Sunday, May 10, 2009

SKF and Ultrashort ETFs - Are They That Bad?

It's been a fun month since this blog was started, and I thought it appropriate to look at the namesake of the blog, SKF. SKF is Ultrashort Financial ETF, designed to replicate twice the inverse of the daily performance of the underlying index, Dow Jones US financials index. (Mark the key word: DAILY.)It has been quite popular with investors particularly since last October, although it's been somewhat overshadowed by a triple short financial ETF, FAZ, in the past few months.

Jim Cramer of CNBC Mad Money intensely hates this ETF, calling it an ETF of mass destruction. He doesn't seem to grasp how this ETF works, though, and his anger seems misdirected. He is mad because he thinks the ETF shorts both good banks and bad banks. (Oh boy...)

Here's a better argument against ultrashort (double short and triple short) ETFs from Volatility Decay: A New Kind of Risk, by James Anderson:

"The danger in holding double and triple ETFs has already been discussed in Minyanville, but these horses are nowhere near dead - they definitely need to be beaten again.

"I’ll call ETFs that are leveraged 2 or 3 times in either direction, long or short, LTFs. LTFs have an intrinsic feature never seen before in anything traded on exchanges. I call it “Volatility Decay” which if you do a Google search, it pretty much doesn’t exist, so I think it hasn’t sunk into very many people on The Street. Time decay in stock options is logical and intuitive. Volatility Decay is not and it needs to be fully explained before too many investors get hurt."

He puts up a table of hypothetical double short and triple short ETFs with non-leveraged ETF, and concludes:

"The point is that any and all volatility in any LTF will eventually cause these LTFs to trend to zero. It doesn’t matter whether they're long or short - they'll all go to zero in the long run.

"So, is there a play here? Well, obviously shorting these LTFs is a long-term play, but can you handle the volatility in the short term? As John Maynard Keynes said, “ The market can remain irrational longer than you can remain solvent."

"I'm not advocating any long-term position in any LTF, but the real message is to avoid any LTF position for more than a day or 2. Volatility Decay is a new concept; please be aware of the risk."

As a holder of double and triple short ETFs, I've come to understand "Volatility Decay" concept very well from my own experience. But I don't necessarily agree with his conclusion that you should avoid any such ETF position for more than a day or 2. I held SKF, SDS, FAZ anywhere from 2 weeks to 6 weeks, and I closed them for a tidy profit. The key here, is not so much of a daily volatility but sustained, increasing volatility over time. The reason I got lucky then is because of the time period I was holding these ultrashort ETFs - a sustained down-market with heightened volatility, from October 08 to March 09.

On my other blog (trade blog) I have some charts of these ultrashort ETFs including SKF since last September. Take a look.


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