Macro Tsimmis

intelligently hedged investment

SELL Ultrashort Oil & Gas ETF

Posted by intelledgement on Wed, 25 Mar 09

Well, this has certainly been educational.

This ETF is designed to doubly inversely track changes in the price of oil and gas. That is, if the price of oil goes up 1%, you’d expect the price of this ETF to decline 2%, and vice versa.

We bought this ETF last September with the price of oil around $110 and clearly declining, while the economy looked to be in trouble and energy demand also under pressure. Now, with the market rallying, we are reacquiring some energy plays and unloading this bearish position. The price of oil did dip as low as $31/barrel a couple of months back, but even here it is just about $50/barrel. So it’s nice to have been right in expecting the price of oil to decline sharply, and really nice to be unloading this hedge play here with a cool 100% profit (50% decline in the price of oil x 2 = 100%)…WHOOPS! WHAT THE HECK?!? We are DOWN 28% here!?!

This is a great example of the perverse nature of leveraged inverse ETFs. Because the funds are repriced on a daily basis, over the long haul moves down are more significant mathematically than moves up. We wrote about this effect in some detail a couple of months back, but essentially the problem is that if you start with $100 and lose 10%, that gets you to $90. Then if you gain back 10%, you end up with $99. So you lost 10% and gained 10% and ended up worse off than you started. Works the same way in reverse order: start with $100 and gain 10%; it puts you at $110. Then lose 10%: now you’re at $99, worse than when you started.

The price of oil has been very volatile since last September, and even though overall it has declined from $100/barrel to $50/barrel (and natural gas is down from $8/mmbtu to $4), there have been enough days with sharp up moves (which drive the price of DUG down) to cause the ETF to grossly underperform our expectations over the full six months.

Morale: eschew leveraged ETFs other than for short-term speculative plays.

Previous DUG-related posts:

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