In light of the incredible decay seen in leveraged ETFs in the past year, many have suggested shorting both the bull and bear leveraged ETF to profit from the decay (such as FAS/FAZ). The belief is that over enough time, both ETFs will either decay toward 0 or do reverse splits. Hence, the myth is that the pair shorting strategy is a ‘can’t lose’ strategy and a one way ticket to profits.

The Flawed Assumption

Unfortunately, this myth is based on the assumption that leveraged ETFs always decay more than they grow over long periods. In the period from October 2008 to March 2009, this was most certainly true as the markets saw such incredible volatility that caused leveraged ETFs to decay up to 20 to 40 times more than normal. This period has ‘colored’ people’s thinking, making them believe that leveraged ETFs will always behave this way and that any long term investor will most certainly lose money. The belief that leveraged ETFs always decay more than they can grow is simply not true. All it takes is some simple simulations to prove otherwise. Simulations show that there periods where the decay is greater than the growth and that there are also periods where the growth is greater than the decay.

The Risks

Like any other strategy, shorting both ETF has its risks. In order for it to work, it needs certain conditions to be met. Just like ‘going long’ requires the market to go up in order to profit, the paired shorting strategy requires the market to be horizontal or exceptionally volatile in order to profit from the decay. When these conditions are not met, the shorting technique can result in significant losses.

Example #1 – A Recent Trend

An excellent example that has probably blown out anyone recently attempting the ’short both’ strategy is the recent gains of many leveraged ETFs since the March bottom. Case in point, TNA:

A 240% increase implies a massive loss for anyone holding a short through this period. Even though there was 15% decay during this period, the trend was too strong. A chart showing the paired shorting profit through this period is shown below.

At one point the strategy is down 98%. This is certainly damaging to one’s confidence in this strategy.

Example #2 – A Bull Market

Advocates may say that the previous example did not give the strategy enough time to work itself out. Well, let’s run a simulation to see how it holds up in a bull market. By applying a 3x multiple on IWM’s data from 2003 to 2007, we can get a simulated version of both TNA and TZA during the last bull market. Running the strategy yields the following results.

A 400% loss is definitely not a one way ticket to profits.

Example #3 – S&P 500 (1950 – 2009)

We can take this strategy to the extreme by seeing how it would work over the course of almost 50 years of S&P 500 data. Again, a 3x multiple is applied to simulate a 3x bull and 3x bear ETF (such as UPRO and SPXU). Unfortunately, running the strategy over this timeframe results in such a drastic loss, plotting a chart shows astronomically high losses that make the chart difficult to read. Only a partial chart is displayed to make it somewhat readable.

Coming in at over a 100,000% loss, this strategy clearly did not work over this long period.

Myth Result: Busted

While there are periods where the pair shorting strategy works (like volatile bear markets), there is ample data that proves it fails to work during a multitude of conditions and timeframes. Hence, this myth is busted. For more coverage describing the challenges of this strategy, read this:

Why your brilliant plan to short a pair of 3x ETFS will not work.

Articles describing the pair shorting strategy:

Triple Leveraged Arbitrage
A Winning 2X and 3X ETF Long Term Strategy
The Equal Short Bull-Bear As The Ultimate Negative Correlator?
Shorting 3x levered bull and bear ETFs: Possibly a very cool strategy
Shorting Leveraged ETFs – Low Risk High Gain Potential?

Disclaimer: Results do not take into account any borrowing costs, transaction costs, or leveraged ETF costs.

For 6 months it seemed like decay was in control and that all leveraged ETFs would fizzle away to 0 (reverse splits). However, since the market bottom in March, the trend has been so strong that the decay has been almost non-existent.

For example, FAS has the following stats from July 9, 2009 to August 4

Gain: +91.9%
Decay: -1.4%
Index:  +25.3%
Effective Leverage: 3.6x

Even though there was a bit of turbulence from the March 9 bottom causing some decay, TNA has seen an incredible trend to August 4

Gain: +240.6%
Decay:  -15.8%
Index: +64.9%
Effective Leverage: 3.7x

Also from the March 9 bottom to August 4, TYH has seen an incredible trend.

Gain: +231.3%
Decay:  -9.38%
Index: +58.9%
Effective Leverage: 3.9x

This period of strong trending is the polar opposite of the high volatility and sideways market of late 2008. The information presented here is merely useful proof that even though leveraged ETFs are affected by decay, in times of low volatility and strong trends, the returns can be significant.

I agree that leveraged ETFs may be highly misunderstood and extremely dangerous, but they actually achieve their stated goals (daily leveraged percent change tracking) probably better than most people think. It does not matter that the ETF internals need to buy high and sell low. What matters is that they should work as advertised, and that traders or investors should understand how they work over their respective timeframe before they decide to use them.

Meet Marcus and Larry

In order to illustrate how leveraged ETFs decay for a reason and why it is not a ‘flaw,’ I will demonstrate an alternate scenario outside of the world of finance that also experiences decay. To keep things as simple as possible it will be explained using a 5^th grader’ish storyline.

Imagine three bicyclists that are training for a long race. Their names are Igor Index, Marcus Margin, and Larry Leverage. Igor is a veteran and has lots of experience. His training regimen is very strict. He alternates days where he rides a long distance and then a shorter distance.  More specifically, on Monday he rides 100 kilometers, Tuesday he rides 80 km, Wednesday back to 100 km, and so on. Though his short rides are only 20 km less, Igor has found this training schedule has helped him become one of the best cyclists in the world.

Two up and coming young cyclists named Marcus Margin and Larry Leverage idolize Igor and they have been looking for a training schedule that will put them in better shape for competitions. Marcus has studied Igor’s training technique and decided he will do twice the change value of Igor. Rather than do 20 km less on Tuesday and Thursday, Marcus decides to double it and do 40 km less. Larry Leverage has decided to do things a bit differently. Larry wants to double the percent change that Igor does each day. Using this training plan, we can see what each cyclist will do on Tuesday.

It is clear that both Marcus and Larry will be riding less on Tuesday, both by the same amount. However when Wednesday comes around, Igor increases his riding by 20km (25% of the 80 km), Marcus doubles Igor’s 20 km increase for a 40 km increase, and Larry decides to do double Igor’s percent increase for a 50% increase. Since Larry rode 60 km on Tuesday, an extra 50% puts him at 90 km. What he does not realize is that just tracking Igor’s percent change will cause his training to have some weird effects if he continues over multiple days. A chart shows what happens to the Wednesday bike ride.

Over the course of two days Larry’s long ride has become 90 km instead of 100 km all because he decided to track Igor’s changes by percent instead of value. If Larry keeps this up, after one month he will have a long ride of 35 km instead of Igor’s 100 km long ride. This is proof that decay in leverage ETFs does not happen due to buying high and selling low, it is from them working as they should: daily leveraged percent change tracking.

Decay is not a ‘flaw’

Even if the leveraged ETF fund managers had nightly parties where they take turn shoveling money into a furnace, as long as the funds meet their stated goals, it seems irrelevant as to how they achieve them.

To those that think leveraged ETFs are flawed:

• Decay is by design.
• Trends can offset the decay.
• Decay of leveraged ETFs tracking the S&P 500 is roughly 20 times less during normal volatility.
• Decay of leveraged ETFs tracking the financials is roughly 40 times less during normal volatility.
• Any instrument that has goals similar to leveraged ETFs is also affected by decay.

The only flaw is when someone expects these instruments to perform 2x or 3x over long time periods. Just like it would be flawed to think a car with a V12 engine is going to use the same amount of gas as a V4 engine. In all fairness, a V12 versus V4 engine gas usage comparison is probably more obvious than understanding why leveraged ETFs are affected by decay over long timeframes. Hence, I can understand people’s frustrations and confusion. That is why this blog attempts to spread information about how leveraged ETFs work; so that traders or investors can be better informed for the decisions they make.

We avoided a disaster

I am not opposed to people that think leveraged ETFs should not be used. That is their opinion and they are entitled to it. It is actually good that leveraged ETFs have become more popular during the past year instead of before the 2008 crash. The abnormally high volatility has amplified the effects of decay and significantly increased awareness of how these ETFs work. Had leveraged ETFs become popular 5 years ago during the bull market, investors probably would have piled into them long term, not prepared for the financial tsunami that was about to hit. Long term investors probably would have been blind-sided by the compounding effects of the market going down coupled with the negative effects of decay during the once in a lifetime volatility. Now that market volatility has subsided, the leveraged ETFs are becoming much less affected by decay. Future articles will go more in depth on just how well leveraged ETFs track, and the kind of decay we should expect to see in the future at normal levels of volatility.