Andreas Cseh. Quantum Fading. Strategies for Leveraged & Inverse ETFs. Anchor Academic Publishing. disseminate knowledge

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1 Andreas Cseh Quantum Fading Strategies for Leveraged & Inverse ETFs Anchor Academic Publishing disseminate knowledge

2 Cseh, Andreas: Quantum Fading : Strategies for Leveraged & Inverse ETFs, Hamburg, Anchor Academic Publishing 2014 Original title of the thesis: Quantum Fading 2x & 3x - Leveraged & Inverse ETFs Buch-ISBN: PDF-eBook-ISBN: Druck/Herstellung: Anchor Academic Publishing, Hamburg, 2014 Additionally: The Hong Kong University of Science and Technology, Hong Kong, China, Master Thesis, 2011 Bibliografische Information der Deutschen Nationalbibliothek: Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über abrufbar Bibliographical Information of the German National Library: The German National Library lists this publication in the German National Bibliography. Detailed bibliographic data can be found at: All rights reserved. This publication may not be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publishers. Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Dies gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Bearbeitung in elektronischen Systemen. Die Wiedergabe von Gebrauchsnamen, Handelsnamen, Warenbezeichnungen usw. in diesem Werk berechtigt auch ohne besondere Kennzeichnung nicht zu der Annahme, dass solche Namen im Sinne der Warenzeichen- und Markenschutz-Gesetzgebung als frei zu betrachten wären und daher von jedermann benutzt werden dürften. Die Informationen in diesem Werk wurden mit Sorgfalt erarbeitet. Dennoch können Fehler nicht vollständig ausgeschlossen werden und die Diplomica Verlag GmbH, die Autoren oder Übersetzer übernehmen keine juristische Verantwortung oder irgendeine Haftung für evtl. verbliebene fehlerhafte Angaben und deren Folgen. Alle Rechte vorbehalten Anchor Academic Publishing, ein Imprint der Diplomica Verlag GmbH Hamburg 2014 Printed in Germany

3 Table of Contents INTEGRATIVE RESEARCH STUDY GOAL... 1 INTRODUCTION AND OVERVIEW... 1 WHAT ARE INVERSE AND LEVERAGED ETFS... 2 THE MAIN STRUCTURE OF A LEVERAGED/INVERSE ETF... 2 NET ASSET VALUE (NAV) COMPUTATION OF A LEVERAGED ETF... 3 INTRADAY INDICATIVE VALUE (IIV) COMPUTATION OF A LEVERAGED ETF... 4 LEVERAGED/LONG BULLISH ETF... 5 INVERSE/SHORT BEARISH ETFS... 5 WHY INVERSE AND LEVERAGED ETFS LOSE MONEY OVER LONG TERM?... 6 CREATION OF LEVERAGE... 6 RE-BALANCING... 6 COMPOUNDING EFFECT... 8 THE LARGER THE DAILY VOLATILITY THE GREATER THE COMPOUNDING EFFECT... 9 PERFORMANCE FLIP AND VOLATILITY MEAN AND MEDIAN RETURNS TRADING STRATEGIES FOR LEVERAGED ETFS STRATEGY #1 DAY TRADING STRATEGY #2 THE MARKET NEUTRAL ( =0) STRATEGY #3 - RIDING THE VOLATILITY CONCLUSION ADDITIONAL CALCULATIONS TO STRATEGY #2 THE MARKET NEUTRAL ( =0) INDEX OF REFERENCES... 58

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5 Integrative Research Study Goal Very early right after the introduction of Leveraged ETFs in 2007/08 I started to invest in these double short and long ETFs. My investments in UYG and SKF never did as well as I expected, caused me to start thinking an old maxim of mine. Do the math. Today, few years later I identified several opportunities to use these products correctly by timing and allocating my investments in LETFS properly. Based on the general idea of what these products are and what they are designed for first I will give an overview about the Leveraged ETFs. Then, I will evaluate on double and triple leveraged ETFs on the principle how these products are structured which factors influence their movements and how they behave short and long term. Finally, based on these findings, actual trends and market volatility influencing events, I will try to construct arbitrage trading strategies using the strength and weaknesses of these products. Introduction and Overview Suppose you believe the market is going to go crash, what would you do? The normal answer is: sell what you have and get out. However, what if you have nothing to sell? Until a couple of years ago, the answer would have been Stay on the sidelines for simple investors. The sophisticated and the professionals always had plenty of avenues: Shorting the stock Buying put options Selling naked calls, etc. The gap was narrowed with the arrival of leveraged and inverse ETFs 1 that allow even novice investors to short the market in a less risky way

6 What are Inverse and Leveraged ETFs Traditional ETFs track an index or basket in a one-for-one approach, they are basically passively managed. In contrast, leveraged and inverse ETFs are intraday traded, exchange-traded derivative funds 2 and shouldn t be confused with more-vanilla ETFs 3. Leveraged ETFs require active management: this involves borrowing funds to purchase additional shares (bullish LETFs), or short-selling (bearish LETFs) and rebalancing the position on a daily basis. At present, most levered ETFs are either 2X, 3X, -2X, or -3X, and therefore offer investors the chance to earn 2 or 3 times (and lose 2 or 3 times) the daily return of a simple long or short position in the index. These levered ETFs have leverage (borrowing) built into their structure, thus eliminating the need for investors to do their own borrowing (margin, futures, swaps, etc.) or short-selling, but the leveraging process is built to achieve an objective quite different from that of the simple, classical ETF 4. The Main Structure of a Leveraged/Inverse ETF The structure of a traditional ETF and LETF are based on holdings transparency. One of the keys to being transparent is publishing all of the numbers required to calculate the fair value of a LETF every day. Six basics involved in the valuation LETF are published every day: ETF Ticker Conventions Bloomberg Google, Yahoo Finance 1. Net Asset Value NAV ETFNV ETF.NV 2. Intraday Indicative Value IV ETFIV ETF.IV 3. Total Cash - TC ETFTC ETF.TC 4. Estimated Cash - EU ETFEU ETF.EU 5. Shares outstanding - SO ETFSO ETF.SO 6. Accrued Dividends - DV ETFDV ETF.DV Source: Bloomberg & Yahoo Finance On the other side LEFTs differ from traditional ETFs in terms of: Fees Expenses/Costs Tax efficiency See: Morningstar June 12, 2009 Article 4 See: Inverse and Levered ETFs by Pat Little, PhD, Page 7 2

7 Investment time horizon Mechanics of rebalancing Tracking error Fees and expenses/costs are higher, often exceeding 1% per annum, and tax efficiency is lower because most trades settle in cash rather than in kind and realized gains from the use of derivatives are generally taxed at ordinary income tax rates instead of the lower capital gains tax rates. The most important difference, expenses and taxes aside, is obviously the leverage, but most important from a performance point of view is the investment holding period dictated by the leverage scheme 5. Whereby, the ability to obtain leverage via equity products without using margin is very enticing. It is very difficult to build leverage into a structure that trades on an intraday basis. Net Asset Value (NAV) Computation of a Leveraged ETF The fund world is based on comparative statistics therefore standardized reporting was critical in the development as for the ETFs so for the LETFs NAV computation. As we can see it in the table below the NAV calculation is a daily computation which is based on the latest closing prices of the assets in the fund and an actual accounting of the total cash in the fund at the time of calculation6. This gives the fund a standardized value that can be compared to other funds for performance statistics and accounting. The NAV of the ETF/LETF is computed by taking the sum of the assets in the fund, including any securities/derivatives and cash subtracting out any liabilities, and dividing that by the number of shares outstanding7. A related and yet important point is to mention, that Leveraged/Inverse ETFs are subject of minimal disclosure regarding the costs and the strategies they utilize 8. NAV = (Asset Liabilities)/Shares/Derivatives Outstanding 5 See: Inverse and Levered ETFs by Pat Little, PhD, Page Bloomberg user can see the daily creation file by typing the fund ticker {Equity} & MHD {Go}. Then 97 {Go} on a Bloomberg Terminal, and you will see the most recent creation unit file for the fund. 7 Own ETF calculations/excel based on information provided by David Root - Vice President at Direxion Funds USA and based on ProShares USA 8 SEC, Leveraged ETFs - 3