Felix Salmon

Why the SEC should look at levered ETFs

By Felix Salmon
April 30, 2011

TBT, the ProShares UltraShort 20+ Year US Treasury fund, is an ETF which returns double the daily decline in an index linked to long-dated government bonds. There are 173 million shares of TBT outstanding, which at a price of $35.65 apiece, means that more than $6 billion is tied up in TBT shares. But average daily volume is just 10.7 million shares — which means that the overwhelming majority of TBT shares are not traded on any given day.

The helpful bloggers at Symmetric Info have explained in great detail — here’s Part 1 and Part 2 — why this is bonkers. But suffice to say that no one should ever hold a leveraged ETF overnight. These things are intraday trading vehicles; they’re not medium-term or even short-term investments.

Given how many people are clearly Doing It Wrong when it comes to TBT, I think there’s a strong case for the SEC to step in here and take a very hard look at TBT in particular, and levered ETFs in general. If day-traders want to day-trade using ETFs, that’s fine — and they can bring their own leverage, if they’re so inclined. But ETFs with embedded leverage are clearly being bought by people who aren’t day-traders at all, and who have no business buying these securities. It’s the SEC’s job to protect those people. It should get on the case.

6 comments so far | RSS Comments RSS

They serve a legitimate business purpose.

Suppose you (a) want to bet on the decline of government long-term bonds, and (b) you want to make more than a few per cent if you guess right, and (c) you want to be limited on the downside.

Shorting government bonds is out, because it fails (b) and (c), and also because very few brokerage accounts actually let you short government bonds.

Shorting non-levered ETF’s is slightly better, but it still fails (b) and (c).

Holding non-levered inverse ETF’s meets (c), but fails (b).

The only options remaining are levered inverse ETF’s and options on non-levered ETF’s. I’m not sure if anyone can make a case that levered ETF’s are consistently worse for investors than put options.

Posted by Nameless | Report as abusive

Nameless, I don’t follow why you think your reasons support holding levered ETFs for extended periods. And why is holding an inverse ETF more limited on the downside than shorting the bond yourself? It would be helpful for you to explain more fully.

It seems to me that a put is indeed a better way to make the levered bet you describe. You are still exposed to liquidity demands due to the margin requirements of daily moves, but you do not have to pay -1/2 (k-1) sigma^2 in expectations. From a cumulative P&L perspective, the leverage is applied to the payoff of the terminal distribution, not the drift (except for interest on the margin account, a very minor factor in the current environment.)

Posted by Greycap | Report as abusive

Your argument regarding puts vs. ETFs is reasonable and I don’t want to dispute it. (Not right now, anyway.)

Holding an inverse levered ETF exposes you to a maximum downside of -100%. Shorting the underlying security exposes you to a downside of -inf%. (Of course, if the underlying security is a long-term government bond, nobody seriously expects the yield to go above, say, 20%, and that limits your downside in practice, if not in theory.)

My initial observation was mostly not so much that “levered ETFs should be held overnight”, as much as “levered ETFs are the only tool that will provide a, b, and c, to the widest range of investors, because most of them can’t short bonds, many of them can’t buy options, and some of them can’t trade on margin”.

Posted by Nameless | Report as abusive

I have to disagree that short levered treasury ETFs serve much business purpose at all for most investors.

I think the best way to short bonds is the way referenced in the article that felix links to. The author mentions at the end that the best way to do it, is to short the unlevered bond fund TLT using leverage. That makes sense. It gives you the similar bet as buying TBT, but acts the way you would expect.

Don’t have a margin account to give yourself leverage? If you don’t qualify for one, then you probably shouldn’t be making levered bets anyway and should definitely not be holding levered ETFs past one day.

Now you argue that holding the levered inverse ETF limits your downside, but if you wanted to limit your downside, then just take off some of your position as it goes against you. You don’t need a levered ETF to do that for you by default and expose you to path dependency, without you realizing it!

Posted by nyc8821265882 | Report as abusive

“no one should ever hold a leveraged ETF overnight”

I’d say that’s a BIT of an overstatement. If you are a retail investor, a 2x long S&P 500 ETF is much simpler than say, investing in LEAPs and rolling them over ever year or so, plus you are able to invest in much smaller “bites” with ETFs than you would be with LEAPs.

Or for example, if you are investing from a retirement account, derivatives may not be allowed, while ETFs are.

There is also the case of wanting to invest in a complex index, like a commodity index that may not be possible to invest in directly with any other single instrument.

And what about the tax implications of ETFs vs continued buying and selling of derivatives?

I think leveraged ETFs are a valuable product as long as you understand them.

Posted by dotybj | Report as abusive

“no one should ever hold a leveraged ETF overnight” may not be true. This article http://ddnum.com/articles/leveragedETFs. php says that the above statement is a myth and that leveraged ETFs CAN be held long term. I would add another qualification to that article: PROVIDED THAT THE VOLATILITY OF THE ETF IS LOW ENOUGH it may be held long term. Indexes have relatively lower volatility than other securities so may be good candidates for long term holding in a leveraged form.

Posted by inoddy | Report as abusive

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