Not enough leverage? Want more slippage? Try some GASX

For those who love risk, take a look at DirexionShares. It exemplifies the proliferation of leveraged ETFs - particularly the ones that give you three times the return (3 x ETFs). Take for example the one with the ticker symbol GASX - that's right, the same name as the famous medicine. It's an ETF that is 3x short natural gas equities.

GASX Fund Objective: - "The Direxion Daily Natural Gas Related Bear 3x ETF seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the ISE Revere Natural Gas Index. There is no guarantee the fund will meet its stated investment objective."

From its inception (about two years ago) GASX is down 38.5%. The negative 3x the natural gas index (which is what the ETF is supposed to be tracking) is up 17% for the same period. If you bet against natural gas companies 2 years ago, you would have been right, but this ETF would have lost you close to 40%. Ouch.

What makes this even more interesting is that its twin, GASL, the 3x long natural gas index ETF is is also down for that same period - a whopping 48%.

What gives? This is what's known as leveraged ETF slippage (illustrated here). Over time you lose either way. And the higher the volatility the more you lose. The chart below shows GASX daily annualized vol - over a period of 250 business days - approaching 100%. Using shorter periods, the volatility measures are even higher. That's why slippage is such a big problem.

GASX - Rolling 250 business days vol

Now if you want to find alternative ways of losing money, try some of the other Direxion ETFs. Indian equities, long-term treasuries, semiconductors - whatever your heart desires - all 3 times. Who said that derivatives and leverage was just for the big guys?

 It is in fact remarkable that this is a retail product. But no worries, there is proper disclosure.

Fact sheet disclosure: - Investing in the funds may be more volatile than investing in broadly diversified funds. The use of leverage by a fund increases the risk to the fund. The Funds are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results and intend to actively monitor and manage their investment. The Funds are not designed to track the underlying index over a longer period of time.

And clearly most retail investors will read this and say: "but of course, the volatility is extremely high - so I should expect some tremendous slippage risk."

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Leveraged ETFs amplify market moves

Some time back we discussed the tracking error associated with leveraged ETFs. Today we see another "side-effect" of these products.  Today after a 3% rally in the US equity markets we saw a sharp upward move right before the close.

 SPY (S&P500) - Bloomberg

One of the drivers of such a move is often a group of leveraged ETFs.  Typically ETFs employ Total Return Swaps (TRS) provided by banks in order to obtain leverage. Some use futures. Usually on a day like today, the rally causes the NAV to grow faster than the assets the ETF holds (because of the leverage). So at the end of the day the NAV is "too big" for the assets the ETF holds, giving it less leverage than its intended target. This forces it to buy assets to get back to the expected leverage ratio. And the bigger the rally, the more it has to buy. Of course it works the same way on the down-side, with ETFs being forced to sell whenever there is a large market drop. See the example below.

This is equivalent to what options traders call being "short gamma". So when you see a big spike at the end of the day, just remember it's the "retail derivatives" products called leveraged ETFs at work amplifying market moves.

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Leveraged ETFs - the rules of the game

As volatility returns to the markets, it's worth revisiting leveraged ETFs and the tracking error associated with these products. The rules of the game are simple:

1. Leveraged ETFs do well relative to the underlying index in trending markets,
2. underperform in mean-reverting markets,
3. underperform significantly in mean-reverting high volatility markets,
4. underperform over longer periods of time,
5. inverse (bear) leveraged ETFs underperform more than the equivalent leverage bull ETFs. The tracking error for a bear ETF is equivalent to a bull ETF with an extra turn of leverage. That is an inverse ETF tracking error is equivalent to that of a 2x bull ETF. The error for a 2x inverse ETF is equivalent to that of a 3x bull ETF, etc.

The chart below shows a potential underperformance (in a mean-reverting market) for leveraged bull ETFs over a one-month period (roughly) as a function of daily volatility.





The chart below shows the same for inverse ETFs (bear ETFs).





Here is an example of what happens with leveraged ETFs over a longer period of time. The chart below compares TNA, a 3x Russel 2000 ETF with the performance of Russell 2000 (small cap index). The index is up some 12% YTD, while TNA instead of being up three times that is actually up less than half for the year.





So if you really like risk, by all means take advantage of all the leverage available out there (before the SEC takes some "anti-derivatives" action against these products), but keep mindful of the nasty tracking error.

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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