I’ve been tossing this idea around on a few other blogs in passing so I thought I might as well post the mechanics and explanation of it here. First some background info to make sure we’re all on the same page:
Flat Market – also could be called a sideways market. Normally the definition is a market in which prices change little, so I threw in an added caveat: a volatile flat market. This would imply prices change quite a bit from day to day, but overall the prices are relatively flat over longer periods of time (i.e. the market goes up for a stretch, down for the next, up again, down again, etc.).
Leveraged ETFs – These are Exchange Traded Funds that track an index with built in leverage. The most popular have a 200% daily exposure to the market. If the index went up 1%, the 200% leveraged ETF would go up 2%. Leveraged ETFs normally come in two flavours: Bull and Bear (or regular and inverse). The “bear” or “inverse” leveraged ETF will provide leveraged exposure in the opposite direction of the index. So if the index GOES UP 1%, you would LOSE 2% with a 200% bear etf.
The problem with leveraged ETFs is that most people don’t understand how they work. I’ll cut to the chase (but you can read here for more detailed info). The initial 200% exposure (or whatever the case may be according to the fund’s mandate) is based on tracking the daily movement of the index. It falls apart when you hold it for longer periods of time (in terms of providing a 200% constant exposure). Here’s a basic example of how this would work:
Let’s say your ETF is trading at $100.00/share and it is a 200% leveraged bull ETF. Your index goes up 10% on the first day, therefore your ETF goes up 20%. The ETF now trades at $120.00/share. Let’s say the next day the index goes down 10%, therefore your ETF goes down 20% again as well. EXCEPT this time 20% is of $120.00/share which is $24.00/share, leaving you with $96.00/share.
Think about this: the index was down 1% over the two days, yet your ETF has lost 4%.
If you want more proof as to how holding leveraged ETFs can be a losing proposition in volatile markets, look no further than the calendar year performance for 2008 of Horizon BetaPro’s Global Gold Bull+ AND Global Gold Bear+ ETFs: -44.56% and -84.47%, respectively. This is not a knock on Horizon BetaPro – their products do what they are supposed to do brilliantly.
In any case, if you had shorted either of those Bull or Bear 200% leveraged ETFs, you would’ve been a very happy camper. In a sideways market with even modest volatility, the bull and bear leveraged ETFs’ values will slowly erode. Therefore, if you short them you could make money in a flat or sideways market.
According to Horizons BetaPro (according to a report by Morningstar Canada), if an index was flat over a year with 25% volatility then you would lose 6.1% (before fees), 50% volatility would incur a loss of 22.1% (before fees). Once you further subtract fees, it only looks better for the leveraged ETF short seller.
To make money holding leveraged ETFs you have to be right both in the direction and the path of the underlying index. I’m not saying you should go out and short these things, what sound good in theory may not work in practice, and remember 2008 and 2009 are turning out to be quite anomalous years.
I’ve set up a simulated account and am experimenting with shorting some 3x leveraged Direxion ETFs, I’ll keep you posted on what happens (in a semi-live environment). Once I’ve seen the results I’m going to put some real money into it in my own discount brokerage account and report my findings over time. Should be educational at the very least! :)