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

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.

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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.