Leveraged and Short ETFs
Separating Fact from Fiction
Live Webinar
October 6, 2009
13.30‐14.30 BST
14.30‐15.30 CET
Paul Amery, European editor
www.id i n exuniverse.eu
email: pamery@indexuniverse.com
phone: +44 (0)20 8834 1257
Fact or Fiction?
Leveraged and short ETFs should/may be banned
L d everaged and sh t or ETFs are suit bl a e for ri ks y t d ra ers only
Leveraged Leveraged and short ETFs must not be held overnight overnight
It’s better to short using other methods than by ETFs
How does this happen? happen?
Direxion Daily Financial Bull 3* (FAS) ETF NAV ytd† ‐63.25%
Direxion Daily Financial Bear 3* (FAZ) ETF NAV ytd ‐86.77%
R ll usse 1000 Fi i l nancials I dn ex ytd +18 58% +18.58%
3* Russell 1000 Financials Index ytd +55.74%
And this?
db x‐trackers trackers DAX ETF 2008 NAV change ‐40 45% .
db x‐trackers ShortDAX ETF 2008 NAV change +55.32%
31.12.2008‐24.09.2009
History
1993 First leveraged index fund (Rydex Nova)
1994 First inverse fund (Rydex Ursa)
2005 First leveraged leveraged ETFs (XACT bull, bear, 1 5. ) *
2006 First European leveraged ETF (LevDAX)
2006 First leveraged ETFs in US (Proshares 2*)
2007 Fi t rs d il a y sh t or ETF in Europe (db x‐tk) rac ers)
2008 Direxion (US) launches 3* leveraged ETFs
2009 FINRA (US regulator) warns on leveraged, inverse ETFs
US and Europe
US Europe
# L d everaged ETFs 46 17
AUM($bn)/% of market 10.4 (1.7%) 1.1 (0.6%)
# Leveraged Short ETFs 52 9
AUM($bn)/% of market 15.2 (2.5%) 1.1 (0.6%)
# Short ETFs 11 31
AUM($bn)/% of market 2.3 (0.4%) 2.7 (1.4%)
Source: Source: Barclays Barclays Global Investors Investors, ETF Landscape Landscape, Deutsche Deutsche Bank ETF Liquidity Liquidity Trends, 24 09 09 24.09.09,
excludes ETCs in Europe
European Providers
ETF Issuer #Leveraged
ETFs
#Leveraged
Short ETFs
#Short ETFs Total Funds Total AUM
(€m)
db x‐trackers ‐ ‐ 22 22 2171
Lyxor/SGAM 7 2 4 13 1204
ETF S iti ecurities 4 4 ‐ 8 53
CASAM 4 ‐ 5 9 69
XACT 2 2 ‐ 4 531
EasyETF ‐ 3 ‐ 3 22
Source: Index Publications, Deutsche Bank, as at 24.09.09. Excl du es ETCs.
European European Equity ETF Turnover Turnover by index type
Week Ending 14.09.09
Country
24% World Country
11%
ee d g .09.09
Sector
6%
Style (incl.
Regional Leveraged,
short)
31%
Regional
28%
S D t h B k ETF li idit t d 16 S t b 2009 Source: Deutsche Bank ETF liquidity trends, 16 September 2009
European European Investor Investor Flows Favour Short ETFs
12 month cumulative net new assets (€m, to 7/09)
Short
Leveraged
0 200 400 600 800 1,000 1,200
S iSh ETP t d d Source: iShares ETP trends, end-J l 2009 July 2009
How do Short ETFs Work?
In erse Inverse Performance Performance of
Total Return index
Incorporated in the Index
calculation
Performance of
D il Sh t ETF
2 x overnight money
market rate
(interest term)* *increases when leverage is
introduced
Daily Short ETF
Management fee
Cost of borrowing to go
short**
**an unknown variable. For
the CAC40 Short Index,
included in the calculation
How do Leveraged Leveraged ETFs Work?
Leveraged performance
of total return index
Performance of
Daily Leveraged
Cost of financing for
borrowed investment
capital to produce
incorporated in the index
calculation
y g
ETF
Management fee
capital to produce
leverage** **increases with leverage
factor
Management fee
The Index Calculation
⎥⎥⎤ ⎢⎢⎡ ⎟⎞ ⎜⎛ 1 1 ( 1) t Eonia T L d In d ex L Id L Id L
⎥⎥⎥⎦ ⎢⎢⎢⎣ − − ⋅ ⋅ ⎟⎟⎠⎞ ⎜⎜⎝⎛ = ⋅ + ⋅ − 1 4 2 44 4 3 44 1 4 2 44 4 3 44 Finanace / Interrest T erm LeverageT e rm 360 1 1 ( 1) T Tt t T Eonia L d In de x In d ex Le v In de x Le vIn dex L
t
L
LevIndex
Index
Time of caclulatio ns
Leverage Factor
Leveraged Index
Underlying Index
=
=
=
= The leverage term measures the inverse or leveraged
return on the benchmark index over a given period
L is the leverage factor (e.g. ‐1, ‐2, 2, 3)
d t T
T t
Number of business days between and
Last trading day from
=
=
The interest term represents the interest income from
selling the basket in case of a short index
In case of a leveraged long index the finance term
describes the cost of leveraging the index performance
The leverage term is restored daily to the original lever
(e.g. ‐1, ‐2, 2, 3)
Index Tracking
Deviation from the
index performance is
attributable to:
• TER of 0.5% p.a.
• Borrowing fees
which depend on
market conditions,
roughly 0 5. % p a. .
S D t h B k 30 07 2009 Source: Deutsche Bank, 30.07.2009
The Effect of Compounding Compounding
The returns of a 2*daily leveraged long index will not be two
times the returns of the corresponding long i dn ex for peri do s
longer than one day
Start Day 1 Day 2 2 day return
Long Index 100 110 (+10%) 104.5 (‐5%) +4.5%
2* daily
leveraged long
100 120 (+20%) 108 (‐10%) +8%
Index
Trending markets…
Steadily rising market
Day 1 2 3 4 5 C l ti umulative change
Daily change 2% 2% 2% 2%
Long Index 100 102.00 104.04 106.12 108.24 8.24%
(+4%) (+4%) (+4%) (+4%)
Daily Leveraged Long Index 100
( )
104.00
( )
108.16
( )
112.49
( )
116.99 16.99%
Steadily falling market
Day 1 2 3 4 5 Cumulative change
Daily change ‐2% ‐2% ‐2% ‐2%
Long Index 100 98.00 96.04 94.12 92.24 ‐7.76%
Daily Leveraged Long Index 100
(‐4%)
96.00
(‐4%)
92.16
(‐4%)
88.47
(‐4%)
84.93 ‐15.07%
And volatile ones…
Day 1 2 3 4 5 Cumulative change
Daily change 11% ‐12% 14% ‐10%
Long Index 100 111.00 97.68 111.36 100.22 0.22%
Daily Long Leveraged Index 100 122.00 92.72 118.68 94.95 ‐5.05%
Simulating the volatility volatility effect
S D t hB k Source: Deutsche Bank
Simulating the volatility volatility effect
S D t hB k Source: Deutsche Bank
Simulation Results
Volatility Index returns LevIndex 2 Returns
10% 7.15% 12.95%
20% 7.09% 10.64%
30% 7 02% . 6 98% .
40% 6.96% 2.11%
50% 6.89% ‐3.79%
60% 6.82% ‐10.53%
Simulation assumption: index follows a geometric diffusion process of the form Index Index ( t Z t ) Δ t = 0 ⋅ exp μ ⋅ Δ + σ Δ
Expected return: 15%, EONIA constant at 1%, No. of trading days in simulations 252
S D t hB k Source: Deutsche Bank
Conclusions
The return on leveraged ETFs is path‐dependent
What matters is not just the period index return but how
you get there
The greater the leverage factor the greater the likely
divergence
The greater the index volatility the greater the likely
divergence
Some Actual Results Results For Short (‐1 ) * ETFs
YTD performance of selected db x‐trackers long/short ETFs
ETF [A] Long fund
return ytd† (%)
[B] Short fund
return ytd† (%)
[A+B]/2
return ytd† (%) return ytd† (%)
iBoxx Euro Sovereigns €zone TR +4.06 ‐3.13 0.46
iTraxx Eur. Sub. Financials 5y TR +6.45 ‐6.55 ‐0.05
CAC 40 +17.40 ‐22.72 ‐2.66
DJ Euro Stoxx 50 +17.41 ‐22.07 ‐2.33
DJ Stoxx 600 Banks +59.61 ‐48.49 +5.56
DJ Stoxx 600 Health Care +7.61 ‐8.51 ‐0.45
† NAV change 31.12.09‐24.09.09 (Source: db x‐track ) ers
Some Actual Results For Leveraged ( , 2* ‐2*) ETFs
YTD performance of selected US ETFs/indices
ETF [A] Long fund [B] Short fund [A+B]/2
return ytd† (%) return ytd† (%)
ProShares Ultra Financials ‐5.97 ‐74.58 ‐40.27
ProShares Ultra S&P 500 +27.90 ‐41.77 ‐6.94
ProShares Ultra Consumer Gds. +25.59 ‐32.82 ‐3.62
Benchmark [C] Index return 2* [C] (%) ‐2* [C] (%)
ytd† (%)
DJ US Financials Index +13.81 +27.62 ‐27.62
S&P 500 +15.62 +31.24 ‐31.24
† Price change 02.01.09‐25.09.09
DJ US Consumer Goods Index +12.56 +25.12 ‐25.12
S G l Fi Source: Google Finance
Hedging Hedging with Short (‐1 ) * Indices Indices in History History
Historic Stress Test DAX vol.
(p.a., %)
DAX (%)
[A]
ShortDAX
(%) [B]
Hedged
(p , ) [ ] ( ) [ ] Rtn. ( ) %
[A+B]/2
2003 (second Iraq war) 46.5 ‐36.1 34.8 ‐0.7
2008/9 credit crunch 42.6 ‐59.9 70.7 5.4
1998 Russia default/LTCM 35.3 ‐24.4 22.2 ‐1.1
2001 9/11 crisis 33.4 29.5 ‐33.3 ‐1.9
1990 Gulf war 30.4 ‐35.9 54.1 9.1
1999 Brazil currency crisis 30.2 ‐7.1 4.5 ‐1.3
1997 Asian currency crisis 29.8 9.8 ‐11.6 ‐0.9
1990 US recession 29.2 ‐24.2 40.3 8.0
2001 US recession 28.3 ‐25.3 30.7 2.7
Source: Deutsche Boerse analysis
Portfolio Uses Of Short ETFs
For example:
• Switch between long/short ETFs at given volatility
levels
• Use short ETFs to hedge long exposure
• Take outright short views in long/short portfolio
• Use as trading tool
Short ETFs vs. Short Selling Selling
Pros of short ETFs
• Allow shorting for broad range of investors
• Maximum loss limited to initial investment
• No margin requirements
• UCITS 3 fund compliance
• ETF short‐selling market underdeveloped in Europe
• A id vo onerous sh t or sale di l sc osure requi t remen s
Cons of short ETFs
• Only short sale generates “true” short return
• Borrowing/finance costs explicit in short sale
• Index drift over long term
Further Ways to Gain Short/ g Leveraged Exposure
Futures
• Very liquid but p y ossibly limited choice
• Active margining required
Options
• Option buying limits risk
• Time decay problem
• Expensive when most needed
CFDs/ d sprea betting
• Popular in UK and tax‐advantaged
• Rollover costs significant
• Counterparty risk
Fact or Fiction?
Leveraged and short ETFs should/ y ma be banned
Unlikely, though keep an eye on regulation
Leveraged Leveraged and short ETFs are suitable suitable for risky traders traders only
No, they are a useful tool in managing portfolios
Leveraged Leveraged and short ETFs must not be held overnight overnight
Depends on leverage factor/underlying index volatility
It’s better to short using other methods than by ETFs
Depends on investor category/restrictions
Panel Discussion
Manooj Mistry
db x‐trackers
Konrad Sippel
Deutsche Boerse
• Heads ETF Structuring and UK • Heads index development & sales,
operation, db x‐trackers
• Developed LDRS, first European
ETF h t M ill L h
p ,
Deutsche Boerse
• Responsible for calculation of
ETFs, when at Merrill Lynch Sh tDAX L DAX i di
• Economics and Finance graduate,
Brunel University
ShortDAX, LevDAX indices
• BSc Mathematics (London
University), MBA (Duke Univ.)
