Macro Tsimmis

intelligently hedged investment

Posts Tagged ‘sef’

BUY ProShares Short Financials (SEF)

Posted by intelledgement on Tue, 06 Sep 11

The bankster royalty are still parading down Main Street in the altogether—clothed with balance sheets crammed with chimerical toxic assets that their captured regulators allow them to carry at par when in reality they are worth next-to-nothing. The bought politicians insist that the clothes look great, and warn us that if we demur, it will be the end of the world. But more and more unruly little boys are insisting on the truth: the emperor has no clothes. It is only a matter of time before the crowd catches on.

It is the European banks that are the most exposed here. If you subtract from their mythical balance sheets the bad sovereign debts they have collected in the past few years and the bad mortgage-backed securities American banksters peddled to them in the last decade, there are several who would be insolvent. The central bank authorities are racing around handing out clouds of free money and distributing dark glasses to market participants, hoping to mask the naked truth a little longer, but any stray ray of sunlight at an indiscreet moment could reveal the truth and start a Lehman/Bear Stearns style bank run.

And of course, the US banks are integrated into the mess big time. If more than one or two Euro banks roll over, a cascade effect is likely. Even short of that, the risk levels are way up here. The stakes were raised considerably last Friday after the market close, when—in a surprise move—the U.S. Justice Department filed suit against 17 banks for fraud in the peddling of mortgage-backed securities.

Thus it is prudent to go short here. Our instrument of choice here is the Proshares Short Financials ETF (SEF), which utilizes short equity positions, futures contracts, options on futures contracts, securities and indices, forward contracts, swap agreements, and similar instruments in pursuit of “daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials Index.” That is, if the fund managers meet attain their objective, on a day the DJ average goes down 1%, this fund should go up 1%…and vice versa. This DJ index represents banks (about two-thirds) and general financial groups (one-third), and the positions of the ETF reflect that distribution.

Over time, because of the way the SEF ETF is designed (to match the daily performance of the index), it has an inherent negative bias, and therefore exhibits a significant tracking error. The problem is that on days the Dow Jones index moves up, the ETF tends to lose relatively more ground than it gains on the days the index moves down. The fund debuted in July 2008 and is down 39% since then…while the Dow Jones U.S. Financials Index over the same time frame is down 43%. As we would expect the SEF to be up 43%, this is a tracking error of a whopping 82 points over three years. Point being, this is not a fund to hold over the long term, because even if the Financials decline, your performance is not likely to reflect that. (Read more about inverse and leveraged fund tracking errors here.)

However, during periods when the financials declines sharply over a short time period, the performance of the SEF has reasonably closely met expectations. And we believe such conditions are likely here.

In the past we have used the ProShares Ultrashort ETF (SKF) to cover this base, but the tracking error of that fund—which is down 71% since inception in February 2007 while the DJ index is down 69%—is even worse at 140 points in four-and-a-half years. The SEF falls well below our preferred benchmark levels for liquidity—only $115 million in assets when we should prefer a minimum of $1B and only 188 thousand shares traded daily on average when we like to see a minimum of one million—but we are holding our noses here and diving in as a hedge against a financial sector meltdown.

Previous financials short-related posts:

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BUY ProShares Short Financials ETF (SEF)

Posted by intelledgement on Mon, 25 Jan 10

For a year now, we have been complaining that the Obama administration has totally failed to deliver “change we can believe in” with respect to the most important issue affecting the USA—managing the economy.

The G. W. Bush administration presided over the terminal phase of a real estate bubble that was exacerbated by lax and irresponsible regulation (to be fair, the real estate bubble was stoked by the Clinton administration and easy money policies go back further than that). When it finally blew up in our faces in 2008, instead of working to fix the problems—letting the overextended companies go bankrupt, working to reduce deficit spending and strengthening the dollar, and putting in place regulatory reform to address dark markets, overleveraging, and naked short selling—we instead attempted to paper over the problems: prop up all the troubled companies with toxic assets, extend artificially low easy credit, inject massive amounts of liquidity thus further weakening the dollar.

Enter the Obama administration, whose leader had decried the policies of his successor. But ironically—and to our dismay—when it came to managing the economy, it’s been hard to tell that there’s been an election and change in control of the government. Here it is a year later, and we are still propping up the companies that had failed and should have gone bankrupt (AIG, Fannie and Freddie, Citibank, GM et al), still maintaining 0% interest rates, our debt levels are up since January 2009, the dollar is down 9% year-over-year, and we still await meaningful regulatory reform. Only the names have been changed to protect the…oh, wait…nevermind…Obama even has the same folks in charge of the economy that G. W. Bush did.

Until—perhaps—last week.

Last Thursday, Obama announced proposals to restrict banks with Federally-insured deposits from conducting proprietary trading and from owning or investing in private equity funds or hedge funds. While the details remain to be spelled out, it appears that this is an attempt to transform savings bank/mortgage writing activities into a utility-style of business—heavily regulated, with limited profitability and insulated from more aggressive financial activities. Given that we have consistently criticised Obama (and previous presidents) for essentially taking their cues from the same guys that got us into this mess, it is bracing to finally see a policy proposal from him that did not have a stamp of approval from Goldman Sachs sputniks Larry Summers and Timothy Geithner.

Now, we don’t actually think much of these particular proposals. Had they been in effect in 2008, they would have applied to Citibank and JP Morgan Chase, but not to Bear Stearns or Lehman Brothers or AIG or Fannie or Freddie. And of course they would have done nothing to address the policies of easy money and easy credit that stoked the real estate bubble. And nothing to regulate the dark markets through which these bad loans were securitized and distributed. On the margins, it’s not a bad idea to insulate savings banks from what amounts to financial chicanery, but if on the other hand the government is still encouraging such chicanery…well, we can’t seriously expect to get healthier with this course of treatment; about the best we can hope for is to get sicker more slowly.

But when the car is going the wrong direction and you change drivers but keep going in the wrong direction, finally changing the navigator is a good sign.

So if this is (potentially) good news, why are we shorting the financials here?

Well, as much as we enjoyed watching Geithner squirm as he pretended to agree with these proposals, in the final analysis, we do not expect the Obama administration to substantively reverse course here. To truly put things right—reduce deficit spending, support the dollar, cease propping up zombie banks, enforce already-existing regulations limiting leverage, naked short selling, and other financial shenanigans which have largely been winked at for decades—would be painful. Painful in the short term for everyone, and in the longer term, for a lot of powerful folks from New York to Washington to London to Beijing. If Obama were of a mind to tackle that Sisyphean task, he should have started a year ago, when he could clearly have blamed everything on G.W. Bush and might have had a chance to make enough progress by 2012 to be re-elected. Now he has followed the same path as G.W. Bush for a year and we are a year further down the wrong road—whose fault is that? Even if he wants to reverse course, he lacks the moral authority and time to succeed.

So what is driving this conniption? We think it’s the loss of the Senate seat held by Ted Kennedy to the long-shot Republican challenger Scott Brown last week that has clearly energized the Obama administration to position themselves as less friendly to “Wall Street.” And folks, this is not positive energy we’re talking about here. The reality is that we have a capitalist system that is debilitated and the spectacle of the government vilifying the banks for no end other than political expediency is most definitely not a step towards healing. Politicians fighting for their (political) lives are not likely to make statesmanlike decisions and exhibit restraint; things are apt to get ugly. That is to say, more ugly.

And if we have misjudged Obama, and he truly does make an attempt to change direction here, then we will really see some economic and political turbulence.

Actually we think Bush-Obama troops have done a decent job, considering the size of the problems we have, sweeping them under the rug once again. Thus we could well get a continued overall market rally so long as job losses continue to slow and consumer spending does not decline further. But we don’t believe the financial sector is likely to lead such a rally. Thus it is a logical choice to short here, as insurance against a downturn sooner than we expect.

Thus we are buying the ProShares Short Financials ETF (SEF) here. This ETF is managed with the intent of obtaining a return of -100% of the Dow Jones U. S. Financials Index each single day. Thus the value of each share of the ETF should go up when the index declines, and vice versa. We have shorted the financials twice previously, both times utilizing the Proshares Ultrashort Financials ETF (SKF; this fund seeks a return of -200% of the Dow Jones U. S. Financials Index each day)—we made compounded annual growth rate profits of 45% and 5% respectively on those trades, but in light of our analysis that leveraged ETFs don’t perform well over time, we are going with the SEF this time around.

Previous SEF-related posts:

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Ultra inverse ETFs fall short of expectations

Posted by intelledgement on Mon, 05 Jan 09

Aide: We’ve analyzed their attack, Sir, and there is a danger. Should I have your ship standing by?
Grand Moff Tarkin: Evacuate? In our moment of triumph? I think you overestimate their chances.

Intelledgement’s strategy is macro-based, which means we analyze broad trends and make investments designed to align with them. Thus if we expect energy and China and Brazil to do better than average in the long run, we will seek to go long (buy) securities that are likely to reflect those successes. Conversely, if expect an economic reversal that will hurt real estate values and depress consumption, we will seek to go short (sell) securities that are likely to decline in price.

Generally, we do not recommend owning (or shorting) individual stocks for most of our clients, because it is easier to be right with a more broadly targeted mutual fund or exchange-traded fund (ETF)—which invest in numerous stocks—than trying to divine the fate of a single company (which could run into accounting problems and tank even if the industry they are in does well overall, for example). And very few of our clients are comfortable with margin accounts and short selling, which is inherently more risky than buying stock (as we have explained elsewhere). Therefore, the tactic we employ to invest money on the short side when the macros so dictate is buying so-called “inverse” ETFs, such as our current position in the the ProShares UItraShort S&P 500 ETF, which is designed to “correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P500® Index,” using short sales, options, derivatives, and other relatively arcane maneuvers. This enables us to take a virtual short position without employing margin or undertaking the theoretically unlimited risk associated with an actual short position.

Now, while ETFs have been around for 20 years, it wasn’t until 1998 when State Street introduced “Sector SPDRs” that it became possible to employ a robust macro strategy using exchange-traded funds. And even then, it was not possible to bet against sectors or national indexes or commodities other than by selling the requisite ETF short. Until 2006, that is, when Proshares introduced their line of inverse ETFs, that go up when the targeted index goes down, and vice versa. So inverse ETFs, including “ultra” inverse funds—which aspire to double (or triple) inverse performance—don’t have a long performance track record.

Ultrashort ETFs—along with their ultralong cousins—have commonly been regarded as the Deathstars of exchange-traded fund investing. Afterall, it stands to reason, if you are absolutely convinced that the price of oil is going down, why be content with an mere inverse fund oil fund when you can buy an ultrashort fund that tracks 2x the inverse of any change in the price of oil?

One concern that commentators have pointed out is that the design of the funds—to reflect the inverse of fund performance on a daily basis—gives them an inherently bearish bias in a volatile environment, because mathematically, an x% move down always trumps an x% move up. That is, if you start at 100 and have a 10% up day followed by a 10% down day, you end up at 99; and by the same token if again starting at 100 you have a 10% down day followed by a 10% up day, again you end up at 99. A slow and steady move in either direction minimizes this effect, but it is likely to be augmented when volatility is high, as demonstrated by Eric Oberg in his article last month.

Of course, we don’t have a lot of performance data to analyze—as the inverse ETFs are so new—but let’s take a gander at the data we do have:

Security Symbol Inception Cost Value ROI Index Index ROI Rating
Cons Svs Ultrashort SCC 02-Feb-07 46.47 84.78 82% DJUSCY -39% +3
S&P500 Short SH 21-Jun-06 55.81 72.02 29% GSPC -28% +1
DOW30 Short DOG 21-Jun-06 57.69 68.55 19% DJI -21% -2
QQQ Short PSQ 21-Jun-06 60.43 73.03 21% IXIC -26% -5
Cons Goods Ultrashort SZK 02-Feb-07 52.92 74.01 40% DJUSNC -24% -8
Oil & Gas Short DDG 22-Jul-08 57.72 68.16 18% DJUSEN -35% -17
S&P500 Ultrashort SDS 13-Jul-06 57.28 70.94 24% GSPC -27% -31
DOW30 Ultrashort DXD 13-Jul-06 51.33 53.56 4% DJI -19% -34
QQQ Ultrashort QID 13-Jul-06 60.79 57.35 -6% IXIC -23% -52
Financials Short SEF 22-Jul-08 68.32 76.03 11% DJUSFN -66% -54
Financials Ultrashort SKF 01-Feb-07 66.74 103.01 54% DJUSFN -55% -57
Oil & Gas Ultrashort DUG 22-Jul-08 26.45 25.04 -5% DJUSEN -35% -75
R/E Ultrashort SRS 01-Feb-07 62.07 50.71 -18% DWRSF -60% -138

Security = the name of the exchange-traded fund (ETF)
Symbol = the symbol of the ETF
Inception = date the ETF started trading
Cost = closing price of the ETF on the first day it traded
Value = closing price of the ETF on 31 December 2008
ROI (Return on Investment) = on a percentage basis, the performance of this ETF from inception to 31 Dec 08
Index = the market index the ETF is tracking (inversely)
Index ROI = on a percentage basis, the performance of this index from inception of the associated ETF to 31 Dec 08
Rating = how well the ETF has performed relative to expectations (see notes below)

Notes: our rating is derived by comparing the ROI of the inverse ETF with the ROI of the index it is tracking and calculating how the ETF has performed relative to expectations. For example, if the underlying index declined 10% since the inception of the fund, we would expect an inverse fund to be +10%, and an ultra inverse fund—which, you will recall, strives to log 2x or 3x the inverse performance of the underlying index—to be either +20% or +30%. So, if the index has declined by 10% and an inverse ETF is up 10%, that yields a rating of 0 (zero), as it matches our expectations. For example, as of 31 December 2008, the Proshares S&P 500 Short fund (SH) was up 29% since inception while the S&P 500 index itself (GSPC) was down 28%…so that ETF has a rating of +1. In contrast, Proshares Real Estate Ultrashort fund (SRS) is down 18% since inception while the index it tracks is down 60%…we would expect SRS to be +120% and thus it has a rating of -138.

In general, the news is bad for the “ultrashort” 2x funds. Every single one of the eight ultrashort funds we analyzed are tracking an index that was down through 31 Dec 08…and therefore we would expect them all to be up twice as much as their respective index was down. This was true of only one: the Consumer Services Ultrashort ETF (SCC), which was up 82% while the Dow Jones US Consumer Services Index (DJUSCY) was down 39%. Four of the remaining seven ETFs were up, but only one of them was close to expectations: the Consumer Goods Ultrashort ETF (SZK), was up 40% while the underlying index was down 24%. The Financials Ultrashort ETF (SKF) was up 54%, but that was less than half what it should have done relative to its index, which was down 55%. And the S&P 500 Ultrashort ETF (SDS) was up 24%, less than half what it should have done relative to the GSPC, down 27%. The DOW 30 Ultrashort was up 4%…way lower than it should have been with the DJI down 19%.

From there, it gets really bad. The other three ultrashort funds were all down, even though with their respective index down, they should have been up sharply. We would have expected the QQQQ Ultrashort ETF (QID) to be up 46%…but it was down 6%. We would have expected the Oil & Gas Ultrashort ETF (DUG) to be up 70%…but it was down 5%. And the SRS was discussed above (should have been +120%, was -18%).

And it gets still worse! In every case where there are both an inverse ETF (targeting mirror image performance of the underlying index) and an ultra inverse ETF (targeting 2x inverse performance), the performance of the inverse ETF is relatively better than that of the ultra inverse ETF:

Index Short Fund Ultrashort Fund
S&P 500 +1 -31
DOW 30 -2 -19
QQQQ -5 -52
Oil & Gas -17 -75
Financials -54 -57

In absolute terms, the SKF ultrashort financials ETF still outperformed SEF, the inverse ETF (as you would expect when they both underperformed their expectations by about the same degree). But in the other four instances, the four inverse funds not only did relatively better, but beat their ultrashort cousins in absolute ROI. The DUG and QID ultrashort ETFs actually lost money, even though their respective indices each was in the red.

While this does not prove Oberg is correct in his analysis that volatility is doing in the ultrashort ETFs, it does constitute prima-facie evidence that his conclusion—the ultrashort ETFs are underperforming—is on target.

And accordingly, it is time to consider evacuating the Deathstar.

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