ETF FAIL: Understanding Time/Volatility Decay in Short and Leveraged ETFS

There is a crack epidemic on the stock market. It trades by a variety of street names, FAZ, FAS, SRS, TZA & QID being just a few. Like crack cocaine these vehicles promise fast and stunning highs, one small hit can take you to the top. Occasionally they even succeed, but like crack cocaine these vehicles are doomed to collapse, each successive hit providing ever diminishing returns, lower lows that an addict believes they can only escape from via another hit.

Unlike crack there is nothing illegal about these things, they are short and/or leveraged ETFs. Exchange Traded Funds designed to replicate the effects of shorting various industries and trading with high amounts of leverage like the big boys do. ETFs are a very new concept to finance, they are basically mutual fund like entities that trade on the stock market, making them more liquid and more accessible to investors than mutual funds. They've been around for about two decades, but it's only in the last few years that they have really taken off in big numbers, with "innovative" short (aka bear) and 2x or 3x leveraged ETFs popping up left and right. Take a look at a chart for FAZ, the 3x Short Financial Industry ETF and look at the volume indicator on the bottom to get a sense how interesting in these things has exploded.

In 2008 leveraged bear etfs like FAZ were tickets to riches, as the stock market crashed they erupted in value, possibly making a few clever operators insanely rich. But that initial success quickly turned nasty. These ETFs are all flawed to the core, they are designed in a way that they decay over time, their values fluctuate up in down, but the overall tend is mathematically almost guaranteed to be down. The easiest way to see this flaw is the look at chart of a leveraged Bull and Bear pair over time. FAZ is a 3x Bear, it is designed to go up when financial industry stocks go down, and to return 3 times more than the value that those stocks go down. FAS is the 3x Bull counterpart, it is designed to go up when the financials go up, and to go up 3 times faster on a daily basis.

One would logically expect these two ETFs to cancel each other out, one goes up 3x when the other goes down 3x, so over time the net result should be zero. Yet if one looks at chart of these two mapped out over the past 6 months a very different picture is drawn. FAZ is down 94%, and FAS somehow is down too, by an almost as nasty 75%. Both are decaying rapidly taking their holders down to the bottom all because of a nasty mathematical quirk (or less generously flaw) in their design.

What's happening is volatility decay, these ETFs all lose value when the stock indexes they track are fluctuating up and down. The key to understanding why is a very basic mathematical fact relating to the way these ETFs are designed to reflect the daily percent changes of the parts of the stock market. The problem is that percents going up and percents going down don't always sync up, but instead have a distinct downward trend. This is easiest to see by looking at a 3x leveraged ETF. Lets call this ETF BSBS, and assume it's positively tracking the Bull Shit Index. When it starts both the index and BSBS are valued at 100. The next day the index goes up by 25% to 125. Now BSBS is designed to return 3 times that percentage or 75% so it goes up to 175. For a day at least it's a great investment vehicle. Now suppose the next day the index falls back down to earth, a 20% decline back down to 100. Well BSBS is now designed to go down 3x that or 60%. Now 60% of 175 is 105, a monstrous decline. The BSBS ETF is now all the way down to 70, while the index is still hanging in at 100. That's it in an essence, these things rise fast, but they fall even faster. It's that simple and that toxic.

The exact same thing is even truer with Bear ETFs. A non leveraged Bull ETF will actually have no volatility decay (although there are other smaller decays in their design). But the corresponding non leveraged Bear ETF will have a decay. Say you have a Bear ETP called UUPP designed to track the Bull Shit Index. Like BSBS it starts with both UUPP and the index at 100. Now say that the index goes down 25% to 75. Well that's why you bought UUPP, cause you wanted to sell that Bull Shit Index short and for a day you were right, UUPP goes up 25% to 125. Now the next day, the index doesn't behave and goes back up to 100, a 33.3% rise from 75. Well the index is back where you started, but was does UUPP do? It does down 33.3% from 125 to... 83.75. Yep, once again the ETF structure is screwing you. There is only one way in the end with these drugs and it's down.

Now one has to assume the ETF makers are well aware of these properties, yet they still sell the ETFs. Of course to protect themselves they warn the buyers, these ETFs are marketed as daytrader vehicles, things that should be bought and sold over the very short term, a few hours at a time maybe, if not a few minutes and a day or two maximum. Its a fair enough warning and not bad advice, but it's also a misleading warning. The reason is that there are circumstances where these ETFs are actually perform well over longer periods of time, and in 2008 we experienced some of these circumstances. Buying say QID (2x Short the Nasdaq index) in early 2008 and holding on to it for the year would have netted you a very healthy return.

When the stock market is trending very strongly in one direction, with very little volatility, just day in and day out moving the same way, than a leveraged ETF in that direction is going to produce stunning results. But stock markets rarely move smoothly, they stop, start, reverse, correct, roll sideways and then jump. They usually have some direction, but it's rarely and clear path, and it's the volatility that cracks you.

There is at least one more misleading thing about how these ETFs are framed as well, the way the term leverage is used. There are situations where an 3x "leveraged" ETF produces returns a similar result to being 3x leveraged (ie borrowing money to buy three times the amount of a stock than you have the cash for.) There are also situations where the results are quite different. Again it's the result of a basic mathematical effect/flaw in the ETF construction. Basically these ETF return numbers like classic leveraged situations when moving away from your baseline investment. However as soon as there is any reversion back towards that baseline the numbers begin to skew.

Say you have $100 that you want to use to buy XXX. But you want to make more money so you go borrow $200 more so you can buy $300 worth. That's classic leverage. If the next day XXX jumps up 25% to $125, well you now have $375 worth of stock and $200 in debt. Net result is being up $75 on a $100 investment, so you've made 3 times the 25% increase in the stock.

You could also buy XETF though an 3x ETF that tracks XXX. $100 worth, on day one would also go up 3x the 25% increase, so far so good, you've made triple profits without even borrowing money. Sounds a little too good to be true, no? It is. Cause say the next day XXX goes back to 100, a 20% decline. In the classic leveraged situation you go from holding $375 to holding $300. Minus your debt you are even (ignoring interest for simplicity.) Not great, but not bad either. But with the "leveraged" ETF, as we've seen before, that same 20% decline in XXX is going to have a different result. It will produce a 3x the percentage decline, so 60%. Now 60% of 175 is 105, so this ETF is decaying down to 70. Instead of being flat on your initial $100, like you would in a classic leveraged situation you are down 30. Just like a crackhead you just can't back to those initial highs like that can you?