Use access key #2 to skip to page content.

Understanding ETF decay part 2: leverage reset decay

Recs

26

May 30, 2011 – Comments (2)

In my last post, we took a look at contango and backwardation and how they can affect the performance of an ETF or ETN.  In this one we will take a look at the other way that ETFs can decay over time.  This will focus on the leveraged, resetting ETFs like FAZ, FAS, TZA, TNA, and so forth.  This is actually a fair bit simpler than contango/backwardation. 

Why would these things decay?  Lets take a specific example, TZA.  TZA is designed to move -3x the daily moves in the Russel 2000.  So if the R2K drops 2%, TZA should go up 6% (-2%*(-3))=6%.  Simple enough.

But the key here is that it resets its leverage daily, so as to accurate track daily moves.  To see why this would lead to decay (or could), lets look at this example:

Day   R2K move   TZA move    R2K value   TZA Value

1          -10%          30%             90%          130%

2.           5%            -15%           94.5%        110.5%

3.          -10%         30%             85%           144%

4.         17.7%         -53%           100%          67.7%

So here we have 4 maniac days of wild swings in all directions.  The Russel 2000 wound up exactly back where it started, but TZA would have decayed (from volatility alone) by almost 1/3.  

Now lets take a look at some real world examples:  

Chart from last year of the R2K, TZA, and TNA (the 3x leveraged daily R2k) from April to December.  The Russel was flat in this time, but TNA had dropped almost 10% and TZA had dropped almost 30%.  These drops are due to volatility decay.  Inevery case I have ever looked at, the leveraged bearish ETFs decay at a faster rate than the leveraged bull ETFs, and this different is reasonably consistent over time.  For the purposes of this discussion, it doesn't matter why, but it does bring us to my next point:

The behavior of these things over time doesn't exactly follow simple volatility decay + fees taken out.  There are other factors at play here as well.   The leveraged bear ETFs perform worse than the leveragedbull ETFs.  The primary take-away from this is that, combined with the natural tendency of markets to rise over long periods of time, it is extremely unlikely that buying a leveraged bear ETF such as TZA or FAZ will ever win over a long period of time, like a year or even less.  It is absolutely possible for a leveraged bull ETF to win over even decades.

The flip side of volatility decay:  compounding returns.   As we saw above, this daily resetting of leverage creates significant decay due to day-to-day volatility.  But what if the market moves just one direction?  Then we don't have decay, we have compounding.  Look at this example:

Day   R2K move   TZA move    R2K value   TZA Value

1          -1%          3%           99%          103%

2.           -1%         3%           98%        106%

3.          -1%         3%            97%          109.3%

4.         -1%         3%          96%           112.6%

5.         -1%         3%           95%           116%

....  a drop of 1% every day for 20 days, day 20 shown below

20.       -1%           3%          82%          181%

The Russel dropped 18%, but TZA would have moved up 81% in this simple example (which ignores all factors except volatility decay and compounding).  Because the market moved every day in the same direction, the daily reset actually helped TZA rise much higher than you'd expect.  "anti-decay" if you will, just like backwardation can cause in volatility and commodity ETFs and ETNs.  

 

An important point from history:  If you look at the markets in the fall of 2008 and early 2009, the volatility was unbelievable.  Take a look at this chart on yahoo finance.   

From the inception of FAZ and FAS, BOTH were down at the March 2009 bottoms, despite the fact that financials fell 40% in that time.  Why?  So great was teh volatility that decay overwhelmed the positive force on FAZ's value of dropping prices.  Shorting pairs of leveraged ETFs in that time period was simply a winning game, period.  

Once, over a beer, somewhere far away from my humble midwest town, I sat and listened to some hedge fund managers telling stories about how a couple dozen hedge funds had started to short-sell these things and take advantage of the decay.  Free money, no way they could lose.  

They all blew up in the summer of 2009.  Why?  How?  If they had been patient wouldn't they have been bailed out in time by decay?  No, they simply didn't understand what they were doing and ignored three fundamental realities:

1.  The leveraged bull ETFs decay lessthan the leveraged bear ETFs

2.  The market had dropped almost 60% (more for small caps) and could rally back a long way

3.  Volatility drops substantially in bull markets relative to bear markets, meaning if a market rally ensued, volatility would substantially drop, resulting in a lower rate of decay.

4.  Markets can go up for a long time in a row, causing some compounding to occur.  

Well, all 4 of those materialized and anybody short-selling a pair of leveraged ETFs in early March 2009 and going on vacation, smug in their knowledge that they "couldn't lose", would have come back broke.  Behold:

A chart of march 2009 through April 2010 for the Russel 2000, TNA, and TZA.  

You'd have banked major coin shorting TZA!.  And you'd have gone bankrupt shorting TNA, because the markets made a dramatic move up and TNA went up a whopping 400%.  

And all the hedgies went boom.

 

Summary:  So we have taken a peek at 2 different types of decay that can occur in ETFs and ETNs.  Contango related decay, and leverage-reset decay.  Along the way we've learned some pretty sweet things including the fact that the conditions (contango and volatility) that can cause decay in these things can also reverse and lead to "anti-decay" (backwardation and compounding). 

Which form of decay is more powerful?  Both and neither, it completely depends on market conditions.  While FAS and FAZ were decaying their brains out in the fall of 2008 and early 2009, VXX would have been handsomely rewarding its holders with the fruits of enormous backwardation.  

As the markets calmed a bit, the rate of decay for FAS/FAZ (and others) dropped dramatically, and contango set into VXX as the markets calmed but nobody believed they would sdtay calm for long.  

Along the way USO has had periods of dramatic decay, and also periods of no real decay at all.  

Etc, and so on.  The potential for decay (or "anti-decay") is just another factor investors and traders need to understand before making bets, long or short, on these types of securities.  

From reading about eleventy-billion blogs over the last couple of years, I have come to feel that a whole, whole lot of really smart traders and bloggers and "pros", really don't understand what they are doing, but nonetheless dip their toes into the crimson waters of these securities all the time.

There is terrific money to be made with these things, but taking some time to really understand what you are doing is a good idea.   

2 Comments – Post Your Own

#1) On May 30, 2011 at 1:12 AM, checklist34 (99.71) wrote:

There are several other factors that affect the performance of all of these types of things including interest rates, management fees, and on and on. 

But contango/backwardatio and volatility decay/compounding are the big ones.  

Report this comment
#2) On May 30, 2011 at 10:58 AM, anchak (99.85) wrote:

At least we think along the same lines - :)

 

http://caps.fool.com/Blogs/234n-x-leveraged/132045

Report this comment

Featured Broker Partners


Advertisement