Thursday, November 19, 2009

The Wages of Fear

"Beta Slippage" is fairly new to the financial lexicon. It is associated with the effects compounding will do to leveraged ETFs and leveraged mutual funds. I was aware of its attributes and consequences long before I invested in ProShares Ultra Short S&P 500 (SDS), but noted a detailed explanation of it in Robert Prechter's Conquer The Crash. It basically states that because leveraged ETFs are rebalanced daily, you may or may not replicate the performance of the index you are invested in if you hold these instruments for the long haul. I think it is stated best in a ProShares FAQ: "Due to compounding, the return of these funds over longer periods may be more or less than the daily market multiple. Compounding tends to help returns in upward and downward trending markets and tends to reduce returns in volatile markets. The positive and negative effects of compounding are significantly magnified in leveraged funds.".

Here is an example from an article by Michael Iachini from the Schwab Center for Financial Research on a long leveraged ETF: "Consider a hypothetical ETF that promises twice the return on an index. Let's say you buy a share of the ETF for $100 while the underlying index is at 10,000. If the index goes up 10% the next day to 11,000, your ETF should go up 20%, to $120. If the index goes from 11,000 back down to 10,000 the next day, that's a decline of 9.09%, which means the ETF should go down twice as much, or 18.18%. A decline of 18.18% from the $120 price of the ETF should leave it at $98.18. So even though the index ended up right back where it started, the ETF is down 1.82%!". Caveat emptor. Let the buyer beware when investing in leveraged ETFs because you are playing with fire.

As I reflect on the negative returns in this portfolio the past four months, expressions like numb skull, chowder head and lame brain come to mind, but I digress. The objective of this blog is not to track my original investment in the short-term, but over a multi-year period. The market could boomerang any day now causing a seismic shift in investor sentiment. I refuse to pull the plug on my original investments because I've only held them a few months. Many influential analysts are currently bearish on the markets and believe we are in a bubble no matter how optimistic the government is. My belief if that if I were to sell my shares of ProShares Ultra Short S&P 500 (SDS) and go into cash or go long, I'd only be whipsawed when the smoke clears. Housekeeping is not in order at the moment, although in a what have you done for me lately world, it is difficult not to second guess myself.

My last post was a review of the above mentioned book Conquer The Crash and I will continue to review books on this blog as long as they cover the subject of investing and remain within the spirit of the overall milieu of my original premise. In fact, since I am an infrequent trader and not an economist, I will probably be reviewing many investing books here to keep the content fresh and the readers coming back for more. At least that's the plan for now. Next on the docket is Don't Blame The Shorts: Why Short Sellers Are Always Blamed For Market Crashes and How History Is Repeating Itself by Robert Sloan. It will be posted next week.