A Very Profitable Low-Risk Alternative to Cash.

[Billy]

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:
http://falkenblog.blogspot.com/2011/...etf-pairs.html
Billy

[Rembert]

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.

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.

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.

[Timothy Clontz]

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 :-)

[senco]

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:
http://www.futuresmag.com/Issues/201...Fs.aspx?page=2

senco

http://math.nyu.edu/faculty/avellane...TF20090515.pdf
http://www.docstoc.com/docs/5577389/...e-Traded-Funds
http://papers.ssrn.com/sol3/papers.c...act_id=1344133

[Rembert]

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 ?

[senco]

Black Swan: "An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict".
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