Confessions of a Leveraged ETF Junkie, Part 1

• ByTimothy Collins, RealMoney Contributor
• On 1:16 pm EST, Thursday November 5, 2009

We are all junkies, whether we admit it or not. Each one of us can pinpoint a moment when our interest in the markets turned to addiction. Mine was when I spurned a broker's advice while involved with a stock market game back in high school. Instead of buying his recommendation (Pepsi ), I took our last-place portfolio and went all in on Scoreboard for the nine weeks that remained in the competition. One free trip to the NYSE floor later (after a monstrous climb in the standings from 273rd to 5th), I knew I was hooked.

Make no mistake, we are all addicts. You will seldom hear about accounts that were bankrupted, the trades that went against us, or the decisions that were made out of "tilt" as opposed to sound reasoning. And the rare times that you do hear these stories, they generally come from someone who is now wildly successful and wealthy. This is what makes us human, but it also means that we can continue to learn and grow.

The most dangerous thing about the capital markets is that they are like dealers ever feeding our addiction. Wall Street pumps out new products that grow, morph and change right along with our addictions. One of these new addictive products for many traders is also one of the most hotly debated: leveraged ETFs.

I have followed leveraged ETFs since day one. The concept is not new. In fact, several of the current leveraged ETF providers ran the concept via mutual funds for the last five to 15 years. I utilized these funds when developing portable alpha portfolio models until the dramatic impact that volatility could have upon returns became evident. I observed the oft-mentioned volatility decay firsthand, the negative drag/impact of volatility in connection with the daily rebalancing of leveraged funds.

After the introduction of these ETFs, both leveraged and inverse leveraged, the idea of creating a strategy to profit from volatility decay immediately came to mind. It has taken almost three years to find a consistent strategy, but that's not what this article is about. This is about the education along the way: the bumps, the bruises, the half-truths, the dark things managers don't like to talk about, just like an addiction.

There have been many articles conveying the concept about how easy it is to make money by simply shorting a leveraged long ETF while simultaneously shorting the corresponding leveraged short ETF in equal dollar amounts. In the two years of implementing this type of strategy, I can say firsthand that it is easy ... until it isn't. It is too easy to look at the results of these ETFs over the last 12 months and conclude, "Hey, they are both down. All you have to do is short the leveraged long and the leveraged short, sit back, and watch the account grow!" Unfortunately, there are a few items unaccounted for in that statement:

Interest rate charges: Most leveraged ETFs are difficult to borrow. We've seen many firms cease offering them altogether. Assuming that you can even get a share borrow, the interest rate charges can range from the very low single digits all the way into the teens on an annual basis. Furthermore, these rates can vary on a day-to-day basis. This holding cost has a major impact on the bottom line. If employing such a strategy, I would factor in borrowing costs around 4%. I've been tracking them for some time now, and this number will vary; however, the longer-term average for the most heavily traded funds seems to be in this area. I have seen some brokers that are significantly cheaper than others, so shopping around is very important.

Inventory: Even if you find shares to borrow, there is no guarantee that you can keep them. Beyond simple interest rate risk/cost, the shorting strategy also runs the risk of a force buy-in. Focusing back in on the firms that ceased the sales and solicitation of the leveraged ETFs, inventory has become more concentrated. Currently, I've found inventory most plentiful in some of the retail do-it-yourself brokers, but it changes from time to time. The difficulty with a forced buy-in is simply that: it's forced. You don't control the time or the price. The pairing may not even be profitable when this happens, and if it is, it could trigger short-term capital gains, as opposed to a longer holding period that may offer preferential tax treatment.

The tax problem is much smaller than the potential for having to close the trade at a loss, since volatility decay may have not had enough time to work. Also, you run the risk that only one out of the two positions will be called in. If this happens, then you either need to relocate shares to borrow (that were just called in), or you would be forced to close the other side of the trade. By not doing so, your position would then be a levered single-direction trade, and no longer hedged.

Lastly, it has been very difficult to predict what pairings are most subject to call in risk. Inventories have been very volatile, and often the trends of the market dictate which securities become hard to borrow. Lately, hot money has moved from sector to sector, sometimes in the blink of an eye, and that is making predictions even harder.

Margin/capital requirements: Currently, the double short strategy can be done in either a Reg T margin account or portfolio margining account. Although the pairing begins market neutral, each pair will take a directional bias very quickly. The ideal situation is a market that goes up one day, down the next day, then up, then down, etc. Unfortunately, that simply cannot be expected.

If the market trends in one direction for any length of time, the compounding effects of the leveraged ETFs have a very quick, negative impact on your portfolio value. One short position will be rising at a faster rate than your other short position is falling, since your losing short position is compounding from a higher value each day, and your winning position is falling from a lower value each day. It is quite possible to suffer the effects that are opposite volatility decay. Each day as the trend continues, your directional bias becomes larger and larger. Starting from a position of neutrality, you may soon find yourself with either a large market bull or bear position. The biggest risk is that the trend stays in place longer than your margin availability.

This strategy can prove the old Keynes adage that the market can stay irrational longer than you can stay solvent. And as unlikely as it may seem that we would see trends that would last long enough and run far enough without a significant retracement, you need only to look at the market moves over the last 12 months. There were several periods when your starting point and the subsequent market moves could have proved quite devastating to this strategy.

This may not always present a problem; however, many market-neutral arbitrage strategies will use leverage in their strategy. This leverage would be beyond what is inherently found within the products themselves. In the situation of a trending market combined with the additional use of leverage, someone utilizing this strategy could find that he or she faces a margin call or forced liquidation at the most inopportune time. Again, the pairing(s) could be closed at a time not of the holder's choosing.

Psychology: One variable that is very difficult to predict is the psychological strength of the portfolio holder. The pairings will be volatile. Also, for some, it may be difficult to handle the early movements. There is a very high probability that this trade will show a paper loss before any increase. The decrease in value may only be a few days, or it may take weeks or months before the pairs start to show a profit. Again, this all depends upon the path of the underlying index.

In conclusion, the double shorting strategy can work, but it comes with more speed bumps and challenges than appear on the surface. Like most strategies, it has its share of risks. Being prepared for those risks will afford you a great opportunity at success.

In Part 2, I will examine some other alternative strategies that seek to profit from the volatility decay of leveraged ETFs.

Buzz up!