ETFs - Diversifying, Arbitraging, and Making Money

This post will outline, in-depth, how you can make money shorting two inverse, levered ETFs. I also propose that left unchanged, institutions that issue these ETFs will come under close scrutiny because of an inherent flaw in the compounding mathematics behind which these ETFs track an index. I can almost guarantee that those of you who read through this whole post will understand ETFs on a much deeper level and understand why levered ETFs represent an incredibly uncovered arbitraging opportunity. The breadth of this post will discuss this arbitrage opportunity, which any investor can achieve if he is able to short-sell securities. First, I'll discuss the major benefit of investing in ETFs and why ultimately, unlevered ETFs are here to stay.

Diversification: An ETF is a basket of securities that give you cheap exposure to a certain industry, country, or index. By only paying one commission fee to own a little bit of multiple companies, ETFs provide a cheap method to get broad exposure. Further, through ETFs, investors are able to expose themselves to countries or asset classes that would have been near impossible otherwise. In this sense, ETFs allow investors to diversify their portfolios more efficiently and effectively. However, investors need to be wary of levered ETFs.

Arbitraging: Levered ETFs are those that track 2x or 3x the daily movement of a certain index. For instance, many investors may be familiar with FAS or FAZ, which move 3x that of the Russell 1000 Financials Index on a day-to-day basis. FAS is the inverse of FAZ, meaning when the Russell 1000 Financials move up, FAS moves up three times that and FAZ moves down three times that. When the Russell goes up 2% on a particular day, FAS goes up 6% and FAZ goes down 6%.

Let’s start our analysis by looking at two long-term charts – one of FAS and the other of FAZ.

 And now FAZ...

Notice how in the long-run, both ETFs are lower than their original price when they first hit market. In other words, both are in a downtrend. How could this be if one is the inverse of the other and they should move in opposite directions? The answer lies in a concept called volatility decay. Volatility decay occurs because these levered ETFs track the daily movement of an index, which means the compounding and ultimately the trend in price, differs drastically than the index over time. This video with an ETF analyst describes this volatility decay process very well.

To make money from this phenomenon, you can short both ETFs and profit from the volatility decay. If you’re willing to hold the ETFs long enough, you can reap large gains. I have shorted both the FAS and the FAZ ETFs and have profited greatly, just from the volatility decay. Bearing reverse splits, in the long-run these levered ETFs tend to approach zero. There are a few key risks to be aware of when considering this trade.

1.)  ETFs reach zero faster through more leverage and through more volatility in the markets. A 3x ETF reaches zero faster than a 2x ETF. Further, the more up and downs the market experiences, the faster the ETF reaches zero. A good gauge of how volatile the markets are is to observe the trend in the VIX market. If the VIX market spikes up, this ETF trade becomes very attractive.

2.)  There is a risk that the long ETF more than doubles in value, which could possibly outweigh any gains you’ve made in shorting the short ETF, depending upon the time frame. To offset this, I would consider using leverage in shorting the short ETF.

3.)  There is a risk that the prospectus on these levered ETFs changes and the companies that issue them may decide to track the index in a different manner.

4.)  There is a risk that your broker does not allow you to short both ETFs. I’ve tried shorting a few levered ETFs before with my broker, but I was not allowed to.

All in all, this trade seems incredibly easy and profitable. As long as the markets move up and down, this trade should pan out in the long-run. Of course, I could be missing something and as I wrote on my last post, I should seek out facts and opinions that point this trade towards failing. If anyone sees a flaw in this trade, I’d love to hear your thoughts.

I believe firms will continue to issue ETFs because there is a demand for those who are looking to hedge their risks in the short-run. More importantly, the fees from these ETFs are too huge to ignore. At the very least, I foresee many institutions making the prospectus more clear and understandable in order to protect the investor. I wouldn’t be surprised if the government took a role in regulating these ETFs or establishing some standards of behavior.

Whatever happens, as long as these levered ETFs compound daily, take the ride and profit from the volatility decay.