How To Prevent ETF Decay And Make Leveraged ETF’s Work (SKF)

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July 7, 2009 9:36am ETF BASIC NEWS NYSE:SKF

decayLeveraged 2X and 3X ETF’s seem easy to understand on the outside, but on the inside they are very complex products.  They are meant for daily trading or else you will end up in the decay trap.

I found the following story clip to have some interesting data and thought it would be a useful read.

Jason Ruspini from SeekingAlpha reports “A prime example of the evils of leveraged ETFs is the cumulative performance of the ProShares SKF fund, which tracks double the inverse returns of the Dow Jones U.S. Financials Index. Through July 2nd, the cumulative performance of the SKF since its inception in February 2007 is -33%, despite the underlying index, tracked by the IYF, being down by -63%. This sort of example has lead many to scream that leveraged ETFs “don’t work.”

“While these results aren’t intuitive, this is more-or-less a caveat emptor situation, and there is a rebalancing strategy that will keep the cumulative performance of the SKF near -2x that of the IYF.  First, the divergence is not principally caused by the daily returns of the SKF straying from -2x those of the IYF. Error in daily return replication is not the main issue. The answer is more basic. If you start with $100, make 10% and then lose 10%, you are left with $99. If you make 20% and then lose 19% you are left with than $97.20 even though the sum of your returns was positive. The more volatile the returns are, the more likely it is that you will have a situation where the sum of daily returns is positive but your cumulative return is negative. Higher leverage multipliers will also aggravate this effect,” Ruspini reports.

“Fortunately, this “volatility premium” problem is avoided by periodically rebalancing the position. The necessary adjustment is found by multiplying the original position size by the underlying IYF NAV ratio, divided by the SKF price. The “NAV ratio” is the current IYF price divided by its adjusted price when the trade was initiated. Assuming no daily tracking error, if you initiate a $10000 position in SKF when IYF is at 100 and IYF immediately falls to 90, your 100 share position will be worth $12000. In order to maintain the -2x cumulative return ratio, you now only want 75 shares, or 10000 * (90/100) / 120.,” Ruspini  reports.

Read The Full Article: HERE


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