ETF Daily Compounding

First read - On The SRS.

Here's the salient point Funny Circus Bears made in the comment thread:

CN, these levered etf's are such an enormously bad proxy over time for the markets they purport to mimick that they are only good for day trading - and they ARE very good for day trades.

Just look at the SRS alone: The corresponding long opposite of the SRS is ROUGHLY represented by the IYR, which is down 40% over the last year. That would make one think the SRS would be up ROUGHLY 80% (2x's short) over the same time period. In fact the SRS is DOWN about 40% - That's some slippage!

Now I freely admit that I didn't fully grasp the full, destructive value of the daily compounding of reverse ETFs until a few months ago (when I read about it on a blog). I had been trading them (SRS, SKF, EEV, and TBT) very profitably and really never did full due diligence. What the heck, I have about 1.5 hours a day at my computer because of my two young kids and family priorities.

But it is true, the *slippage* from range bound trading will annihilate long-term holders of the ETFs I mentioned above and our foundering trade/investment in DXO. Just do the math on how much oil would have to rise for that thing to get back to 10. It ain't looking too promising. I will buy more at 1.50 - perhaps doubling my position; but then my exit targets will drop considerably.

However, there is an upside to these *double-shorts*. Compounding is your friend when a security makes a *straight* move. It's not sufficient to just look at *year-long* investments - we must examine the behavior of these ETFs during other time intervals.

The indisputable conclusion from FCB's point is that one would have been sooooo much better shorting the IYR directly - over that period - than utilizing the SRS. I'm sure the savvy Wall Street trading houses even paired the two - short IYR and short SRS as an arbitrage spread. I'm sure there has to be some whacky volatility skew in the SRS options as well.

But let's consider the behavior of the two - IYR and SRS - over the period from 11/5/2008 to 11/21/2008. That is when the SRS defied all of its most bullish proponents' expectations and touched $295 per share. Believe me, I read all the doom and gloom blogs, and no one, NO ONE had a target that high. Most of the dour bastards said to look for $150; and a few threw out $200.



Y'all should check my numbers, but here's what I came up with:

From 11/5 close to 11/21 close, the IYR went down 30%, and SRS rose 66%.

So clearly, the SRS did at least a little better (66% vs. 60%) on a percentage basis than the prospectus advertises. It didn't do that much better, admittedly.

But if we look closer, at the full set of trading opportunities over that period:

From the 11/5 closing prices to 11/21's intraday nadir/apex, the IYR went down 40%, and the SRS rose 127%.

What that means is that when the SRS hit its magical 295.00 plateau, it was up 127% from the 11/5 close. At the same time, the IYR was only down 40% from the 11/5 close. In other words, again we have considerable *outperformance* as the SRS should have tracked only 80% higher at that moment.

So it looks like these ETFs, while flawed horribly in choppy markets, do actually provide a steroidal boost, real leverage, in the rare instances that the underlying cliff dives. In the period I just highlighted, the IYR was down (SRS up) in roughly 9 out of the 12 trading days.

But how good could this compounding really get? Let's do the math on a 9-day-straight decline in the underlying Dow Jones Real Estate Index. The first table shows the theoretical effects on daily 1% drops and the second demonstrates daily 5% drops.



With the 1% daily slides, you can see that after 9 days the SRS only *outperforms* slightly. With the IYR down a cumulative 8.65%, the SRS finished up 19.51% - only a smidge better than the 17.3% one might roughly expect.

But, in the case of a shellacking, in the case that REITs get whacked 5% everyday, for 9 days straight, the results are much more favorable. With the IYR down a cumulative 36.98%, the SRS finished up a whopping 135.79% - a whole lot better than 73.96% a non-prospectus reading, un-Captious investor might expect.

Look at it this way, SRS holders are better off getting gradual, steady declines over time than big single day drops. If the IYR dropped on day one 36.98%, the SRS would only rise from 100.00 to 173.96 - far short of the 235.79 close it would reach after the above hypothetical prolonged slump.

This is what they mean when they say that leveraged inverse ETF holders are betting on *path* as much as direction.

So what have we learned? Does the upside from potential unbroken *trends* make up for the slippage of trendless times?

Probably not.

I do want to add a few more things.

First, though I haven't vetted it completely, I think securities that move with less volatility, e.g. the long bond, I think their inverse, levered ETFs will have less slippage. This would effect TBT and my sizable position in it. Thought I really need to crunch some more numbers to test my hunch.

Secondly, it's not so easy to short the IYR or the entire basket of REITs. Many are *hard-to-borrow*. And while professional traders can easily input basket orders of 82 stocks - small traders either can't, don't know how, or will get killed on commissions. So with that in mind, we might forgive a trader for betting with imperfect proxies.

Third, let the record show that back in September 2008, when the deflecting, scapegoating thugs of Big Government changed the rules in the middle of the game, when they banned *short selling*, if it weren't for my ETF position in SKF, I might have been totally destroyed. At that time, the SKF traded at premium to its NAV because of the short ban. It hung there for quite a while, until shorting was re-permitted.

So the dude who shorted the basket of bank stocks directly took a larger bath from the ban, AND he may have even had his stock *called in* which would have been disastrous. I also had a direct short position in Wells Fargo at the time - rather large to boot. That POS printed up to $44.69 a share (today it's 14.30). I was so beside myself that I couldn't even look at my account; I was scared to death that they called away my stock. Luckily they didn't.

We'll talk some more on this vitally important issue. I regret that I haven't addressed it previously and that it may have led to some piggy-backers losing hard earned dollars.