I’ve been tossing this idea around on a few other blogs in passing so I thought I might as well post the mechanics and explanation of it here. First some background info to make sure we’re all on the same page:
Flat Market – also could be called a sideways market. Normally the definition is a market in which prices change little, so I threw in an added caveat: a volatile flat market. This would imply prices change quite a bit from day to day, but overall the prices are relatively flat over longer periods of time (i.e. the market goes up for a stretch, down for the next, up again, down again, etc.).
Leveraged ETFs – These are Exchange Traded Funds that track an index with built in leverage. The most popular have a 200% daily exposure to the market. If the index went up 1%, the 200% leveraged ETF would go up 2%. Leveraged ETFs normally come in two flavours: Bull and Bear (or regular and inverse). The “bear” or “inverse” leveraged ETF will provide leveraged exposure in the opposite direction of the index. So if the index GOES UP 1%, you would LOSE 2% with a 200% bear etf.
The problem with leveraged ETFs is that most people don’t understand how they work. I’ll cut to the chase (but you can read here for more detailed info). The initial 200% exposure (or whatever the case may be according to the fund’s mandate) is based on tracking the daily movement of the index. It falls apart when you hold it for longer periods of time (in terms of providing a 200% constant exposure). Here’s a basic example of how this would work:
Let’s say your ETF is trading at $100.00/share and it is a 200% leveraged bull ETF. Your index goes up 10% on the first day, therefore your ETF goes up 20%. The ETF now trades at $120.00/share. Let’s say the next day the index goes down 10%, therefore your ETF goes down 20% again as well. EXCEPT this time 20% is of $120.00/share which is $24.00/share, leaving you with $96.00/share.
Think about this: the index was down 1% over the two days, yet your ETF has lost 4%.
If you want more proof as to how holding leveraged ETFs can be a losing proposition in volatile markets, look no further than the calendar year performance for 2008 of Horizon BetaPro’s Global Gold Bull+ AND Global Gold Bear+ ETFs: -44.56% and -84.47%, respectively. This is not a knock on Horizon BetaPro – their products do what they are supposed to do brilliantly.
In any case, if you had shorted either of those Bull or Bear 200% leveraged ETFs, you would’ve been a very happy camper. In a sideways market with even modest volatility, the bull and bear leveraged ETFs’ values will slowly erode. Therefore, if you short them you could make money in a flat or sideways market.
According to Horizons BetaPro (according to a report by Morningstar Canada), if an index was flat over a year with 25% volatility then you would lose 6.1% (before fees), 50% volatility would incur a loss of 22.1% (before fees). Once you further subtract fees, it only looks better for the leveraged ETF short seller.
To make money holding leveraged ETFs you have to be right both in the direction and the path of the underlying index. I’m not saying you should go out and short these things, what sound good in theory may not work in practice, and remember 2008 and 2009 are turning out to be quite anomalous years.
I’ve set up a simulated account and am experimenting with shorting some 3x leveraged Direxion ETFs, I’ll keep you posted on what happens (in a semi-live environment). Once I’ve seen the results I’m going to put some real money into it in my own discount brokerage account and report my findings over time. Should be educational at the very least! :)
Effing brilliant!
Cool idea.
One nit pick with the example. If the market gains 10% one day and loses 10% the next, then it’s actually down 1%. For example, if it was 10,000 and gained 10% it would be at 11,000; then if it lost 10% it would be down to 9,900.
However, your point is still valid: the market lost 1%, while the supposedly 2x-leveraged ETF lost 4%.
@Patrick – Thanks! Post amended with credit.
I looked at a couple of leveraged ETFs and found that they seem to have a leak even beyond the volatility losses: link
I’ve seen this idea tossed around quite a bit for a number of months now.
I think there are practical difficulties in implementing it. For example, finding a brokerage that will lend you the ETFs at a reasonable cost.
I think it’s sort of a risky arbitrage play to try this strategy. The value of the BetaPro product has always been to hedge portfolio risk. In particular they are great for business portfolios to hedge commodity price risk. For example, there are actually some commercial farmers loading up the oil ETF to lock the amount the spend on oil.
As money making strategy these things add a lot of risk – especially if your shorting – that’s where you bring in potential margin calls and liquidity issues if there is a sustained rally in the sector your shorting.
Just wanted to clarify my earlier posting was not a criticism of your post, Preet. I think it’s an excellent analysis and clearly articulates what’s not been communicated well by a lot of people.
@Ink – no worries, you always raise great points. My discount broker will allow me to short these at prime + 1.5% (so 3.75% currently). Could I reduce that (in my head by the 1.15% management fee of the underlying ETF)? Also, you are right about it being risky – it’s still leveraged, and you still need to win on direction (net flat) and path (the more volatile the better) – either is hard enough on it’s own to predict.
@Michael James – great analysis, I encourage others to visit (see the link in his comment above)
Preet, I have mentioned this idea on Financial Webring Forum before, but I heard that HBP ETFs are simply not available for shorting at some discount brokers (e.g. you place the order and it’s rejected). Can you verify if you or someone you know has actually managed to short them?
@Charles in Vancouver – Check this link out, and navigate around: I did a query on HXU on interactive brokers
They also provide inventory (it was 85,000 when I checked), so yes it can be done – although I have not done it myself (yet!).
I’ve heard to help combat some of the leak, you are best to short the opposite position to which you think the market will go.
Let’s say you think the market will be up over the next 2 years. Instead of buying a 2x bull version of whatever indices, you short the 2x bear version. The leakage works more in your favour.
I looked at some charts for the bull/bear component and it definitely shows a difference over time and that difference widens as time marches on.
Preet,
Love your blog and I read it often. Just a quick question, is there a special tax treatment on the capital gains of these leveraged ETFs (bull or bear) in Canada? I read somewhere that this is the case in the US.
@Shaynepathum: I’m including some info from the prospectus from Horizons BetaPro below. My (non-tax professional) take on this is that you will be able to claim capital gains and losses just as with stocks when you sell them, BUT the tax structure within the ETFs (which are currently treated as mutual fund trusts) could be challenged and the fund itself could have a greater tax drag within the fund (ultimately reducing the investors after tax return). Best to check with an accountant for a professional opinion. My guess is even they won’t have a definitive answer on the internal tax treatment.
***
Tax Risk
In determining its income for tax purposes, each ETF will treat gains or losses on the disposition of securities in its
Common Share Portfolio under its Initial Forward Documents as capital gains and losses. The CRA’s practice is not
to grant advance income tax rulings on the characterization of items as capital gains or income and no advance
income tax ruling has been requested or obtained.
If, contrary to the advice of counsel to the ETFs or as a result of a change of law, upon physical settlement of the
Initial Forward Documents the character and timing of the gain under the Initial Forward Documents were other
than a capital gain on the sale of the securities thereunder, after-tax returns to Unitholders could be reduced.
It is anticipated that each ETF will qualify at all times as a “mutual fund trust” within the meaning of the Tax Act.
For an ETF to qualify as a “mutual fund trust,” it must comply on a continuous basis with certain requirements
relating to the qualification of its Units for distribution to the public, the number of Unitholders of the ETF and the
dispersal of ownership of its Units. Each ETF has or intends to make an election in its first tax return so that it will
qualify under the Tax Act as a mutual fund trust from the commencement of its first taxation year. In the event an
ETF were not to qualify as a mutual fund trust under the Tax Act at all times, there may be adverse tax
consequences to Unitholders.
Currently, a trust will be deemed not to be a mutual fund trust if it is established or maintained primarily for the
benefit of non-residents unless, at that time, all or substantially all of its property is property other than “taxable
Canadian property” as defined in the Tax Act. The “at that time” requirement was added to the Tax Act in 2007.
Tax Amendments released on September 16, 2004 propose that a trust would cease to qualify as a mutual fund trust
for purposes of the Tax Act if, at any time after 2004, the fair market value of all units held by non-residents or
partnerships which are not Canadian partnerships for the purpose of the Tax Act is more than 50% of the fair market
value of all issued and outstanding units unless no more than 10% (based on fair market value) of the trust’s
property is at any time taxable Canadian property within the meaning of the Tax Act and certain other types of
specified property. It is not clear whether the 2007 amendment noted above supersedes the Tax Amendments
released on September 16, 2004.
– 33 –
If an ETF were to cease to qualify as a mutual fund trust, the income tax considerations as described under “Income
Tax Considerations” would in some respects be materially different. Neither current law nor the Tax Amendments
provide any means of rectifying a loss of mutual fund trust status.
Provided an ETF complies with its investment restrictions set forth under the heading “Investment Restrictions and
Practices”, no more than 10% of the fair market value of that ETF’s assets will at any time consist of taxable
Canadian property and such other specified property. As each ETF intends to continue to meet all other
requirements necessary to maintain its status as a mutual fund trust, the Manager does not anticipate that under
current law or these Tax Amendments (if enacted as proposed) any ETF would lose its mutual fund trust status.
There can be no assurance that Canadian federal and provincial income tax laws respecting the treatment of mutual
fund trusts will not be changed in a manner that adversely affects the Unitholders of an ETF.
The Tax Act contains rules concerning the taxation of publicly traded Canadian trusts and partnerships that own
certain types of property defined as “non-portfolio property.” A trust that is subject to these rules is subject to trust
level taxation, at rates comparable to those that apply to corporations, on the trust’s income earned from “nonportfolio
property” to the extent that such income is distributed to its unitholders. These rules should not impose any
tax on the ETFs since the ETFs are not expected to have any income from “non-portfolio property.” If these rules
apply to the ETFs, the after-tax return to Unitholders could be reduced, particularly in the case of a Unitholder who
is exempt from tax under the Tax Act or is a non-resident of Canada.
On October 31, 2003, the Department of Finance announced a Tax Amendment relating to the deductibility of losses
under the Tax Act. Under this Tax Amendment, a taxpayer will be considered to have a loss from a business or
property for a taxation year only if, in that year, it is reasonable to assume that the taxpayer will realize a cumulative
profit from the business or property during the time that the taxpayer has carried on, or can reasonably be expected
to carry on, the business or has held, or can reasonably be expected to hold, the property. Profit, for this purpose,
does not include capital gains or capital losses. On February 23, 2005, the Minister of Finance (Canada) announced
that a more modest legislative initiative to replace the Tax Amendment of October 31, 2003 would be released. No
such legislative proposal has publicly been released to date. If such legislative proposal were to apply to deny
deductions that would otherwise reduce an ETF’s taxable income, after-tax returns to Unitholders would be reduced
as a result.
Why do brokers charge you when you short? They receive the money for the sale and don’t pay you the interest they earn on the receipts!
@rosestan – this is because for you to short, you have to sell shares you don’t own. They have to come from somewhere, and they usually come from your broker’s inventory. You are essentially borrowing the shares from your brokerage in order to sell them to someone, and with all borrowing comes interest. You pay back the “loan” of shares when you eventually cover your short (by buying shares and closing your position). Hope that helps…
Excellent, brilliant
Preet, are you sure that investors are always charged a fee for selling short, or is that just the rule in Canada? In the US, I was under the impression that most brokerages only charge a fee on top of any application margin fees and the standard trading commission if the equity being sold short was so hard to find that the broker had to borrow from a different brokerage firm. Feel free to correct me if I am wrong.
@Jim – it depends on the broker. Shorting securities will always require the commission to sell, and interest charged on the value of securities on loan. The Hard-to-borrow fees varies from nothing to “a lot”. The HTB fee may or may not be due to having to source securities from another brokerage so much as the general liquidity of the underlying security. My guess is that it is just arbitrarily assigned, as these fees are egregious.
Good luck trying to find a pair of 3x ETFs to short sell. I don’t get how a stocks trading at such volume lack shares to short. Total joke.
Scottrade let me short TYD. There were two other leveraged bond funds that were not available. Maybe the shares are not available to short because someone got there before you.