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?



 
 

The Tariff

So we are deep into a recession, with no particular end in sight. Obama has promised to jack up the governments debt already. The trade deficit is still stratosphere high. Tax cuts promised too, unemployment rising fast, and economists are worrying about deflation.

Something in those numbers doesn't add up, does it?

Right now the whole situation is staying afloat based on the fact that the US government can borrow money in a currency it also funnily enough can print itself. As long as they can keep doing that, deficits don't mean jack, we can get all the money it's shipping away back for the price of some paper and ink.

Then again the government has lowered interest rates to practically zero, how long will it be able to borrow money at those rates?

Raising rates means putting a squeeze on all the individuals and companies in the US currently deep in debt. Raising taxes to pay debts just sucks money out of the US economy. Maybe the economy just does a 180 and exports pick up, revenues rise and things correct. Or maybe the US Government really can borrow forever for free. Neither seems particularly likely though.

Things continue on a course like we see today and I have to wonder if we are charging fast towards the end of the free trade era. The government needs revenue, and they want to do it with taking that money out of the country's economy. The country needs jobs, the government is worried about deflation and the economy is net bleeding billions due to it's trade deficit. I'm not really one to predict the future, but are we looking at a big time return of the tariff?

edit (05/10/2009): Well a 100+ days past this entry and it's clear that tariffs are not high on the agenda, yet. It's all about the Federal government borrowing money and printing dollars and likely will be until either recovery or collapse of that system let's see how this plays out...



 
 

Outlier Tailored Performance

OG-4Seasons-Anii.jpg

Outlier is my new venture. Probably find me writing a bit more there then here for a while. Outlier makes tailored performance clothing for cycling in the city. SItes filled with info so take a look. Smart shoppers probably want to head here or here to catch a discount...

blackswan-260x250.gif



 
 

The World For

Seth Carnes, my old friend and former partner in both One Infinity and 47 has a brand new project that allows the whole world to get in on this US presidential election. Check it out below and don't forget to vote.



 
 

Market to Marks

Hidden amongst this current financial crisis is a nasty little truth about neoclassical economics the hits to the core. This is the idea that economic objects should have one "market price" or equilibrium. The truth that lies in plain site is that this just isn't true. A bottle of orange juice might be a dollar in one shop, a buck fifty down the road and seventy five cents across town. There is a whole bullshit loads of talking around the clear fact of how this undercuts the very basics of economic theory. And there are also massive systems in place at stock and commodities exchanges, explicitly design to produce something as close to equilibrium prices as can be generated. But under this age's crisis all that cover falls clearly apart.

The issue is what is known as "mark to market", a system by which firms need to value their investments for accounting purposes based on the present market value of each financial object. And it needs to be done daily. In stable yet liquid market conditions this is generally a good thing, it promotes transparency and prevents firms from hiding bad investments behind dubious accounting practices.

However the system has fallen clean apart over the course of 2008. As firms get more and more risk adverse the liquidity for many investment vehicles has evaporated. The market value has plunged to zero, no one is out there that is willing to risk buying these things. Standard economic theory would have it that these things with zero market value are then financially worthless. But the fact is that they actually stand to return quite a bit of money over their lifespan. They have no market value in a risk adverse environment but have plenty of value to the firms holding them.

The mark to market rules have played at least some role in worsening the current financial crisis by exaggerating the losses in many firms. They are forced to report huge losses as the market value hits zero for their illiquid assets, yet these same assets will return at least some income over their lifespan. The SEC is currently "loosen" these rules, but just how so remains a bit unclear. Ultimately I can be almost sure they won't address the core issue though.

What really needs to happen is for economics to give up it's insistence on the idea of equilibrium pricing and acknowledge that markets can happily support a multitude of prices for any given object at any given time. It's no easy task because it essentially means scrapping a mass of economic theory and starting over from close to scratch. No easy task there, to say the least. But for a discipline that still can't answer Thorstein Veblen's 110 year old question of "Why is Economics Not an Evolutionary Science?" it's a completely essential step.



 
 

The Spam King of Nigeria and Other Stories

Ordinarily I'd just post a like like this one on the side bar but :apophenia: a google horror story: what happens when you are disappeared is a crazy one. A couple years ago I did a scenario planning session that revolved around spammers hacking email accounts and impersonating people from your past. That's not exactly the story, but as "phishing" attacks get more and more sophisticated it's heading in that direction. And google's centralization of power sure is going to help in that process.

I've been terrified of google for a long while now for exactly these reasons. They just have too much power, too much information centralized in one location. (Or really centralized and multiplied across multiple locations) It doesn't really matter if google is good or evil, or both because that much info placed into one interface and virtual location ensures that bad shit is going to happen. You know like your entire digital identity being hijacked, used abused and then sold off as scrap to the highest bidders. Add in google's god awful customer service (and a company with engineers at the helm is almost always ensured bad customer service) and the you've got an awfully frightening entity.



 
 

True Conservatives

When uber right wing pundit Ann Coulter stated she'd campaign for Hillary Clinton over John McCain I was quick to write it off as a play for attention from one of the worst media whores in the business. Coulter loves to take extreme positions and run with them as far as possible. But the continued hate for John McCain spewing from the likes of Coulter, Rush Limbaugh and James Dobson is fascinating.

Politically I've never gotten McCain's rep for being centrist. He's a right wing warmonger in my book and his vote record is deeply right wing. But when Coulter says Hillary is more conservative than McCain, she's not really talking policy and shockingly enough she's actually right. Policy wise of course Clinton is moderate but far to the left of McCain. But personality wise, Clinton couldn't be more conservative.

At it's core conservatism as a philosophy is about maintaining the status quo, keeping the power structure intact. Clinton has climbed her way to the top of US politics and she has no interest in sharing that power or letting it slip away. McCain on the other hand has spent years cultivating an image as a maverick, a man who will think for himself and won't take orders. For people like Rush Limbaugh and Coulter who value blind obedience to the power structure this is a threat of the highest order. There is no space for mavericks in their world view, free thinking undermines their values to the core.

It's exactly because of this that voters tend to flock to Obama in the days leading up to their primaries, yet a substantial number break to Clinton at the last second. As inspiring as Obama may be his message of change is scary to the conservative minded. Hillary is the safe path, the choice of the risk adverse, the people who regardless of how they stand on policy are scared of new.

No matter how much conservatives hate Clinton personally, there must be a huge comfort in the pattern, they did Bush then Clinton before, why not keep it going. They wanted Bush as king, but Hillary as queen is far more palatable then a maverick or change agent as president.



 
 

Union Experience

Despite being part of "Super Tuesday" New York still hasn't gotten much of the full court political press. Judging from the conversations overhead at the Time Warner repair center today it seems like plenty of New Yorkers just heard the name Barack Obama this morning. Meanwhile the only people I've seen actively campaigning for Clinton are union members outside Grand Central.

It's a pretty remarkable contrast really, gruff teamsters pushing Hillary's tepid literature. It's certainly a sign of progress on one level that the gasp of blue collardom in New York City is out pushing for a female president. But at the same time it's not quite the coalition of the future is it? The hands on down and dirty politics the Clintons love to play certainly fits right into to an old school union hall. But for better or worse it's not really that clear that the hall itself is ready for the 21st century...



 
 

Notes on Yahoo Microsoft

Couple quick notes on the Microsoft- Yahoo deal:

- Yahoo and Microsoft are two of perhaps only four companies, the other two being Google and Amazon (via it's Alexa purchase) that have massive databases of information spidered from the web. Given how much effort now goes into gaming these same spiders that historical database just might be extremely valuable. The spidering infrastructure they have is probably even more valuable, except Microsoft already has much of that built via their MSN search already. How much value is there in keeping this out of other's hands?

- Microsoft going into debt for the first time? Signs of a financial empire finally crumbling? There cultural clout of course has been plummeting, but they still have a near monopoly on business desktops so who knows.

- Apple + Yahoo rumors = very interesting.

- The US tech world is always so US centric. Where do the foreign search engines stand in all this? Are there other datamining powerhouses that are below the radar but with a whole lot at stake in Yahoo's fate?



 
 

Hype Uncheck

I knew I left something out in my little musical Hype Check, but I couldn't remember what for the life of me. That can't bode to well for the band, but they still got some hype in them... Anyway, the Virgins? The Strokes if the Strokes were actually any good...



 
 

What More Can I Say, Top Billing

When Bill Clinton started going after Obama it sure made it easier to see my the right wing hates him so much. But man when he shifts back to attacking the right, it's pretty easy to remember what was so great about him. His praise of John McCainfor instance, is such a deft and subtle political maneuver that it brings a smile to my face. The Clintons clearly have identified McCain as their biggest threat in a general election and by tying him publicly to Hillary, they are striking right where it will hurt him most in his attempt to win the Republican nomination. So nasty but so clever...



 

Abe Burmeister is a designer, writer and artist. This is his weblog on the subject of design, networks and culture. His first book Economies of Design and Other Adventures in Nomad Economics is currently available as a public draft. More details can be found at nomadeconomics.org.

Abe Burmeister is available for consulting, speaking and design projects. More information is available at abeburmeister.com.


Please enjoy the site and as always feel free to contact us with questions, comments and the like. Of course, an RSS Feed is available.



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linkflow

March 31, 2009

The Disadvantages of an Elite Education: an article by William Deresiewicz about how universities should exist to make minds, not careers | The American Scholar

October 23, 2008

TheWorldFor - Where the World Votes for U.S. President

October 18, 2008

The Confidence Game - WSJ.com

July 29, 2008

Display of market impact in algorithmic trading engine invention

Surprise! Hit Song is Secretly a Commercial | PSFK - Trends, Ideas & Inspiration

July 13, 2008

OldSchoolPartyFlyers - a set on Flickr

June 30, 2008

An Attack That Came Out of the Ether - washingtonpost.com

June 22, 2008

The lessons of Lil Wayne's No. 1 - Los Angeles Times

June 11, 2008

American Murder Mystery Very interesting and somewhat disheartening look at the latest developments in the huge story of poverty and crime in America. One huge issue with the article, the tag line talks about the rise of crime in "many American cities", but the causes it pinpoints are much more about the distribution of crime, not the actual rise.

June 09, 2008

Do food miles matter? | ES&T Online News

May 12, 2008

Annals of Innovation: In the Air: Reporting & Essays: The New Yorker

brand tags really nice and simple project from Noah Brier

internet black holes

May 06, 2008

Hiplife - The Bluffer's Guide - Stylus Magazine

Cassette Playa: Carri Munden - cartoon couture, streetwear, M.I.A. Carri Munden, fashion,cassette playa - Page 2 - LIPSTiCK TrACeZ

May 04, 2008

Black Stars - Ghanas Hiplife Generation - Hip Hop / Reggae / Afro-beat

April 30, 2008

Microsoft hacks itself. How retarded is this company? I can imagine they are now about to get sued for false security claims...

April 25, 2008

Massimo Vignelli's New York Subway Map: Tech: mensvogue.com

April 16, 2008

B e n j a m i n M a r r a i l l u s t r a t i o n s

visualcomplexity.com | Bus structure 2am-2pm

databeautiful

Sleevelessness – a blog about graphic design, the web and digital music

murketing “Buying In”, can't wait to buy it myself, Walker is a great writer covering some of the trickiest, hard to capture social terrain of this era.

Larger Prey Are Targets of Phishing - New York Times

April 07, 2008

"The Clintons, man, they would lie on a stack of Bibles. Snipers? Thats not misspeaking; thats some pure bullshit. I voted for Clinton twice, but thats over with. These old black politicians say, Ooh, Massuh Clinton was good to us, massuh hired a lot of us, massuh was good! Hoo! Charlie Rangel, David Dinkinsthey have to understand this is a new day. People aint feelin that stuff. Its like a tide, and the people who get in the way are just gonna get swept out into the ocean."

April 01, 2008

Chris Harrison - Internet Map: City-to-City Connections

March 31, 2008

naked teddy bear

Patagonia - The Footprint Chronicles: Tracking the Environmental and Social Impact of Patagonia Clothing and Apparel

March 28, 2008

murketing Blog Archive Guest Q&A: The Shirt Project

Cloverbucks - Diner’s Journal - Dining & Wine - New York Times Blog

"So, in essence, cafes that have been using Clovers and the CloverNet have been helping to document and codify a body of knowledge about how the machine, which really is a new bit of technology, functions and performs.

They helped the company compile data about sales, about how the machines are holding up in the field and which specific times, doses and temperatures showcased individual coffees best. Now that information is something that Starbucks a direct competitor to every small cafe in the country has ownership of, and soon it will no longer be available to original Clover users. "

Whoa, that turns the Starbucks Clover acquisition more than a few shades more diabolical... Ultimately I hope it'll work out well for all parties, Starbucks still (or no longer in some cases) can't make good espresso so the indie market has a huge market space. Meanwhile if Starbucks starts making some decent lighter roasts for their new Clovers then coffee quality rises across the country.

The big question remaining is whether someone steps up and creates a Clover competitor for the indie market. Without it there is a nasty gap in the market. It's doubtful Starbucks will be able to brew the uberpremium stuff that places like Intelligencia & Grumpy are producing, and the indies that can do it won't be able to get the machines to do the style.



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