From the April 2013 issue of Research Magazine • Subscribe!

Tactical Trading With Long/Short ETPs

Day-to-day portfolio management is no longer a simple matter of growing capital or generating more income. It also includes limiting risk, dealing with unexpected shocks, and matching investment strategies with client expectations.

Along these lines, using long/short ETPs can help advisors to manage volatility, reduce risk, and even take advantage of strong directional movements in financial markets.

The long/short ETP universe offers outstanding asset coverage to stocks, bonds, commodities and currencies. Let’s see how these products operate.  

Understanding the Goal

Long/short ETPs come in various flavors. Leveraged products are either 2x or 3x, meaning they aim for 200% or 300% daily leverage to their underlying index. On the other hand, –1x, –2x and –3x products have the goal of daily inverse returns that are 100%, 200% or 300% opposite their benchmark. Since today’s generation of long/short ETPs have daily goals, they are best used as short term trading instruments.

Another important aspect of long/short ETPs is their legal structure. Some products use an ETN wrapping, which exposes their owners to credit risk of the financial issuer. Products that use an ETF structure avoid this risk. 

Regardless of their legal structure, all long/short ETPs that use derivatives are subject to counterparty risk. This can result in losses if the counterparty has difficulty meeting its contractual obligations in the securities transaction. While counterparty losses are generally rare, they are still possible. 

Leverage Pros and Cons

Obtaining magnified exposure to a certain asset class without having to borrow money is one of the primary benefits of leveraged long/short ETPs. Unlike with traditional margin lending, the ETP investor pays no borrowing costs and cannot lose more than was invested. 

Because of their daily goals, all long/short ETPs—even those without leverage—require careful monitoring. They are not buy-and-forget investments.

Let’s analyze three market scenarios and how leveraged ETFs would typically react:

Steadily rising markets. If the underlying index moves in a linear trend favorable to the leveraged ETF (up for a bull fund, down for a bear fund), the fund’s actual gain may be larger during a given period. Why does this occur? As the fund’s exposure rate increases, market gains are magnified based upon favorable index movements. Likewise, the fund’s assets will rise in response to sharp directional trends. 

Steadily falling markets. What if the benchmark index moves sharply in an unfavorable direction (down for a bull fund, up for a bear fund) to the leveraged ETF? Interestingly, the losses for the fund in a given period might be less than expected. This happens because as unfavorable index moves take place, the fund’s assets decline along with its market exposure. As a result, this process mutes the adverse impact of subsequent index trends not favorable to the fund. 

Flat markets. Perhaps the least ideal case for leveraged ETFs is in trendless markets coupled with high volatility. Over long-periods of time, the negative impact of daily rebalancing is destructive to performance.

Since leveraged ETFs follow a momentum strategy, they respond to market gains by increasing their exposure at the end of each day. Conversely they respond to market losses by decreasing exposure. How can this become a problem? Because a gain leads to increased exposure ahead of a loss, which then leads to decreased exposure in advance of a gain, and so forth. At the end of a given period, the ETF records a loss when it might be expected to have provided a return of zero. 

Short, No Leverage

For advisors who want to obtain inverse market exposure but without leverage, the –1x ETPs are an ideal choice. Can they be held for longer periods of time compared to leveraged short ETPs?

Most single beta inverse (–1x) ETFs still seek a daily goal and must be rebalanced at the end of each trading day. This rebalancing process of single beta causes what’s commonly referred to as compounding. In turn, this compounding can cause the ETP’s performance to differ from the cumulative returns of the benchmark index for periods greater than a day.

However, the volatility levels of the single inverse funds, tends to be less as compared to the leveraged (2x or 3x) products. This translates into less of a compounding effect and therefore makes it more reasonable to hold the funds for somewhat lengthier periods of time. “We would always recommend that users of these, as well the leveraged products, monitor their holdings very regularly in order to fully understand the level of market risk they are exposed to,” counsels Andy O’Rourke, chief marketing officer at Direxion Shares. 

While they may be less volatile than their leveraged cousins, non-leveraged short ETPs still require a hands on approach.

Strategic Plays 

How are financial advisors using long/short ETPs?

“Many users of inverse ETFs do so to hedge a corresponding long position that they would prefer not to sell at any given point in time,” says O’Rourke. “Additionally, the users of these products are firm believers that all markets are bi-directional, particularly in the short-term.”

In the case of fixed income, some advisors believe that we are on the brink of a bubble in the asset class. As a result, they are expecting interest rates to rise and bond prices to fall. In this scenario, bearish bond ETFs like ProShares UltraShort U.S. Treasury 20+ Year ETF (TBT) and the Direxion Shares 20+ Year Treasury Bear 3x Shares (TMV) would be gainers. 

The same principle applies for advisors that want to hedge against a downturn in stock prices. The Direxion Daily Total Stock Market Bear 1x Shares (TOTS) and the ProShares UltraShort S&P 500 (SDS) are designed to increase in value when stock prices fall. As with all long/short ETPs, the ideal time to enter new positions is once the market has confirmed a clear trend.

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