3/6/09

Risky Leveraged ETF Arbitrage Strategy

This post is yet another demonstration of why holding leveraged ETFs for a longer period is not worthwhile. It is also a brief examination of how the less risk averse among us might take advantage of this fact.

I wrote a while back about the dangers of holding leveraged ETFs over the longer term. As everyone should know, these instruments are designed to be used for short term trades. You can see this by looking at any of the leveraged bear ETFs' highs and lows. Even while the market is making new 52 week lows, many bear ETFs are off their highs, some by as much as 50% or more. This is because the longer one holds them, the more likely it is that volatility will kill performance. Morningstar recently summed this up in a two part video series.



So if holding the leveraged ETFs for a long time may not be very profitable, what about selling them? Here is a pretty risky arbitrage strategy that should work as long as the market stays volatile. This one is best left for the gamblers among us.

Sell short the leveraged ETFs in pairs. That is, sell short both the bull and bear ETFs for the same underlying index for the same dollar amount. For example, short $10,000 worth of BGZ and short $10,000 worth of BGU. This position is partially hedged. Since the ETFs essentially mirror one another's movements, as long as the market does not take one direction for too long, the position should be relatively stable. For example, suppose BGU goes up 10%. BGZ should fall 10%. You've neither gained nor lost anything. Any underperformance of the ETFs relative to the underlying index is the short seller's profit.

Take a look at the following most liquid 3x ETF pairs, and their performance since November 19, 2008 (the first date on which it was possible to buy/short both simultaneously).


Large cap stocks: BGZ and BGU.



Energy: ERY and ERX.


Small cap stocks: TNA and TZA.


Since November 19, BGZ is up around 10%. Its counterpart BGU is down close to 50%. Shorting both of these in equal dollar amounts would have produced a gain of around 40%. Since November 19, TNA is down around 50%. Its counterpart TZA is also down (although not nearly as much). Although the ETFs trade in opposite directions, one could have made money on both. The same is true for ERX and ERY from November 19 until March 5th. ERY is down around 10%, while ERX is down over 50%.

I've used various different periods, and for the most part, one ETF in each pair is down more than its counterpart is up. Occasionally, over the very short term (i.e., intra day), both ETFs in a pair were up.

If this seems too good to be true, you are right to be skeptical, for there are plenty of risks.

I say above that the strategy of shorting the bull and bear pairs is mostly hedged. It is not completely hedged. For one thing, although the ETFs trade inversely (e.g., if one goes up 1% the other falls 1%), the movements are inexact. It often happens that one ETF rises more than its counterpart falls, and vice versa. A more important reason that the strategy is not completely hedged is that while the ETFs can go up more than 100%, they cannot go lower than 0. In shorting these ETFs, one's potential losses are unlimited. Consider UYG and SKF, where one would have lost money by shorting both:



One way to guard against this would be to purchase out of the money calls (say 100% out of the money) on each position, but the cost of this insurance would likely make the enterprise not worthwhile.


Other risks include liquidity issues as well as difficulty in borrowing the shares. One's broker may also close out a position at the most inconvenient time.

Although the strategy seems to work well over the medium/longer term, it might be safer and wiser to close out the position as soon as it is possible to realize some predetermined gain, say 5% or more. Close out the position then start one anew. One must watch it like a hawk.

I am not going to try this out myself. I am too scared of short selling (perhaps irrationally so) and like to replicate short strategies with puts. Unfortunately, the puts on these ETFs do not go out past October, the strike prices are too low, and the premiums are too high.


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