the whole wad.
We are entering uncharted waters here, and trust is in short supply for good reason.
The opportunity to short REITs (or IYR, a REIT-heavy ETF) is fantastic at right this moment. This is about as perfect a short set-up as you could ever wish for: securities of companies in a rapidly deteriorating sector have rebounded to near where they were a year ago when optimism was abundant and the stock market was making new highs. The ETF is actually trading where it was in the first quarter of 2006, the exact peak of real estate prices in the US.
Here is a 5-year look at IYR (I like to take the long view):
Click for sharper view. Source: Yahoo! Finance
There is a heavily traded double-short ETF, SRS, that tracks the opposite of the Dow Jone Real Estate Index with 200% magnitude on a daily basis. My preferred way to short is with LEAP puts, because despite common notions to the contrary, these options are more dummy-proof and safer in some ways than short-etfs, while allowing greater leverage so you can risk less capital on your shorts.
One more thing that makes this such a great short is that, in contrast to financials, there has not been much of a panic sell-off yet. XLF (a popular financial ETF), made a waterfall plunge from June to mid-July, which, while certainly not the final bottom, served to blow off some steam for the short-term.
I haven’t said anything about fundamentals here, but it should be obvious to anyone that commercial real estate, like residential, was heavily overbuilt because of cheap credit readily extended to Joe Blow Developers, Inc. We now have way more shopping malls, office parks and trendy urban condo complexes than we could possibly use at prices high enough allow Joe to cover his debt payments.
As the consumer gets frugal, the corporate sector contracts, and inner cities get scary again, vacancies in the respective developments will soar and rents will drop. And because this game, like housing, is played with leverage, holders of CRE are in big trouble (as are the banks that hold these loans on their books – they will soon be the not-so-proud owners of shiny new rental properties).
It should also be noted that as Treasury rates have fallen (a big red flag for the economy), there has been a little fad to buy CRE or REITS for the slightly better yield, as though they can be compared to Treasuries! Gimmie a break! Holders of this junk are in for a world of hurt, sooner rather than later.
Inverse ETFs are best used for trading, rather than to buy and hold for the duration of a bear market. Non-traders looking to hedge their longs or profit from the bear market should consider long-term put options instead. Contrary to popular belief, options can require less expertise and offer a lower overall risk to a portfolio than short ETFs.
Brutal math
The main problem with short ETFs is that as the underlying indexes get lower, small dollar moves become large percentages, especially in 2X funds. This math works against you as the market exhibits volatility on its way down. A dollar of loss in an index wins you a smaller gain in your short fund than a dollar of gain in the index from that lower level gives you a loss in your fund. Here’s an illustration:
Imagine if XLF (a financial index ETF) goes from 20 to 19 one day, and SKF (SKF’s 2X inverse) goes from 100 to 110.
$1 out of $20 is 5%, so SKF goes up 10%
$1 down = $10 up
The next day XLF goes from 19 to 20, so SKF goes to $98.42 . $1 out of $19 is 5.26%, so SKF goes down $11.58.
XLF is back where it started, but SKF is down 1.42%.
As many have learned in the bounce from the July 15 lows, this math can be brutal with larger percentage swings, and these moves will only get wilder as the market goes lower.
LEAPS are lower risk than short ETFs (in smaller quantities)
If you are very confident about financials or REITs or the broad market going lower and are not a proven trader, use LEAPS (Long Term Equity Anticipation Securities), long-dated options. The whole idea behind the existence of an options market is to decrease risk. Make the concept work for you.
You can buy January 2010 puts on XLF, IYR, SPY, IWM, QQQQ, whatever you want, and just sit tight. 2011 LEAPs are being rolled out, and December 2010s are available on SPY. Don’t trade in and out if you aren’t a pro. Those blistering rallies on the way down won’t change the fantastic percentage gains that await if you have the longer trend right.
So many people risk big chunks of money in double short ETFs, and then screw it all up through bad trading, when they could just put a fraction of the money into LEAPS puts and get out of their own way, with the ultimate dollar gains being the same in the end. The balance saved can be kept safe in treasury bills, and those could be a lifesaver if things get really hairy and the markets are compromised. This strategy offers lower risk than inverse ETFs without sacrificing potential gains.
LEAPS may also offer reduced counterparty risk due to the rules of the options market, as opposed to whatever wizardry the investment banks use to make those funds do what they do.
FAQ: How high can inverse ETFs go?
For the record, the theoretical gains in any short ETF are unlimited. You can always go down another 1% or 10% or 50%, no matter how low an index goes, so a short ETF can keep going up by the same (or double) percentages forever. The catch is that volatility and the math explained above will keep things down to earth.
Don’t dismiss cash. It’s in a bull market.
I am not recommending shorting to anyone. Only you can decide what may be appropriate, and the key to getting through the next few years will just be to come out with your capital intact. That will be heoric enough.
