A friend of mine has a knack of homing in on financial folly like a dowsing rod waved above the Atlantic finds water.

This week he proudly informed me that he’d bought a short ETF.

He hasn’t done so because he’s got too much money and thought the financial services industry deserved a donation, via yet another poorly understood product.

No, he believed that holding a short ETF would help protect his portfolio if we are hit by further bear market declines.

It might sound good in theory – although I’d argue it’s better to think about portfolio protection before the market has already slumped 20% and the crash is mainstream news, and that the best way to reduce your risk is simply to sell – but anyway, the maths of how a short ETF works is rather different to what my friend imagined.

If my friend holds the short ETF the way he planned to, he could lose money even if the market does fall.

Insurance that costs you money when you expect it to pay out is surely even worse than having no insurance!

In this post I’ll explain why my friend was wrong to buy a short ETF to try to insulate his portfolio from a prolonged downturn in the stock market. (Next week we’ll consider what he might have done instead).

What is a short ETF?

A short ETF (also called an inverse ETF) is an Exchange Traded Fund that delivers the opposite of the daily return from its underlying benchmark – often an existing, conventional ETF.

For example, the db X-Tracker FTSE 100 Short Daily ETF from Deutsche Bank (factsheet) delivers the opposite of the return you’d get from the bank’s normal FTSE 100 ETF tracker.

• If the FTSE 100 falls 1% in a day, the short ETF will rise 1%

• If the FTSE 100 rises 1% in a day, the short ETF will fall 1%

You can also get leveraged short ETFs, which usually have 2x or 3x in the title. As the name implies, these ETFs return two or three times the opposite of the daily return of their benchmark.

Short ETFs are synthetic ETFs with the usual risks you’d expect from such securities, such as counterparty risk.

But there’s a more fundamental problem with short ETFs – at least in the way many uninformed buyers aim to use them.

The snag: The only way is not up

The problem arises due to the way that the mathematics of compounding works.

Maths will probably not be on your side with a short ETF should you hold it for more than a day or two.

Over one day, short ETFs do what they say they’ll do on the tin (not that every buyer reads the label). They deliver the opposite of the benchmark’s return.

The trouble comes if you hold a short ETF for more than one day, let alone the weeks or months my friend had planned in order to try to offset any losses from a falling stock market.

Because of the impact of compounding, longer-term returns will be more or less than you’d expect from simply summing the inverse of the daily returns.

The impact is especially noticeable in volatile market conditions. Which is to say most market conditions – shares rarely go up or down in a straight line for long.

Examples of how short ETFs work in practice

This is all pretty counter-intuitive, so let’s illustrate it with a couple of examples.

Let’s say we’re bearish about the FTSE 100, because it’s just broken through the 10,000 level and we think that’s quite enough for now.

We decide to buy £10,000 worth of a short ETF that delivers the inverse of the FTSE 100.

In other words, if the FTSE 100 falls 1% in a day, we’ll gain 1% on our £10,000, and vice versa.

In addition, my friend – let’s call him Harry – decides to go one better, buying a 2x short ETF with his £10,000.

If the market falls 1% in a day, for example, Harry expects to gain 2%.

Example 1: A declining market

We buy our ETFs on Monday. Let’s say we’re even luckier than we deserve given we’re punting on a single day’s return from the FTSE. The market falls 2%.

Here are the returns ¹:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9800	-2.00%	£10,200	£10,400

 

So the index fell 2% and we made £200 on our £10,000 investment. Harry has made £400.

All as expected so far.

Now we get greedy and think the market will keep falling. (Why are we so confident? Perhaps we heard it on CNBC. Those guys are never wrong…)

Let’s say the market falls 2% a day every day for the rest of the week.  That’s five days of 2% declines.

Think we’ll be up 10% at the end of the week? Think again!

Here’s how our returns stand by the end of play Friday:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9800	-2.00%	£10,200	£10,400
9604	-2.00%	£10,404	£10,816
9412	-2.00%	£10,612	£11,249
9224	-2.00%	£10,824	£11,699
9039	-2.00%	£11,041	£12,167
-9.61%		10.41%	21.67%

 

As you can see, the way the compounding works, the FTSE 100 index has declined by a little less than the 10% you might have expected.

Similarly, the short ETFs are both more than 10% ahead. Already we can see the returns aren’t the simple opposite of the underlying index, due to compounding.

Incidentally if the market had actually risen by 2% a day – thwarting our purchase of the short ETF – then this relative performance would have been reversed.

Example 2: A volatile, declining market

Sometimes markets go in one direction for a week or so, but in practice they’re usually more volatile. Two steps forward and one step back is more common, whatever the overall direction of travel.

Here’s how our two short ETFs perform in a bumpier market:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9500	-5.0%	£10,500	£11,000
9975	5.0%	£9,975	£9,900
9476	-5.0%	£10,474	£10,890
9950	5.0%	£9,950	£9,801
9453	-5.0%	£10,448	£10,781
-5.47%		4.48%	7.81%

 

In this example, the index has declined by 5.47%, but the short ETF has only climbed by 4.48%. Meanwhile the 2x short ETF has grown far less than the near-11% gain you might have expected from simply doubling the index’s decline.

All sorts of different outcomes are possible depending on exactly what numbers you plug in. Try creating a spreadsheet and having a play.

Example 3: A volatile yet flat market

Perhaps the most shocking example of how you can come unstuck with a short ETF is when the market is flat over the period, yet you still lose money.

Take a look at this sequence of returns:

Index	Index Change	Short ETF	2x Short ETF
10000		£10,000	£10,000
9000	-10.0%	£11,000	£12,000
9450	5.0%	£10,450	£10,800
9923	5.0%	£9,928	£9,720
9625	-3.0%	£10,225	£10,303
10000	3.9%	£9,827	£9,500
0.00%		-1.73%	-5.00%

 

Here we see that after five very volatile days, the index has ended up exactly where it began.

In contrast, we’ve lost money on the short ETF and Harry has pretty much taken a bath on his 2x leveraged one!

This isn’t because these ETF products don’t work. They are doing what they are meant to do, which is deliver the opposite of the daily return, with knobs on in the case of the 2x short ETF.

It’s all down to the mathematics of compounding.

Short ETFs deviate in the real world, too

This is not a case of odd examples chosen to prove a point. Such behaviour from short ETFs happens very often in the real world, too.

A striking example cited by the FT a while ago involved a double leveraged short ETF based on the FTSE Xinhua China 25 index.

After the Beijing Olympics, this index fell 34% in four months. Yet rather than making a 68% gain, the short ETF delivered a 56% loss!

More mundanely, you may simply find that your long-term holding of a short ETF does go in the right direction, but for the reasons I’ve cited it turns out to not be enough to offset the declines you’re trying to guard against.

For instance, between 1 April 2015 and now the FTSE 100 has declined by nearly 12%, but the DB X-Trackers DBX FTSE 100 Daily Short ETF (Ticker: XUKS) has only risen by 7%.

So much for protecting your portfolio.

Again, I stress that’s not to say these products are doing anything wrong – rather they are doing what they are meant to do, which is offering inverse correlation to the index on a daily basis, in this case to the FTSE 100.

But if you buy and hold them as longer-term portfolio protectors, then you are doing something wrong, though exactly what result you’ll get – good or ill – will depend on the lottery of volatility over the period.

Note too that there may be other reasons for deviations with short ETFs, involving costs, taxes, dividends, and also financing charges in the case of leveraged ETFs.

The compounding effect is the most important one though, and reason enough for everyone but day traders to avoid these ETFs entirely!

(And you already know that you should avoid being a day trader…)

Further reading on short ETFs:

• ETF Securities has a comprehensive PDF about short and leveraged ETFs.

• The US Securities and Exchange Commission has issued a warning about short ETFs.

• Here’s some better ways to protect your portfolio.

1. For simplicity, I’m obviously ignoring the TER cost of the ETFs in all these examples.[↩]

I have decided to reverse my usual policy of looking at my portfolio about as often as Dracula out the window on a sunny day. Why? Because while we’re being roughed up I might as well discover a few home truths about my risk tolerance.

How big a beating can I take?

I don’t think I know.

Sure, I’ve done some tests. According to Finametrica’s industry-standard metrics, I’m quite the risk jockey – in the top 2% when it comes to laughing in the face of volatility.

But, but, but… the only test that counts is real life.

How do I feel when the numbers are actually streaming red down the screen? As they are right now – we touched bear market territory last week. A true test of nerve as the FTSE veered 20% below last April’s highs.

Obviously 2008 was bigger. The FTSE buckled by 31% then.

But I had a lot less to lose in those days. I got a statement at the end of the year and everything looked shot to hell, but it didn’t seem to matter much.

I was more worried about my job. Retirement was a faraway land – a 30-year pipe dream, minimum.

In skin-in-the-game terms, I chafed my pinky in 2008.

But now I could lose an arm and a leg.

It’s a test designed to provoke an emotional response

So I’m staring my numbers straight in the face.

And it’s weird.

Somehow, when I wasn’t really looking, my portfolio crossed a threshold. It grew up.

Now a day or two’s volatility can wipe off thousands from my name. Look again and the thousands are back. (Some of them, anyway.)

Wipe on, wipe off.

It’s like watching time-lapse photography of a watering hole. It shrinks in baking tropical sun. It’s replenished by the rains. It expands, it contracts, it expands, it contracts, at unreal speed. The only thing missing is a cameo by a curious water buffalo.

If that sort of money disappeared from my bank account I’d phone the Police.

I’d be on my knees sobbing, “It’s gone, Lord help me, it’s gone.”

If I won it back on a gameshow I’d be dancing like Topol.

But when money is dangled and whipped away faster than a card sharp playing Follow The Lady, it doesn’t seem to matter. It isn’t real, even though it is.

My emotions are caged. My pulse low. No sweat prickles my brow.

Why, why, why?

Is the risk tolerance test accurate? How much rougher does the sea have to get before I feel out of my depth?

That’s why I keep looking at my numbers. It’s a staring contest between me and the market.

I want to know how much wealth I can watch evaporate and not blink.

When I hit my limit, I want my withdrawal to safer ground to be orderly and gradual. Otherwise, I could risk years of gains.

Early warning

Some clues that you’re nearing the limit:

• Feeling down, queasy, or panicked by the decline.

• Not sleeping well.

• Not able to rebalance into the teeth of the storm.

That last one is the best friend you’ve got, because who wants to live with the first two?

If it’s too scary to rebalance into the losers now then how would you feel if losses ramped up to -30%, -40% and beyond?

Dialing back your equity allocation and upping government bonds will reduce your exposure – but do it gradually in the coming months and years.

Not in a panic when equities are on sale.

To give you a sense of what carnage looks like, the biggest real terms stock market drop in UK history was -71% between 1973 and 1974.

It took the market ten years to return to its previous level. If you were accumulating equities on the cheap in the meantime then your portfolio recovered much earlier.

But if you were selling off then it took much longer. Possibly never.

For me, education is the best armour. Knowing that crashes are normal makes it easier to shrug off bad times.

The Irrelevant Investor has posted some brilliant stats about double digit declines in the US. We don’t have those figures for the UK but they’re likely to be in the same ball park.

• 64% of all years experienced double digit declines.

• 36% of all double-digit decline years ended positive.

There’s an even starker chart from Larry Swedroe that shows how often the US goes into the red even when the year ends in the black.

(Spoiler – all the freaking time.)

So we’re down a fair chunk. This is normal. Equities across the globe are now cheaper and that raises the prospects for future expected returns. If you’re still accumulating then this is good news.

The rewards of investing come to those who can take the pain when the world mood darkens. Many people can’t. That’s why they fold and sell out at lower and lower prices.

Do that and the spoils go to the winners who scoop up those unwanted assets and sell only much later when the fearful have returned, confidence restored, and confidently buying back those self same assets from you at much higher prices.

So hang in there and use the pain.

Take it steady,

The Accumulator

Good reads from around the Web.

I have half-written several posts over the years about how ordinary savers have been shafted by the aftermath of the financial crisis, while the reckless were rescued.

While we still hear angry complaints that the bankers were bailed out by the Government ¹, the big winners were the millions of middle-class consumers who over-stretched to buy houses they couldn’t afford in the boom and then saw interest rates fall to near-zero levels – and who have since enjoyed bubble-like returns from property in London and the South East.

Many Monevator readers are homeowners who got lucky on interest rates. But before you get too indignant I’m not castigating everyone as fortunate chancers.

It’s those at the extreme end – who would have got their comeuppance in a typical recessionary purge – that should be glad things got so bad it saved their bacon.

Similarly, it’s not cavalier risk-tolerant active investors like me who’ve suffered from low interest rates.

It’s more normal successful young people who earn say £30,000 a year and who have saved what would have once been considered a heroic £2,000 to £3,000 a year towards a house deposit, but whose savings have (relatively speaking) gone nowhere while prices – at least in the South East – have gone into orbit.

The new normal

A young couple who bought a two-bed flat in Tooting in 2007 when prices were already high, using a £25,000 deposit from his grandmother and a four-times multiple of her salary, because they had to start somewhere, they wanted children in five years, and they needed to get on with their life – they were pragmatic, not reckless, as I see it.

In contrast, the 10th decile who paid 6-10x their income for their properties, who employed self-certification to make up their income anyway, those who created deposits from credit card advances, and those who had their parents remortgage the family home to enable them to buy a ritzy flat in Fulham where they couldn’t afford a bicycle shed – they are the ones for whom the financial crisis was like a windfall Monopoly card that reversed the normal run of recessions.

• Those who had bought a second or third buy-to-let property at the peak of the bubble.

• Those who had paid a year’s salary for a brand new BMW, on credit.

• Those who acquired a holiday flat in Paris by re-upping their mortgage in Westminster.

All saved by a situation so dire that interest rates went to 300-year lows.

Now, I can already hear some of you loosening your fingers to bash out an angry defense of these buccaneering go-getters…

• Perhaps I’m just seeing through my own circumstances?

• Hasn’t the stock market or even bonds been fine for investors – bad luck for those dumb enough to stay in cash?

• Was the Bank of England supposed to sink the economy for the sake of moral hazard?

• And so on.

True, these points all have some reality behind them. The older I get, the more I realise there are three sides to every argument – my view, your view, and the truth – and the less tolerant I am of those who believe they have a monopoly on two of them.

Alas, the Venn diagram of those who believe they are always right and those who comment on blogs is very large, too – even among our readers, who are in general about the smartest and most sensible in this sphere that I’ve encountered.

And to be fair, perhaps the overlap is large among those who write blogs, too.

“The first principle is that you must not fool yourself – and you are the easiest person to fool.”
– Richard Feynman

The result is I’ve avoided too much crusading about all this over the years.

But maybe that was a mistake, given the magnitude of these shifts.

Sinking the marshmallow test

While I muse on whether it was wisdom or cowardice that has so far prevented me climbing more frequently into the bully pulpit, I will point instead to an article on the virtues of saving by Gaby Hinsliff in The Guardian of all places.

Despite writing for a paper that has never seen a consumer that doesn’t deserve compensation or a family that isn’t hard-pressed, hard-working, and yet let down by Government, Hinsliff has written eloquently on the dangers of not rewarding those who get by under their own steam:

Saving teaches self-discipline, impulse control, the ability to forgo instant gratification in exchange for future reward – all the things famously measured by the Stanford marshmallow test, in which four-year-olds were offered the choice of one marshmallow now or two if they could bear to wait 15 minutes.

What makes the experiment so famous is that those few kids who resisted temptation didn’t just grow up to get higher exam scores, but were also still leading more successful lives four decades later.

But what if it had all been a con, and there hadn’t been a second marshmallow?

What happens when you save and save for a whole lot less reward than expected?

For eight years I’ve written a blog based on the belief that a second, and a third – and fifty more – marshmallows will come to those who do the right thing.

We’ll see.

Is this the best we can do?

Now, perhaps you’re alright, Jack. (As I am, as it happens). You bought your flat in 1997 and didn’t go on holiday in that year, and anyone who says the current system is distorted is a hopeless whiner.

But even if you believe that, if you’re reading this blog presumably you believe in the power of incentives?

And to that end, don’t we want to see more marshmallows instead of:

• Homes located where people want or need to live looking permanently out-of-reach to everyday successful young people?

• Kids lumping around great tranches of debt acquired from often pointless university degrees instead of starting to save for the future?

• Saving and investment to pay better than borrowing and betting?

As for the expected upcoming changes to pension tax reliefs (featured in two links below, and I could have included another half-a-dozen) I appreciate this is a tricky issue for various reasons we all understand.

But should we too readily swap a level playing field for one that looks set to be made massively less generous to those responsible middle-class higher earners who save for an increasingly uncertain future, compared to the perks enjoyed by previous generations?

We’ll pay for this

We had a financial crisis driven by debt – yet so far those with debts have won the day.

In fact the single best financial move of the past 20 years was to skip university, scrape together all the money you could from rich relatives, lie about how much you earned to get a dodgy mortgage, and then take a massive punt on the biggest house you could buy in the priciest part of the country and cross your fingers.

[continue reading…]

1. Tell that to long-term Northern Rock, HBOS, RBS and even Lloyds shareholders.[↩]