ETF Decay

With the recent newly introduced volatility into the stock market, interest has spiked in ETFs. Not only has there been a huge increase in popularity in ETFs but even more so in the leveraged ETFs. With the 2x (SKF and SRS), and now, even 3x leveraged ETF's (FAS and FAZ), there are new opportunities for enormous volatile swings all in one day. Many penny stock day-traders have moved to the NYSE to trade these funds, as recent volume has been record high.

However, there are risks to playing these leveraged ETFs. First of all, they are momentum based funds. This means that you get better performance the higher the VIX levels are. As time has gone, a realized etf decay has shown up in these funds. Due to the leveraged factor of the funds, and that the funds are leveraged either at 2x or 3x interest rates on margin, there is an interest expense involved. Not only that, there is also the managing expense fee that is factored in, which digs into profits as well. By factoring these outside influences into the fund, over time, the price range of the fund slowly traces down.

After enough time, you can find funds trading at much lower levels than they did in times past. For instance, take UYG and SKF. Both are 2x leveraged Financials ETF. In November of 2008, SKF was at $262, with its inverse UYG at $3.74. To date, SKF is currently at $60.30, where its inverse is actually lower than before at $3.40. You would think with the rapid decline of SKF of almost 400% would result in a 400% gain in UYG, putting UYG near the $64 levels. However, due to the decrease in VIX levels as well as this ETF decay, the funds do not follow perfect tracking performance and allows for slippage.

As a result, it is important to play these "leveraged" etfs with caution. These funds will find best performance when VIX levels are high (since at high VIX levels, prices for options are inflated due to the "fear factor") and when holding periods are short. The 3x leveraged funds will experience slippage much quicker and more severe than the 2x. Non-leveraged etfs are almost immune to slippage, but still suffer some slightly due to management expenses.

This is not to discourage traders from trading these funds, instead to encourage to trade with caution. Obviously, best performance will be based on if you can time the bumps at the right time. Be cautious of your holding time, as that 52 week high for that leveraged etf may never be reached again, regardless of sector performance. ETFs can be traded as easily as any other stock with your brokerage firm. If you are without a brokerage firm, check out Zecco.com, as you can get free monthly trades.

6 comments:

  1. Peter T Says:

    The decay you're discussing is purely mathematical and caused by volatility in the underlying asset.

    This is how it works:

    http://www.stretchtarget.se/2009/04/08/how-volatility-deteriorates-your-leveraged-etf-eg-xact-bull-over-time/

    You're writing:

    "Non-leveraged etfs are almost immune to slippage, but still suffer some slightly due to management expenses."

    They are of course "immune" to slippage due to volatility.

  2. SC Says:

    I was thinking about buying long-dated out of the money puts on these leveraged ETFs, seems like a no brainer if the options are not too expensive yet. What do you think of a strategy like this?

  3. QUALITY STOCKS UNDER 5 DOLLARS Says:

    Theirs so many exchange traded funds out their its hard to keep up with them.

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