Sunday, October 30, 2011

Shorting Leveraged ETF Pairs

ProShares offers a wildly successful array of Exchange Traded Funds (ETFs) that allows people to easily gain leverage and short targeted subsets of stocks. They trade a lot, and so clearly are satisfying consumer preferences, but probably the more delusional part of investor beliefs. Their explicit goal of targeting a daily benchmark return correlation leaves the secondary consideration less important: maximizing long term return. Thus, they tend to underperform their benchmark over longer durations, and this adds up. I suspect they end up burning money trading so much in a way that traders can anticipate and game.

If the Proshares are underperforming, there's a simple arbitrage here. Take the 'Ultras', which offer 2x leverage, and the 'UltraShorts', which offer the opposite, -2x exposure. Going short both stocks generates a very low-risk portfolio pair, because on a daily basis when one goes up 1% the other will almost surely go down about 1% by design; the positions will offset each other. But the drift for both is negative, as they burn money. Since ProShares has been very busy adding ETFs, this simulated strategy started with 23 pairs in 2008, and is now up to 45. Below is a graph of the total return to going short all the Ultra and UltraShort pairs offered by Proshares since 2008. I rebalanced every week. The annual return was 14%, and the annualized standard deviation was 12%.

Now, I am ignoring the short rebate, which for these may have been highly negative for some of these, but on average these have pretty meager short rates. As the S&P500 has a prospective Sharpe of 0.3 (excess return of 5% and standard deviation of 15%), this is a very dominant strategy. Notice that while the annualized vol is 12%, this really overestimates the risk here because most of this volatility is 'good': sometimes returns are much higher than average. It's a rather Madoff looking strategy

Another way to shade this is to notice that it works best during periods of high volatility, and among those pairs with the highest volatility. Notice that the October 2008 to March 2009 was a great time for this strategy, and so was August 2011, when markets were reeling.

Below are the returns to the various pairs I used, annualized. You can also use these pairs to simulate them yourself. Over time, I suppose these ETFs should start trading at a discount to their net asset value, but until then, it's a pretty simple strategy that seems to work.

Total Return to Short Pairs


misterz said...

What happens if you rebalance daily to exactly match the ProShares strategy? Methinks weekly rebalancing gets you long momentum/short mean reversion.

Eric Falkenstein said...

Sharpe is about the same, but vol and the return go down by 25% or so. Weekly rebalancing just means you avoid trending towards a case where you are long 150 units of x and short 50 units of y. On a practical level, daily rebalancing is overkill, and doesn't reduce risk much, but sure would add to trading costs.

Unknown said...

Hi Eric,

I've been using this strategy for over 2y now with the 3x funds. It's really no panacea of returns as many people think (borrows can be pricey and you can often find yourself unable to borrow at a bad time). Additionally people forget that there's the issue of dividends, which erode returns of the short seller.

It can be a wonderful tool, though. We use it to take a position on HV and, in volatile sideways markets, it can be really profitable, but in directional markets your delta exposure explodes exponentially (basically you are short a lot of gamma). A lot of people attribute the gain to the "inefficiency" but truth is these instruments are highly efficient at what they do (giving buyers a constant positive gamma exposure) but a natural side effect (by the fact that 5% of 105 is more than 5% of 100) is that they lose value in choppy mkts.

Obviously, ProShares takes their Xbp fee for making the instrument and the writer of the total-return swap makes money from the tendency to bleed.

In my opinion, these instruments have caught a bit of a bad rap. People are buying a premium for that gamma and the sellers are just holding a short vol position.

That being said, my original point is that shorting these isn't "arbitrage" like many people think, but really more like renting out liquidity, or selling volatility. In certain ways it's similar to gamma bleeding or like like selling options on volatility. (notice I said volatility, not IV, as IV has a tendency to be inversely related to mkt moves in short time periods)

We weigh this strategy like any other. Calculate potential losses and margin requirements in different scenarios (HV + trend) and then calculate what the return on capital and liquidity-requirement would be to decide if it's a a relatively good or bad risk to take. Once you take this approach a lot of people are surprised by how seldom this trade is actually a good position to have since it has a habit of sucking away your liquidity exactly when it would be most useful.

By the way, I love this blog, one of my favorites in the entire economics and finance spheres.

Anonymous said...

why give away a dominant strategy? methinks not so dominant.

Anonymous said...

also the UYG-SKF pair has a negative return YTD. how can that be?

Anonymous said...

If ProShares have an ultrashort fund in say silver of 100mm, and an ultralong fund in same of 175mm, why dont they just net off the 100mm against each other, and just invest the 75mm remainder? Of course, there may be regulations against this, but seems much more efficient.

Mercury said...

The math/mechanics of short/leveraged ETFs erodes profitability over the longer term (there are several good walk-throughs of this online). I've always suspected that shorting both the ultra-short and ultra-long ETFs in a given class would be a long-term winning strategy but I've always been too chicken to do it and some of these things don't have much history (or stable market conditions) to look back on. Thanks!

Kapil said...

Hi Eric,
Since you are short both sides, you must constantly take losses by reducing the position that goes against you and adding to the other side. Given this, I am surprised that the returns are so big on the most volatile assets. Would you post the numbers on one of the pairs (ie silver or real estate) just to show how it works?

Kid Dynamite said...

Erik -

if you rebalanced daily (I know you don't, but just pontificating on an earlier comment), wouldn't you destroy all of your potential returns? In other words, the reason this strategy works is because you do NOT rebalance - because of the compounding math. (that's also why it doesn't work well in trending markets, of course).

Said differently, these products do exactly what they are supposed to each and every day - so if you rebalance every day, you have no trade here.

I think looking into the borrow costs is essential, as it kills most of the PnL (as Guillermo noted above)

Anonymous said...

Isn't this a highly known trade by now. Can't believe this can make any more than a couple percent a year because of borrow costs.

FP said...

My broker designates almost all 3x ETFs and the majority of 2x ETFs as "hard to borrow" and prohibits shorting them.

Anonymous said...

The borrow on many of these is quite high - greater than 5% in many cases. For the 3x Etfs it can be >10%. Can still be profitable but not considering borrow rates makes your results irrelevant.

BRM said...

I agree that this is a known trade. I do, however, know of two reasonably sized hedge funds that have baskets of these positions on and intend to hold them through. Both are > $1B funds that have them on at a reasonable size (5-7%).

Thanh Bui said...

I was searching for any news on UYM and SMN then I discovered you. I have a question about the volumes of these 2 ETFs. They suddenly drop like a rock since yesterday, Nov 1, 2011.

Something wrong? Something fishy about?

Blixa said...

I've been playing with this strategy for some time too, and borrowing cost can be a killer: I think I've seen 25% per annum on some leveraged ETFs, plus costing, administering, monitoring shorts is labour intensive, at least with the miserable tools my broker provides.

Also you have nominally infinite downside risk: if the underlying goes strongly directional you can lose more than the start capital (as one leg goes to zero and the other goes to infinity against you). It's far fetched, but still unpleasant.

And if this trade became popular, I don't think it can result in a discount, as this conflicts with the ETF NAV arbitrage condition. If shorting was friction free, the equilibrium would be to have one of the pair have zero net assets, as every long investor is immediately matched by a double-shorter. That should ultimately make their issuer withdraw the ETFs as they become too small to be worth running (at least for the less popular side of the pair). With market-driven shorting cost, the shorting cost just becomes equal to the return of the strategy.