A Very Profitable Low-Risk Alternative to Cash.

Much has been said here about the decay factor of leveraged and inverse ETFs.

For example, buy & hold of IWM would give a negative return YTD of -5.33%. So could a long term bear on January 1, 2011 buying and holding the inverse triple-leveraged TZA expect a YTD return of +15.99%? No, because of high volatility magnifying the decay factor, the actual return YTD on TZA is a dramatic NEGATIVE return of -37.26%. And if you expected a negative return on TNA YTD of only -15.99%, the actual return YTD has been -33.70 %!
But let’s suppose that you were market neutral on January 1, 2011 and, instead of staying in cash, you decided to short BOTH TNA and TZA each with 50% of your account balance, your reward YTD for being market neutral would be a net return of + 35.48% instead of the low interest on your bank account.

This can be a strategy on its own, or an alternative strategy when the robots are in cash like now.
And apparently, the drawdowns are very limited.

Many more details and examples can be found in the following article:
[url]http://falkenblog.blogspot.com/2011/10/shorting-leveraged-etf-pairs.html[/url]
Billy

Thanks for the link Billy. I've read a similar study a few years ago when FAS/FAZ first came out.

In theory it looks like a good strategy. But in practice I have my doubts. I think what seems low risk at first glance is hiding a potential high account risk. The post in the comments by Guillermo is very interesting.

[QUOTE]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.[/QUOTE]

Selling options is like selling insurance to people. When an unforseen event takes place the black swan may rip one's account to pieces. Maybe I'm wrong about this. But I do believe there is no such thing as a free lunch on wallstreet.

A losing position could go 200 to 500% against you in a very short time frame. The highest amount any portfolio could withstand would be about 15% invested. And even then, the broker could trigger a forced buy to cover if the shares were no longer available.

Nothing can blow up faster than a sure thing :-)

The strategy of shorting long and inverse leveraged ETFs can work - but it is not risk free. In order to employ it successfully one need to understand its mechanics and risks well, and continuously monitor and adjust positions as otherwise drawdowns could be substantial.

Leveraged ETFs decay at periods of volatility, but rise faster than the underlying index multiple in a directional market. The perceived downward returns are a result of non-symmetrical statistical distribution, not a negative expectancy.

I use the strategy from time to time in a conservative manner, targeting only modest returns by adjusting positions in order to reduce risks. Balancing risk/reward is not trivial. When the market moves in one direction the initial position is in a loss, and the position is not market-neutral anymore; return to the mean will be profitable, but further move in the same direction will create a loss. Re-balancing the position to be market-neutral will reduce the potential gain.

In periods of volatile sideways market - like we have seen recently - the strategy works great. I squeezed a few percents out of it in the last couple of months. One could have gained much more, but with the cost of risk. If one were holding short equal amounts of both TNA and TZA in the last 6 months, the return would have been about 29%. However, holding 6 months starting around market bottom in March 20 2009 without any adjustment would have resulted in about 69% loss; continuing to hold without adjustments until now would have had a drawdown of over 200% of the original amount shorted.

This strategy sells volatiliy, but in a different manner than selling options.
The bottom line - it can be profitable, especially in volatile sideways market - but one needs to be very careful to avoid losses when the market starts trending.

Most blog posts I found about the strategy do not discuss much the path-dependent behavior or performance in a trending market. There are several academic papers discussing the behavior of leveraged ETFs - see references below. For less academic discussion there is a good summary in a Futures Magazine article:
[url]http://www.futuresmag.com/Issues/2010/March-2010/Pages/Trading-with-leveraged-and-iinverse-ETFs.aspx?page=2[/url]

senco

[url]http://math.nyu.edu/faculty/avellane/LeveragedETF20090515.pdf[/url]
[url]http://www.docstoc.com/docs/5577389/The-Dynamics-of-Leveraged-and-InverseExchange-Traded-Funds[/url]
[url]http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344133[/url]

Interesting. So the 'black swan' in this case would be a market that keeps on trending on very low volatility.
This would cause a huge drawdown even with daily/weekly rebalancing ?

Black Swan: [I]"An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict". [/I]
A directional market is not a black swan :-)

With daily rebalancing you will not get huge drawdowns. You will also not make profit.
You can view rebalancing as working against the 'time decay'. It is somewhat similar to rebalancing an options trade trying to remain delta neutral.

senco

With a black swan I mean a situation one didn't see or think would be possible, only in hindsight one has an explenation for it. Like funds that went bankrupt relying on historical asset correlations that they tought could never break. Because we're dealing with short positions here there is in theory potential for unlimited risk. So I imagine there could exist a 'black swan' scenario that can ruin an account using this strategy.

I tought it might be a market that goes on a never before seen mega trend with little to none volatility ... but only if one doesn't do daily rebalancing. I found the original articles I referred to in my previous post. This guy uses daily rebalancing and drawdown indeed seems minimal.

[url]http://abacusengineer.blogspot.com/2009/03/shorting-both-fas-and-faz.html[/url]
[url]http://abacusengineer.blogspot.com/2009/04/update-shorting-both-fas-and-faz.html[/url]
[url]http://abacusengineer.blogspot.com/2010/03/final-update-on-fas-faz-short.html[/url]

The leveraged ETFs reset daily. In a day where the fund value goes up it needs to buy some more of the underlying (or contracts that represent it) in order to be leveraged correctly the next day. If fund value went down, it needs to sell some. This daily process - buying after price goes up, selling after price goes down - causes the time decay.
If you short a pair and rebalance every day, you will be doing exactly the same. The fund that went up in value increased your short position and you need to buy some more, and vice versa. The daily rebalancing will offset the gain from time decay.

In real life daily rebalancing will look a bit differently. The offset is not accurate. The tracking might not be accurate, and it may vary according to the time when it was made, or the execution. In a theoretical backtest one may see a small profit but this will most likely be 'eaten up' by the borrow fees, and will turn into a loss taking into account commissions, spreads, and slippage.

In order to make some gain with this strategy one has to take the risk of letting the position move away from market-neutral, allow drawdowns, and lose money if the market is directional with low volatility. In addition there are the risks of called shorts, possible imbalance in a flash crash etc.
There is no free money.

I made a backtest on shorting both TNA and TZA, with a theoretical daily market neutral rebalancing at the close. For the two years from close of 11/9/2009 to 11/10/2011 (without any trade friction) the strategy gained theoretical 19% on the amount shorted per each side of the pair (9.5% on the total shorted amount). I do not know what were the borrow rates over that period; today my broker rates are approximately 5.5% for TNA and 3.5% for TZA, a total of 9% /year for both sides. If these numbers are representative for the borrow rate over last two years, the compounded rate would have roughly taken away the 'gain' the backtest showed. This before commissions on the daily trades.