The Perils of the ProShares UltraShorts
One of these days in your travels, a guy is going to show you a brand-new deck of cards on which the seal is not yet broken. Then this guy is going to offer to bet you that he can make the jack of spades jump out of this brand-new deck of cards and squirt cider in your ear. But, son, do not accept this bet, because as sure as you stand there, you're going to wind up with an ear full of cider.
-- Sky Masterson in Guys and Dolls

I was amazed at how much discussion my piece and subsequent Q&A on levered, short-sided ETFs generated, particularly for a holiday launch. We received a number of comments at RealMoney and about how this helped to explain the perplexing (under)performance of these securities -- and the chat rooms were abuzz.

For the chat-roomers, let me clear up one thing -- contrary to speculation, I am not a disgruntled loser in these things; I have never bought or sold a "bear" or "bull" levered ETF. Their construct has fatal flaws, and you can do what these set out to accomplish much more efficiently in a margin account.

In reference to the quote at the top, you will not catch me uttering, "Daddy, I've got cider in my ear," as Sky Masterson did after being hoodwinked into a bet as to whether he could get Sgt. Sarah Brown of the Save-a-Soul mission to accompany him on a dinner date to Havana, Cuba. Yet many professionals, who have been deemed "smart money," may feel like invoking that very line as they towel their ears dry.

A couple of interesting news articles hit the streets Monday, and they sadly highlight how some of the smart money has been gaffed by these. I mentioned that these products are really marketing gimmicks and not created for professionals, so I was stunned when I saw some professionals get suckered in.

Barron's current edition of "The Roundtable" has a review of the 2008 professionals' picks. At the beginning of 2008, Marc Faber made the prescient call of being short China. He recommended two ways to do so: short the iShares FTSE/Xinhua 25 Index ( FXI) ETF (which was down 46.7% -- nice call) or to buy the ProShares UltraShort FTSE/Xinhua China 25 ( FXP) (the double short on the same index which the FXI is long). The FXP ended up being down 57.2% ... whoops! We saw the same thing with the ProShares UltraShort Real Estate ( SRS) -- the 2 times levered ultra short fund ended up doing worse than being long the very index that was down ~40%. Wrong execution of the right idea.

Don't miss "You Ask, Oberg Answers."

The second article of interest was in the morning's Financial Times. This was an article on the hedge fund Harbinger, and how it had thrown up "the gate" and restricted redemptions. The article went on to describe how Harbinger got the subprime call right, and through six months of 2008 was up more than 40%, yet closed the year with a 27% loss.

A lot of the chat rooms associated with these levered ETFs pointed to Harbinger's ownership of the ProShares UltraShort Financials ( SKF) ETF as a validation of these securities as a smart buy (Harbinger owned 3.5 million shares as of Sept 30, 2008, according to the 13-F filings). I wonder now, in light of the second-half performance, how Harbinger feels about the efficacy of this position vs. employing the capital elsewhere.

On the message boards, several people said, "Oberg just doesn't know how to trade these things -- you have to know how to ride the bumps." That is simply a naïve intellectual position to take. Maybe I could have chosen a measurement point that reflected outstanding performance (note: my dates were entirely coincidental ... I just started examining these things right around Thanksgiving), but it really doesn't matter. An efficacious trade or hedge should perform more or less in line with expectations, regardless of the point in time of measurement. If you cannot measure it at any point in time and have it perform as would be expected, then you are in an inefficient positional expression of a view. If you cannot admit that, then you are rationalizing. When you rationalize a position, nine times out of 10 you will lose money.

I stated in the original piece that there are only three reasons someone would buy these:
  • they are uninformed (and indeed, the Journal of Finance research piece I referenced, which was co-authored by someone at the SEC, showed that reduction in margin requirements leads to increase in uninformed traders),
  • they are trying to circumvent the margin rules, or
  • they are attempting to manipulate the markets.

The fact that professional investors could get caught up in these is just mind-boggling to me. Let's give them the benefit of the doubt, and assume that they are not attempting market manipulation -- I'll leave that up to the regulatory bodies to sniff out. (As a parenthetical aside, I will also choose not to debate whether a fund's potential pro rata contribution measuring anywhere from 10% to 40% of a stock's daily volume is meaningful or not (it is...).) Let's also assume that these larger "sophisticated" investors do not need to circumvent the margin rules, as they should have some access to capital, somewhere, if they truly are legitimate and deserving of their "2 and 20." So maybe that just means they are uninformed.

Leaving aside the oxymoronic concept of aggressively shorting a passive basket of stocks -- I mean, c'mon, if you are so convicted that you want to lever a short, how about a little selectivity? -- let's see if they could have figured this out, and indeed whether an ordinary retail investor could have figured out the dramatic failure of these instruments in advance.

My guess is, unfortunately, they must not have read the offering docs; it just viscerally sounds so good -- "Wow, a product that easily allows me to be 2 times short an index!" Yes, even the "sophisticates" can fall prey to gimmicks. But even still, what if they had read the offering docs?

I have just finished rereading the 165-page prospectus for one of these funds. It is my opinion that in no way, shape or form have they adequately disclosed the volatility risk -- in fact, they have a longer passage for risk associated with foreign investments than they do this concept of volatility eating away at returns outlined in my prior pieces. The "Statement of Additional Information" goes into a little more detail, but is still insufficient to explain the miserable failure of these as a term trade or hedge.

I believe the purveyors of these products were careless, reckless and perhaps even grossly negligent in disclosing the risks. Either they were a) completely clueless as to how dramatically these could underperform due to volatility (in the prospectus, they use 15% volatility and show underperformance of 70 to 220 basis points ... in the 68-page "Statement of Additional Information," they show volatility of up to 40% and underperformance of ~900bps, with the index down 40% ... nowhere remotely close to the underperformance we have seen), or b) they knew that performance looked horrendous at high volatilities but chose not to disclose. Given they show the tremendous potential outperformance of these if volatility is very low, my guess is they knew exactly what it would look like in the type of volatility environment we have seen, thus making "b)" more likely ... but, then again, if they knew of this risk, they'd disclose it more thoroughly, right? To be fair, I have no idea which is the case, but this raises my eyebrows a bit.

Furthermore, the purveyors simply highlight that these seek to replicate (plus or minus 1 time or 2 times) the daily returns, and that they "do not seek to achieve their stated investment objective over a period of time greater than one day" ... despite presumably knowing full well people do not view mutual funds as one-day holds. Indeed, investors are sent a prospectus when they execute a trade, meaning that there is at least three days' price risk before they even get the prospectus, and that alone is enough to cause damage.

In my mind, that is kind of like advertizing on the side of a cigarette box, "Not smoking these may have health benefits" instead of "Smoking these may be hazardous to your health." Both are true, but one does not fully disclose the risks of using the product. Maybe the cover of the prospectus should just say, "This product probably won't do what you think it'll do."

As I said -- viscerally, these sound quite appealing. But their performance is more painful than a random walk. Nothing hurts more than being right but at the same time losing money -- I mean, Marc Faber and Harbinger must be horrified to see their names forever in print next to these gimmicks (at least the individual investor can remain anonymous). The sad thing is that anyone with a margin account can create a far, far more efficacious position to reflect bearish views. And for these professionals, there really is no plausible excuse but laziness.

For those who argue, "Yes, but I've made so much money trading these" -- I'll tell you what: I will start an ETF based on an index linked to a random number generator. Whenever it is up and you are in the money, you can sell it and tell everyone in the chat room of your genius in knowing how to "ride the bumps." But for everyone else: If someone shows you a brand new deck of cards, on which the seal is not yet broken...

Know what you own: Oberg mentions the ProShares Ultra Short funds. Other examples include the ProShares UltraShort QQQ (QID), ProShares UltraShort Oil & Gas (DUG) and the ProShares UltraShort Industrials (SIJ).

The conversation on short ETFs continues on Stockpickr.
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.

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