So let’s say a year ago you had the bright idea that oil prices were bound to fall, and you wanted to put your money where your mouth was. Being a retail investor with limited access or inclination towards complex strategies, you parked your money in the UltraShort Oil & Gas ETF (DUG) which, “seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Oil & Gas Index.”
How’d you do, smart guy? Not too well, as it turns out. Unless you got out during a short period in October when the index took a big spike, you’re actually down 26.72% over the last year.
For comparison, see here for the ProShares Ultra long (DIG), which is down over 70%. That makes sense.
David Merkel of The Aleph Blog recently explained some of the problems with these leveraged ETFs, noting the likelihood of “slippage” when the funds use complex strategies to synthesize a leveraged position. But when the short energy ETF is down for the year, that’s more than just slippage.
A good explanation is found at SeekingAlpha, which offers several reasons why leveraged ETFs don’t do a good job of tracking the underlying over the long term. Here’s one reason:
Leveraged ETFs’ efficiency goes down with volatility. The problem is even more so with inverse ETFs. Let us say the Dow went from 10K to 8K and back to 10K. An inverse ETF tracking accurately will go up from 100 to 120 (20% gain to equal 20% loss in Dow) and then from 120 to 90 (25% loss because Dow gained 25%). So, from period t1 to t2, the Dow stayed the same, while its inverse ETF fell by 10% from 100 to 90. Repeat the same process x number of times, and you will find the inverse ETFs totally wiped out of the value, while underlying has not moved much. If the Dow goes up to 10000 from 9900 and back to 10000, the inverse would be reasonably accurate. However, we are at a historically high volatility – the highest in the last 20 years. Here is the movement of volatility Index [VIX] over the last 18 years.
Here’s their bottom line:
Inverse and leveraged ETFs are great tools that democratized bear strategies. However it should not be used for anything other than short term trading purposes. And when you use it, understand its risks and don’t be surprised when you find the results are not as promised.
So basically, if you went into the UltraShort Oil & Gas ETF at the beginning of the year, you were misusing the tool. That’s not what it’s meant for. Rather you might use it if you have an idea of where oil stocks will go tomorrow. Such a security may has a legitimate use, but people should understand how these funds do and don’t work.