DoubleShortLeveredETFs(Apr10)

8/8/2019 DoubleShortLeveredETFs(Apr10)

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North America Market Commentary 12 April 2010

Portfolio Strategy

ETF StrategyPhil Mackintosh+ 1 212 325 5263

Victor Lin+ 1 617 556 5658 Longer Term Plays on Leveraged ETFs

Leveraged ETFs: Dont Hold Your Beta

Leveraged ETFs Reset DailyIts reasonably well understood by now that levered indexes require an ETF torebalance at the end of each day. Effectively, the ETF is levering new gains(or delevering for losses) from the current trading day. This is important sothat investors buying the funds tomorrow get the correct 2x or 3x beta ontheir trade date (not leverage based on a prior days share price.

In our earlier reports on these ETFs (see Double Trouble & Triple Trouble) weshowed that, for a longer term holder of these ETFs, returns over thecomplete holding period would almost certainly not be 2x or 3x, thanks to thisfrequent releveraging. We also showed that in the underlying indexes, thisreleveraging also happens - automatically!

Via our modeling of potential market return paths, we also highlighted twoimportant factors that longer term investors were exposed to. Since our firstreport, real market events have kindly provided hard evidence of the returncharacteristics of these ETFs. Specifically:

1. Long Momentum

In many instances over the last 12 months, leveraged ETFs have beaten theirbeta. This is because the market has trended higher on decreasing volatility.As a result, we have seen the benefits of positive compounding (levering ordoubling up gains on the returns in the levered ETFs.

Exhibit 1: In the past 12 months, levered ETFs are beating their Beta

1. Buy leveraged ETFs in strong

trending markets: Momentum andcompounding can create returns evengreater than 2 or 3 times theunderlying index

Risk: If the market doesnt trendstrongly in the direction of the ETF,the amount invested may be at risk.

2. Short matching bull and

bear leveraged ETFs in volatile

range bound markets: LeveragedETFs are inherently short gamma soby shorting matching leveraged ETFsone can gain from the volatility drag.

Risk: If the markettrends strongly inone direction, losses can be unlimited.

Key points

The past few years have shown in practicewhat we knew in theory about leveragedETFs that while they deliver on their betaon a daily basis, longer-term performancecan differ due to the effects of momentumand volatility.

Normally best-suited for very short-termtrades, there are also 2 longer-termscenarios in which leveraged ETFs may beworth considering

RETURNS (Mar 8 - Jan20)

Ticker Name Beta Index Index

FAS DIREXION DAILY FIN BULL 3X 3 RGUSFL 72.2%

BGU DIREXION DLY LG CAP BULL 3X 3 RIY 45.6%

SSO PROSHARES ULTRA S&P500 2 SPX 43.8%

QLD PROSHARES ULTRA QQQ 2 NDX 52.3%

SDS PROSHARES ULTRASHORT S&P500 -2 SPX 43.8%

QID PROSHARES QQQ ULTRASHORT -2 NDX 52.3%

FAZ DIREXION DAILY FINL BEAR 3X -3 RGUSFL 72.2%

Beta x Index ETF

216.6% 243.8%

136.7% 186.2%

87.6% 103.8%

104.6% 123.9%

-87.6% -58.8%

-104.6% -62.1%

-216.6% -93.2% Source: Credit Suisse: Portfolio Strategy

Beating Beta:

Even with the market up more than 50%: Double and triple short ETFs still

have positive value. Double and triple long ETFs are at

more than 2x and 3x their entryprices from a year ago
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Portfolio Strategy

This exposure profile is similar to being long momentum. In marketstrending strongly enough, the compounding of the levered index exaggeratesreturns due to the directional consistency of returns.

Momentum & Gamma: a Practical ExampleDespite double long & short Financials both falling in 2008,a short both strategy was actually in losses half-waythrough the year. Highlighting the exposure to momentum(in this case a bearish trending market)

Exhibit 2: Double long & short Financials in 2008

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

Dec-07

Jan-08

Feb-08

M

ar-08

Apr-08

M

ay-

08

Jun-08

Jul-08

Aug-08

Sep-08

PROSHARES ULTRA FINANCIALS

PROSHARES ULTRASHORT FINANCI

Underlying Index

Source: Credit Suisse: Portfolio Strategy

2

Trade Idea: Buy Leveraged ETFs for strong trends

So while holding leveraged ETFs over long time periods can be a riskyproposition, there are opportunities to gain even more than the leveragefactor suggests.

Risks Obviously, the tricky part is predicting when the markets will betrending strongly enough. If they dont trend, there could be significantlosses due to volatility drag (described below).

2. Short GammaThe way the ETFs rebalance, they are always:

Buying at the end of an up-day

Selling at the end of a down day

Even short ETFs need to do this, because on a down day they make gains,which need to be levered (so they need to get shorter). While on an up day,they need to cover loses (buy to reduce shorts).

In volatile markets, this feature can offset the momentum effect decaying

away accumulated returns. And as the markets volatility increases, this dragon performance increases too. In Triple Trouble we showed that this decayincreased exponentially as volatility increased (exhibit 4).

Previous publications have shown that we can approximate the leveraged ETFreturn with the following equation:

( )

2

**)(exp*

22 daysLL = ReRe turnIndexturnLevETF

L

Exhibit 3: When Trend Could Have Benefit 3M Holders of a 3x ETF

Triple Leveraged ETFs and Trend Contribution

0%

10%

20%

30%

40%

50%

60%

3/31/2000 3/31/2002 3/31/2004 3/31/2006 3/31/2008

TrendContributiontoPerform

ance

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

S&P500Level

Trend Adds to Performance

for 3M Holders

S&P 500


xhibit 4: Volatility Drag Increases Exponentially For a

onstant Level of Expected Return

-150%

-100%

-50%

0%

50%

100%

150%

200%

250%

0% 20% 40% 60% 80% 100% 120% 140% 160% 180% 200

Volatility

Realized Return

Volatility Drag

Expected Return

ource: Credit Suisse: Portfolio Strategy

Double Short = profit $100Double Long = loss $60Short both = loss $40

Double Short = loss $2Double Long = loss $70Short both = profit $72
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Portfolio Strategy

Since the exponential (lets call it the volatility drag) approaches 0 as its inputsbecome increasingly negative, we can take away some importantobservations:

Exhibit 5: 3M Log Returns of UYG and Leveraged

Underlying Index

3M Log Returns of UYG and Leveraged Underlying Index

-2

-1.5

-1

-0.5

0

0.5

1

1.5

-2 -1.5 -1 -0.5 0 0.5 1 1

As the leverage factor increases, the volatility drag is magnified and thegreater the index return is needed to offset this effect. Otherwise,

increasing leverage has a larger negative effect.Red line representsBeta Multiplied by3M Index Return

3

Longs and shorts of the same leverage factor have disproportionatesensitivity to volatility. Given the same leverage factor, a short ETF willbe more vulnerable to the volatility drag

Leveraged Index Return

UYGReturn

As volatility (or variance) increases, the greater the volatility drag. Notewhen the index return is 0 (i.e. a range bound market), increasingvolatility deteriorates performance more and more. Essentially, buying aleveraged ETF is a form of selling volatility and vice versa.

As the holding period increases, the volatility drag increases as well.

Once again, we highlight that the ideal scenario for the greatestleveraged return is when volatility is 0 and index returns are high in

other words, a trending market as we discussed earlier.

We illustrate the effect volatility and leverage have on the volatility drag inthe surface charts in exhibits 6 and 7.

Exhibit 6: Increasing Volatility and Increasing Leverage Tend to Detract from Leveraged Returns

0%

8%

16%

24%

32%

40%

48%

1

21

63

126

252

0%

20%

40%

60%

80%

100%

Scalar

Volatility

(Annualized)

Days Held

80%-100%

60%-80%

40%-60%

20%-40%0%-20%

0%

8%

16%

24%

32%

40%

48%

1-1

2-2

3-3

0%

20%

40%

60%

80%

100%

Scalar

Volatility

(Annualized)

Leverage Factor

80%-100%

60%-80%

40%-60%

20%-40%0%-20%


Trade Idea: Short both bull & bear ETFs

Given the volatility decay in leveraged ETFs, one potential wayto profit could be to sell both the long and short leveraged

ETFs on an index. An interesting feature of this strategy isthat the larger realized index volatility is, the less sensitiveprofit is to trend.

Our backtests of the strategy using double leveraged fundssince 2000 (see exhibit 7) showed the greatest profit potentialhistorically when volatility was high and markets relativelyrange bound.

Risks: The largest losses occurred when the markets werestrongly trending in one direction, especially with little volatility.Note that the size of the loss is potentially unlimited.

.5

UYG 3M Returns Below

Line Show Volatility Drag

("Gamma" loss)


Exhibit 7: Theoretical Returns on Double Short Strategy on S&P

500 With a 3M Holding Period Excluding Transaction Costs

Short Strategy (Theoretical Rolling 3 Month P&L)

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

3/31/2000 3/31/2002 3/31/2004 3/31/2006 3/31/2008

StrategyReturn

0%

50%

100%

150%

200%

250%

300%

VIXLevel



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Portfolio Strategy

Deep Dive into a Double Leveraged Short Trade

4

Clearly, this trade is not without substantial risk. So when is the ideal time toput this strategy on?

Weve already established the volatility drag is greatest in a range bound, highvolatility environment. In Exhibit 8, we show the relationship between trend

(index return) and volatility. As realized volatility increases, the more trend canbe offset. For example, if we expect only 15% annualized volatility in theunderlying index, the strategy loses 21% if the index returns 10%. However,if we expect 25% volatility, the strategy returns an estimated 28% for thesame 10% index return. The surface map in Exhibit 8 can provide a roughguide to putting on the trade given return and volatility expectations.

Tail Risk Evident- Plotting the historical strategy returns versus indexvolatility, we find that the return distribution has a long left tail while thestrategy was frequently profitable, there were a few scenarios where it yieldedvery large negative returns. As Exhibits 8 and 9 show, the possibility of asevere loss from a strong trending move in the market is substantial.

Exhibit 8: Estimated Double Short Strategy Return with 3M

Hold

Exhibit 9: Double Short Strategy on 2x S&P 500

Excluding Est. Trans. Costs

-25%

-20%

-15%

-10%

-5% 0

5%

10%

15%

20%

25%

10%

30%

50%

-500%

-400%

-300%

-200%

-100%

0%

100%

200%

300%

400%

StrategyReturnEstimate

Index Return

IndexVolatility

Annualized

Strategy with 3M Holding Period

300%-400%

200%-300%

100%-200%

0%-100%

-100%-0%

-200%--100%

-300%--200%

-400%--300%

-500%--400%

Source: Credit Suisse: Portfolio Strategy Source: Credit Suisse: Portfolio Strategy

Exhibit 10: Short Ultra UltraShort

$-

$20

$40

$60

$80

$100

$120

- 140 280 420 560 700 840 980 1,120 1,260 1,400

Days

SharePrice

UltraShort

Short Ultra


Hard to Borrow?

As we showed in our report ETFs Bounce BackBigger Than Ever(Exhibit 8), most investors holdleveraged ETFs for a very short period of time.

This leads to a short supply in the borrow market,which would normally make it difficult to position forthis trade.

However, Credit Suisse Delta One offers a facilitywhere ETF shares can be created to lend as part ofthe implementation of this trade. Talk to your CSsalesperson for details.

Increasing Volatility

Potential for large

negative returns

High concentration

of positive returns

Trade Costs Can Be High- While the simulations and backtests above weredone excluding financing costs, these costs are subject to market conditionsand may increase, raising the initial hurdle to profitability. For example,borrow costs for leveraged ETFs can easily range up to 4% or moredepending on which ETFs and the current market environment. In lowervolatility environments, these costs can easily outweigh returns. Due to this,using higher leverage ETFs and/or targeting more volatile underlying indicesmay be one method to offset potential costs (see our backtest on the nextpage).

Levered Short Short Levered Long

Simulations and historical performance highlight another feature of theleveraged Index math on ETF returns Ultrashort Short an Ultra. Thepayoffs from these two positions are actually quite different thanks to theimpact of re-leveraging of the ETFs over time (see Exhibit 10).
https://tradeview.csfb.com/edge/Public/Bulletin/Servefile.aspx?FileID=13599&m=1077255411https://tradeview.csfb.com/edge/Public/Bulletin/Servefile.aspx?FileID=13599&m=1077255411https://tradeview.csfb.com/edge/Public/Bulletin/Servefile.aspx?FileID=13599&m=1077255411https://tradeview.csfb.com/edge/Public/Bulletin/Servefile.aspx?FileID=13599&m=1077255411


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Portfolio Strategy

Backtesting with a 3 Month Trade since 2000We looked at the performance of the strategy since 2000 using tripleleveraged ETFs on the Russell 2000. We assumed:

a 4% net cost of borrow (for each ETF)

5

Typical expense/management fees for the ETFs, which are essentially

rebated to short sellers of ETFs a constant 3 month holding period for the sake of comparison (but withtrades initiating on each day)

The results of this backtest are included in the exhibits below. Mostinteresting is that despite being profitable more than 50% of the time, thesharp ratio is still relatively low. This shows the importance of protectingagainst trending markets (perhaps with rebalancing, or the use of options).

Exhibit 12: Double Short Strategy on Triple Leveraged R2 Including Est.

Trans. Costs Since 2007

Double Short Strategy on Russell 2000: Rolling 3M Periods

-160.0%

-140.0%

-120.0%

-100.0%

-80.0%

-60.0%

-40.0%

-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

12/29/06 6/29/07 12/29/07 6/29/08 12/29/08 6/29/09 12/29/09

Return

-100

-80

-60

-40

-20

0

20

40

60

80

VIXLevel

3M Return

R2000 3M Realized

Volatility


A Left Skewed Distribution of ReturnsLooking at the distribution of returns, we found that the strategy returned 0-10% nearly half the time and was profitable in general close to 70% of thetime. However, there is a long left tail so there is a possibility of large losses.

Exhibit 13: Positive Sharpe Ratio (Annualized) Past 3

Years

Exhibit 14: Return is 0 to 10% Nearly Half the Time, But Tail Risk Significant

Return Distribution of Double Short Strategy

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

-50%o

r

greater

-50%t

o-40%

-40%t

o-30%

-30%t

o-20%

-20%t

o-10%

-10%t

o0%

0%t

o10%

10%t

o20%

20%t

o30%

30%t

o40%

40%t

o50%

50%o

rgreater

Return Range (for Rolling 3 Month Holding Period Since 2000)

Frequenc

y

Sharpe Ratio

(1.50)

(1.00)

(0.50)

-

0.50

1.00

1.50

2.00

2.50

2001 2002 2003 2004 2005 2006 2007 2008 2009

Exhibit 11: Trade Results Can Be Volatile (3M Holding

Period, Not Annualized)

-20%

-10%

0%

10%

20%

30%

40%

2001 2002 2003 2004 2005 2006 2007 2008 2009

ReturnStd Dev


Median return of 4% Maximum return of 93% Maximum loss of 151% Sharpe ratio 0.37 (0.77 since 2007)

Average return of 3.4%Overall results




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Portfolio Strategy

6

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USA

Phil Mackintosh +1 212 325 5263 [email protected]

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Portfolio & Derivatives StrategyCredit Suisse
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DoubleShortLeveredETFs(Apr10)

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