Why Short Sector ETFs Aren't So Smart -- Part I

To be fair, these funds do exactly what they set out to do -- track the daily changes in these indices. But that is also their fatal flaw as any sort of long-term investment or portfolio hedge. It is the daily rebalancing of the portfolios in combination with the market volatility and the leverage that has eaten into the returns of what appeared to be a savvy bet. And the irony of it all is that these funds, due to their structure, actually contribute to the volatility, thus directly contribute to their own failure as instruments for anything other than a day trade.

The following is a little bit of an over-simplification, because there are elements of path dependency, the element of compounding slight NAV deviations that affect returns and a few other technicalities, but let me try to explain how on earth it is possible to be double short an index that is down 40%, yet still be worse off than if you were long that index.

I am sure most people are familiar with the concept that if you go down 20% one day, then up 20% the next, you are still worse off than when you started (100 times 0.80 equals 80, and 80 times 1.20 equals 96). This is similar to what happens with these double-levered short side ETFs (the two-times long-side ETFs look like they do what they should), you get shorter on the way down, making bounces hurt more, because you lose more of your capital account.

So when you're frequently rebalancing, volatility nibbles away at your returns. When volatility goes to extreme levels, it eats away at your returns ... and with leverage, it devours your returns. This is essentially a short volatility position, and the short volatility position can outweigh the short index position, as evidenced by the returns in the chart. So these ETFs are not quite as effective as one would think as a mainstay in the portfolio, as a hedge or otherwise; in fact, they may be completely ineffective, or even counterproductive, at achieving objectives.

What's worse, though, is that by their very construct, these ETFs exacerbate the volatility. By bifurcating an index into long side and short side ETFs, they eliminate an "out" for the market maker, causing the market maker to actively hedge in the underliers. With a normal security, all buyers and all sellers come to a central meeting place, and buyers can be matched easily with sellers, and we reach price discovery. But when you set up a specifically one-sided instrument, rather than one common product that people can be either long or short, you contribute to dislocations.

In Part 2 of this article, we'll look further at how volatility eats up the returns on short sector ETFs and sabotage their own performance.

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At the time of publication, Oberg had no positions in the stocks mentioned.

Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.