June 06, 2009

Market Insights 6 June 2009

Weekly Snapshot
• US employers cut 345,000 jobs in May - less than 520,000 forecasted by economists
• US unemployment rate at 9.4% in May - highest rate in over 25 years
• Australia's GDP rose 0.4% in the first Quarter of 2009
• ECB and Bank of England kept interest rates unchanged at historic lows
• Unemployment in Euro area reaches 9.2% in April - highest level in 10 years
• GM and Citigroup removed from the Dow Jones Industrial Average - replacements are Travelers and Cisco
• US Pending home sales rise 6.7% in April
• General Motors Corp filed for bankruptcy protection
• Judge approved the sale of substantially all of Chrysler's assets to Fiat

More on ETFs
The growing popularity of ETFs has kept our attention for some time now. This week, I would like to take a closer look at some leveraged and inverse ETFs. But first, I would like to recommend the following primers:

Must Read
Warning: Leveraged and Inverse ETFs Kill Portfolios - Page 1: http://news.morningstar.com/articlenet/article.aspx?id=271892
Warning: Leveraged and Inverse ETFs Kill Portfolios - Page 2: http://news.morningstar.com/articlenet/article.aspx?id=272055

Must See
Returns at these ETFs could shock you: http://www.morningstar.com/cover/videocenter.html?bcpid=1213900505&bclid=1398215656&bctid=9952874001

Examining inverse and leveraged ETF returns
Let's look at two of the most popular Indexes, the Dow and S&P500, and examine how ETFs and their leveraged and inverse counterparts perform in comparison to the underlying.

Diamonds (DIA) and Spiders (SPY) are the ETFs tracking the Dow and S&P500 respectively. Both ETFs are traditional ETFs with very low fees (DIA = 0.14%, SPY = 0.08%) and have historically done a very good job in tracking the underlying Index. As a matter of fact, comparing the relative performance of ETF versus index, you notice that the ETF (blue line) is performing slightly better than the index. In this case, this is due to the dividends imputed on the price in this chart.

Let's take a look at the inverse of the Dow - ticker symbol: DOG. Proshares, the sponsor of this ETF declares the stated objective as:

"ProShares Short Dow30 seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones Industrial Average Index."
"This ETF is designed to meet daily objectives; results over longer periods may differ. There is no guarantee that any ProShares ETF will achieve its investment objective."

As per earlier "Must See" and "Must Read" seen above, I too wish to begin with a WARNING: The results are not what you would expect on first glance. The culprit is the word "daily"; and while arithmetically the ETF may have performed as stated, the typical investor expectation i.e. matching returns -1:1 are far from being met. Looking at the return of the Dow versus DOG for the past 200 days, if the Dow was down by about 25%, I would have expected a 25% gain by buying the DOG. In this case however, it turns out to be a true "DOG" (no offense to dog owners here) wherein it only returned about 7.5% - far less than one would expect.

Let's look at a leveraged ETF by comparison. SDS is the ETF tracking the double inverse of the S&P500 with the stated objective:

"ProShares UltraShort S&P500 seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P500 Index."

As you might have guessed by now, the performance of the leveraged ETF versus the underlying is disappointing. In the same time period of the past 200 days, the S&P500 was down almost 30%. The expectation of the unassuming investor would be to double that return on the positive side by investing in a double inverse ETF. On first glance, I would expect to be up by almost 60%, twice the inverse of the losses of the S&P. Reality however strikes here as well. Instead of a return somewhere closer to 60%, the double inverse ETF had a negative return of about 2%. Are you shocked by now?

How is it possible that there is such a huge discrepancy? If you're mathematically inclined, I can forward an extensive paper by Barclays Capital which examined the dynamics of leveraged and inverse ETFs scientifically. I haven't read this paper in detail but the conclusion states that leveraged and inverse ETFs are not suitable for buy-and-hold investors and that the average investors (most average investors do not read prospectuses) do not understand the point that leveraged/inverse ETFs will not replicate the leveraged index return over periods longer than one day.

To add insult to injury, these leveraged and inverse ETFs also charge higher fees, much higher than one would expect from an ETF just tracking an index. DOG's expense ratio is 0.95% and SDS charges 0.91% in fees. Add the higher cost in terms of taxation and transaction costs associated with the daily trading and you're basically at the level of a typical Mutual Fund.

To sum it all up, read all the disclosures in detail before you delve into any of the more complex ETFs. If in doubt, check with your financial and/or tax advisor if these ETFs make any sense for your personal investment needs. And as always: Know what you're buying!

Continue reading and get a free copy of our weekly newsletter here...

Good luck & good trading!

Neither the information nor any opinion contained in this communication constitutes a solicitation or offer by us to buy or to sell any securities, futures, options or other financial instruments or to provide any investment advice or service. Each decision by you to do any investment transactions and each decision whether a particular investment is appropriate or proper for you is an independent decision to be taken by you. In no event should the content of this email be construed as an express or an implied promise, guarantee or implication by or from us that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

No comments: