Monday, August 10, 2009

Inverse leveraged ETFs - a sober look

The leveraged ETFs are finally making their way into the courtroom. The well known concept of "tracking error" or "slippage" has come home to roost. ProShare Advisors, one of the top structured ETF firms just got hit with a lawsuit. From the WSJ:
A lawsuit seeking class-action status claims that ProShare Advisors and others violated a securities act by failing to disclose risks inherent in its ProShares UltraShort Real Estate fund, an inverse leveraged exchange-traded fund, including the risk of a "spectacular tracking error."

They are referring here to an ETF with a ticker symbol "SRS". The time period in question is nearly the whole of 2008. It was a good year to short real estate, but holding SRS for a year was a mistake. Here is what happened:

SRS vs. IYR (IYR is an iShares ETF that tracks the Dow Jones U.S. Real Estate Index)

The index was down, but so was the inverse 2x ETF. Clearly it was the compounded "tracking error", but has ProShare Advisors disclosed enough to warn investors of this issue? Here is the current generic disclosure from Proshares, covering all levered ETFs:
This ETF seeks a return that is either 300%, 200%, -100%, -200% or -300% of the return of an index or other benchmark (target) for a single day. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.
Seems clear enough, but if one wanted to over-disclose, what sort of information should be provided? How does one explain the potential magnitude of the tracking error, particularly in inverse leveraged ETFs?

The easiest approach is to perform a simple simulation. Note that the simulation we conduct here excludes fund fees, financing charges for leverage, and re-balancing transaction costs, all of which increase the tracking error.

The problem with leveraged ETF is that their ultimate value is path dependent. The index moving up, then down will not produce the same result as the index moving down, then up, even if the index ends up at the same level. That's why using a simulation is an effective way to look at the tracking error.

These ETFs use TRS to keep the leverage constant. They are forced to buy or sell the index every day to make sure that the ratio of the ETF net asset value to it's exposure is constant - in the case of SRS it's -2.

A typical inverse ETF investor is looking for results like this: the index goes down, the ETF increases in value - hopefully twice as fast.

But the following result is also possible. Just as was the case with SRS, both price paths end up in negative territory:

If you look at the two graphs above, you'll notice one key difference. The second graph shows more volatility in the index, resulting in tracking error. Given the path dependance, the more the path "whipsaws" along the way, the higher the ETF's tracking error. To demonstrate the effect of volatility we simulate 1000 paths for several volatility assumptions. The red box indicates the areas on the scatter plot where both the index and the ETF have lost money - the largest tracking error.

Monthly volatility of 14% :

Monthly volatility of 20% :

Monthly volatility of 28% :

Monthly volatility of 40% :

Monthly volatility of 49% :

That's why we haven't experienced major problems with leveraged ETFs until the financial crisis. As volatility spiked, the tracking error got increasingly worse. Only recently many participants realized that in order to take advantage of this product, one should only hold a position for a short time (to avoid the impact of being whipsawed by volatility.) And that's exactly how ProShares got sued - someone held the SRS position for close to a year during the most volatile period in recent history.

ProShares made the following statement with regard to the suit: "The allegations reported in the complaint are wholly without merit. We plan to defend against this suit vigorously." ProFunds/ProShares is a great firm, providing much needed product to allow firms and individuals to put on highly targeted positions. It would be unfortunate to see them having to cut down on product because of litigation. Perhaps a detailed disclosure such as the impact of volatility on tracking error may help them and their clients in the future.

For those who are interested in exploring this further, please see the simple simulation spreadsheet attached. Make sure you set security level on Excel to medium - to allow you to open macros. Also turn off the auto-calc in Excel. By the way, this is for illustration purposes only, and is not meant for any sort of investment decisions.

SoberLook ETF Simulator

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