We like to think of trading as a zero-sum game -- the money you lose is money someone else has made. But that is not always the case. Sometimes the money you lose simply goes away to "money heaven."

Never has that concept been truer than when looking at the levered ultra-short ETFs. Periodically, I check in on these to see how they are "performing." Typically, what I will do is take the vanilla ETF on an index and compare it with the 2x short sided ETF on the same index and figure out how much the levered short ETF has outperformed or underperformed.

I started this exercise back in November, when I first noticed the tremendous volatility of these levered funds. I keep a spreadsheet, use the adjusted prices to account for dividends and compare the actual performance with the implied performance over various periods of time. Take a look at the data for the U.S. Financial Sector ETFs, the unlevered iShares Dow Jones Financial Sector ( IYF) and the 2x short UltraShort Financials ProShares ( SKF):

3-Apr
From 3/26
From 3/6
From 2/23
From 12/31
From 11/20
IYF
36
5.0%
50.8%
30.2%
-19.7% 8.0%
36.12nav
SKF 80.95 -13.1% -67.6% -59.9% -21.4% -69.2%
80.38nav
implied -10.0% -101.6% -60.4% 39.4% -16.1%
over/(under) -3.1% 34.0% 0.5% -60.8% -53.1%

The table reflects Friday's close and then looks at return from various dates. Of those dates, we have the autumn closing low for financials on Nov. 20, and we also have this spring closing low on March 6. We also have year-end, which is close to the high for the IYF over the time period (the actual high was Dec. 8).

So since the autumn low close on Nov. 20, the IYF is up 8.0% through Friday night. This implies a 2x short return of -16.1%. Yet the SKF is down 69.2% over that period, reflecting an underperformance of 53.1% vs. if one had simply shorted the IYF with two times leverage.

Given that the IYF closed below its NAV and the SKF closed above its NAV, this return discrepancy is not caused by NAV differentials (and for what it is worth, on Nov. 20 the SKF closed about 6 points below NAV). So where did the money go? The answer is in the title of this article.

In previous pieces I have noted how these levered short ETFs are implicitly short a path-dependent volatility position. Sometimes the path dependency can work in your favor -- note that since March 6, the levered ETF has "outperformed," being down only 68% when the implied return suggests a loss of over 100%. (I am sure the buyers of the SKF on March 6 are comforted by that.) But this path dependency is a second-order bet that, as one can see, overwhelms first-order returns. It isn't as simple as saying there is an "arbitrage" here and that these levered funds can recapture that loss -- that money has gone to "money heaven."

The volatility in the relative performance, however, should show people that this is an entirely inefficacious "hedge" or term position vs. other alternatives. And it isn't just the financial sector -- check out how the China and real estate sector levered ETFs have performed vs. their unlevered counterparts:


3-Apr
From 3/26
From 3/6
From 2/23
From 12/31
From 11/20
FXI
30.94
8.0%
28.9%
24.8%
6.4% 47.2%
30.4nav
FXP 22.17 -17.0% -45.9% -46.5% -37.3% -76.2%
22.22nav
implied -16.1% -57.8% -49.5% -12.7% -94.4%
over/(under) -0.9% 11.9% 3.0% -24.6% 18.2%
3-Apr
From 3/26
From 3/6
From 2/23
From 12/31
From 11/20
IYR
29.33
13.8%
35.0%
18.7%
-19.4% 21.5%
29.36nav
SRS 38.1 -28.8% -61.6% -53.8% -24.9% -84.1%
37.96nav
implied -27.5% -70.1% -37.4% 38.9% -43.1%
over/(under) -1.2% 8.4% -16.4% -63.8% -41.0%

The levered short China ETF UltraShort FTSE/Xinhua China 25 ProShare ( FXP) again shows a mixed bag vs. its unlevered counterpart iShares FTSE/Xinhua China 25 Index ( FXI) in terms of relative performance, whereas when it comes to the real estate sector, the levered UltraShort Real Estate ProShares ( SRS) has underperformed in nearly all of the time periods shown. (And as with the financial pairing, the SRS closed above NAV, and the iShares Dow Jones US Real Estate ( IYR) closed below.)

To be fair, the marketing material for these levered short-side ETFs says explicitly that these ETFs are only meant to track daily index movements. But every time I see that, I have to wonder why a fund company would create a fund meant for a one-day hold -- in theory everyone should go home flat every night, and the manager would have no assets under management. So it seems as though there is an implicit "greater fool theory" in place here -- by definition, the company is reliant on someone holding these positions overnight and bearing the volatility risk.

I wrote earlier that there are only three reasons I could think of why someone would buy these: 1) they were uninformed, 2) they were trying to skirt the margin rules, or 3) they were trying to engage in market manipulation. I still stand by all three of these statements. Hopefully if one reads enough of these articles, we can eliminate reason No. 1.

The development of these funds has been a boon to daytraders. If I focused in on it, I am positive I could make a bundle trading the SKF. The reason is that their very construct leads to a self-fulfilling prophecy. A normal security has two sources of buyers (an initiating long or exiting short) and two sources of sellers (exiting long or initiating short). By bifurcating the market and segmenting longs from shorts, the construct of these funds has eliminated half of the liquidity -- no one would go long the market by shorting the short fund. Therefore, the market maker in a trending market is forced to hedge.

So I know if I buy a short ETF, I can force the action by putting pressure on the underlying stocks. This leads to cascading selling pressure -- not just from the leverage imbedded, but also from the follow-on action.

I have no doubt that the existence of these funds exacerbated the selling pressure in the market -- we have quantified this previously. In turn, these have cost the taxpayer even more money.

Speaking of foisting greater cost on the taxpayer -- ProShares (the largest purveyor of these levered and short ETFs) recently took out a full page ad in Barron's: "Now, ETFs for when Treasuries fall." Thanks. Not only did your products likely increase the cost of the bailout, but now you are seeking to help increase the cost of financing the bailout. I know, I know -- you are only offering what people want to buy, but in our sound-byte society, are you not reflecting at all on your actions? (Please see my previous piece on why I think shorting Treasuries is not a great idea right now.)

If you read the message boards on some of these products, you can sense the anger that the posters have towards the financial mess, and they are taking it out by buying the SKF or the SRS. But I doubt they are thinking that they may actually be contributing to the greater problem and the greater cost to the taxpayer.

The greatest irony here is that with all this wealth destruction, the holders of the SKF and SRS are also sending money to money heaven in bundles. It seems that the only winners in this whole thing are the fund companies that provide these, the market manipulators and a handful of daytraders.

Testifying before Senate committee 10 days ago, SEC Chairman Mary Schapiro stated: "Even as attention focuses on reconsidering the management of systemic risk, investor protection and capital formation -- both of which are fundamental to economic growth -- cannot be compromised as a product of any reform effort."

If protecting investors and capital formation are truly a primary focus of this SEC, the agency will need to revisit the approval of these instruments in the context of reinstating the uptick rule.
At the time of publication, Oberg had no positions in 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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