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In the early '90s, there was a story in
The Wall Street Journal
on the prowess of one particular investment bank in complex mortgage securities. It is worth noting that the bank in question is no longer among us. But if you were around then, you probably read the piece; it was kind of a seminal article, particularly given the quote from one of the heads of this area at this firm, which went along the lines of the following:
What we do, is, we look for the really dumb guy and sell him the rich bits of the structure, and then the rest just shakes out from there.
When I was at Goldman, I had been asked by the firm to set up part of a new business. My boss at the time wanted to prep me -- that to do this effectively, it needed to be done the right way. He said, "Look, this is going to be a lot more complex than you think. We are asking you to thoughtfully build this part of the business, and want you to really think through a lot of the issues. This isn't about building a pile of revenues quickly, but building a sustainable revenue stream. Some people out there like to take advantage of the 'dumb guy,' and while that may be profitable in the short run, it really is no way to build a business.
"You see, the dumb guy either goes broke or he gets smarter. If the guy goes broke, then you have built your business on shaky ground to start with, wholly dependant on one guy, and it isn't really a 'business.' If he doesn't go broke, then he gets smarter. And once he figures out that you have screwed him, that has serious knock-on consequences -- for you, for the firm, for the market. So rather than go for the easy money, the lazy money, build something that will endure. It isn't going to be glamorous. You will need to spend a lot of time in the weeds figuring out how to build something that will endure. You need to meet with a lot of clients and listen to what they need out of this product. Only then will you know how you should construct this thing, but that is exactly what we want you to do."
I know it is in vogue to be a Goldman basher nowadays, and I could use that example as a rebuttal to some of that drivel, because the firm I know looks nothing like a "vampire squid." But instead, I want to use that example to highlight the concept of sustainability of products and businesses. Derivative products are nuanced; they have complexities that aren't apparent on the surface. If understood and appreciated, derivatives have a legitimate place in the markets. But if used to pick off the naive, then we all lose. Markets are built on trust, after all.
So it was in this frame of mind that I began the expose on these levered and short ETFs. Starting last December, I
pointing out how they simply did not work.
I had many e-mails thanking me for pointing this out, yet you should have seen the hate mail I also received. People telling me I had no right to criticize these products, that they had been approved by the
, and to simply accept that fact.
Now, eight months later, several brokerage firms have taken the bold step to agree with me and question the appropriateness of such vehicles and begin to curtail retail activity in them. Once retail goes away, then these products will cease to exist. I think that the institutions that "used" these products did so to either manipulate emotions or to take advantage of their flaws. As they say, if you don't know who the mug in the game is, then guess what...
If you read those early pieces of mine, you will recall that although these products say on the surface that they are short (or double or triple short) various indices, they also are essentially a short volatility position given their daily reset nature. As I pointed out, this secondary effect can entirely knock out the presumed primary objective, that of being short the market or a segment of the market. This is true for all of these daily reset short ETFs -- they are all short this volatility position; it just becomes more noticeable if volatility picks up or if it is magnified by leverage.
Let's just review some performance really quick. A year ago, pre-Lehman, pre-Fannie and Freddie, pre-AIG, etc. the unlevered long financials ETF, the
iShares Dow Jones U.S. Financial ETF
stood at $70.56 (adjusted for distributions). On Thursday it closed at $45.90, for a one-year return of (34.9%). The
UltraShort Financials ProShares
, which purports to be 2x short the Dow Jones U.S. Financials index, closed on July 30, 2008, at $118.95 (again, adjusted for any distributions). On Thursday, the SKF closed at $34.79, representing a loss of 70.75%. So the product that was 2x short an index that was
34.9%, lost nearly twice as much! That would be a tracking error of over 140%. That is money that has gone to "money heaven" -- all eaten up by the short volatility position due to the construct of these vehicles.
Let's take a look at some other funds. The
UltraShort FTSE/Xinhus China 25 ProShares
, which is 2x short China, closed July 30, 2008, at $71.62, and closed Thursday at $9.73 -- a decline of 86.4%. At the same time, the 1x long China ETF, the
iShares FTSE/Xinhua China 25 Index
went from $45.90 to $42, a decline of 8.5%. That is a tracking error of just over 103%.
UltraShort Real Estate ProShares
, 2x short real estate, went from $83.44 to $15.36 over the past year, a decline of 81.6%, while the
iShares Dow Jones U.S. Real Estate
, 1x long real estate, went from $58.47 to $35.82, a decline of 38.7%. That is a tracking error of 159%.
What if we add
Direxion Daily Financial Bear 3X Shares
, which is 3x short the Russell financial index, closed its first day of trading on Nov. 19, 2008, at $129.30. It closed Thursday at $34.98 ... but wait ... this one did a 10-for-1 reverse stock split the other week, so in reality we should look at that first day's close as being $1,293. Outstanding a little over eight months, it has lost 97.3% of its value. The index itself is up 26% over that time, so the tracking error isn't that bad. I am sure those who have held this thing since inception are comforted.
What if we reduce leverage? Look at the
Short S&P ProShares
, which is just 1x the inverse of the
. The adjusted close a year ago was $58.56; on Thursday it closed at $60.87 for a gain of $2.31, or 3.9%. The
S&P Depositary Receipts
, on the other hand, went from $125.15 to $98.67, for a loss of 21.1%. So the tracking error of the SH is just over 17.2%, or about a sixth of your original portfolio value a year ago.
OK, I think you've received the point on performance. Over the past year, we have had a dramatic crash, followed by a nice rally. The broader market is still 20% lower year over year, yet these "short" funds have not done what one would have expected. Why do I care? Why is this important? I go back to the second paragraph. I do not trade these things because ultimately, someone somewhere is getting picked off -- and that in and of itself is bad for the markets. The primary motivation for these vehicles is so that people can effect a short position (
to pick off the unsuspecting), yet that is not what they get.
Now, there are some people who have written in and said, "But what can I do in my IRA, where I am not allowed to be short? I have to use these." Nonsense. You don't have to use anything. Just because these appear easy doesn't mean you need to use them, and it doesn't mean that they will do what you think they will.
First off, let's not call this a hedge. Remember, these are both short market and short volatility, so they will not act like a true hedge. A pure hedge should insulate a portfolio from any move, up or down,
over any period of time
. If the market sells off, your hedge offsets that. If the market goes up, you have a loss on your hedge equal to the gain in the portfolio. Thus, a pure hedge locks in today's value. That is kind of the same thing as converting your IRA to cash, isn't it? There is no hedge like a sale. If the market makes you nervous, sell some and increase your cash holdings, pure and simple. And since an IRA is tax-sheltered (generally), capital gains basis shouldn't come into the equation at all.
I know, I know ... these are only meant for daily use (we tend to see that highlighted a lot more in the advertising nowadays, don't we?). But I keep coming back to the point that if they are only meant for daily use, why do they exist? Why would a fund company put these out there if everyone was supposed to go home flat every night? They'd have no assets under management! So implicitly, they are relying on someone to hold these overnight, aren't they?
Or are they just providing the vehicle as a public service? I guess that is why no one balks at the 95-basis-point fee for an ETF, because they all go home flat, right? (Now I may be a little unique on this site in that I do not manage money for anyone other than family. But if the market is offering up 95 basis points per annum to create money-losing products with 140 points of tracking error, I may very well need to rethink my strategy!)
When we first published that initial article on this last year, we were out on a limb in criticizing them - indeed, the "XXXs" were only one month old. I think that time has shown that these instruments have not been what they were cracked up to be. Just because these were slipped by the SEC does not make them right. Just because there are profitable trades to be had trading against these things, it doesn't mean we should -- after all, there is someone long this thing on the other side thinking they are getting something they are not. The primary
for these is so that people can be short the market -- not so the rest of us have something to trade against. That is essentially building a business picking off the dumb guy, and we should know how unsustainable that is...
Since these include "XXXs," it brings to mind the old "socially redeeming qualities" argument about pornography. And these products have none, unless you count taking advantage of the naive. They don't work as people think they should; it was a mistake approving these in a laissez faire, "gee whiz, what'll they think of next" regulatory environment. Kudos to the firms that are looking out for their investors by no longer accepting initiating orders on these instruments. SEC, you're up.
At the time of publication, Oberg had no positions in the securities mentioned.
Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.