Last week, amid some controversy, the SEC approved a 4x levered ETF. For a period of time, and rightly, the SEC was considering cracking down on the 2x and 3x levered vehicles so the move to 4x was surprising. Don’t misunderstand, the levered ETF’s offer gigantic arbitrage opportunities because of their structural problems, so in many respects we hope they never go away (we are invested in a fund that benefits greatly and almost daily from these arbitrage opportunities), but that doesn’t mean they are great products for the audience for which they were created.

Bloomberg recently reported that passive ETF indexes now outnumber individual stocks. Without getting into the multitude of problems created by the explosion in passive vehicles, the one overlooked point seems to be how many of these passive ETF’s, because of supply and structural issues, must use the futures markets instead of underlying securities to create their exposure, and therein lies the problem. Remember, a huge issue leading up to and exacerbating the 2008 crash, was the growth in usage of Credit Default Swaps (CDS). There are many parallels to today’s ETF markets.

For those of you unaware, CDS initially were born as a way for commercial banks to hedge their lending exposure. CDS were quickly latched onto as a way to solve a chronic problem in high yield: a lack of paper. If you were a high yield portfolio manager pre-2000, and you had a great idea about how undervalued a credit was and you wanted to buy a bond, often you couldn’t because there were simply no bonds available to purchase. It was not uncommon in the heyday of high yield for a $300 million new issue to be 80% owned by three holders with scraps available for the rest of the market. Enter CDS.

If one could create synthetic exposure, a high yield portfolio manager could reflect almost any view of credits and credit markets, arguably a good thing. And, like many good things, CDS quickly morphed into Frankenstein, and synthetic securities grew to be multiples of the notional value of the underlying securities and that leverage partly fueled the 2008 unwind.

The same situation exists with many ETF’s today, especially the commodity ETF’s, whose problems are exacerbated by contango. When a fund purchases forward to meet the creation requirements of the underlying ETF, and forward curves are more expensive (contango), value leaks away. It is a mathematical fact exemplified by the chart below, which shows that Crude Oil (the blue line) is up marginally in 2017 while the USO (the yellow line), the ETF that represents the price of oil, is down. It’s down because of the leakage in value it suffers when it sells a future for a lower price than the future it must purchase. For a period in 2016, Crude was up 27%, but the USO was down 1%. You can thank Contango for that result. And the USO isn’t even levered.

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The levered funds magnify the contango effect geometrically. Capturing the gap between the value of the underlying ETF and the commodity it represents is commonly called “roll yield” and billions of dollars are in the market today arbitraging exactly that. As long as contango exists, this situation will persist. Sooner or later, something will give. We thought the regulators would step in and quash the levered ETF’s. For now, they’ve chosen not to. In the meantime, the market is giving you an opportunity.

In practice, it works like this: Assume a 1% daily move to make the math easy. Day one the market goes down 1%, the next day up 1% and so on for ten days (see table below). Under that scenario, the underlying security returns -0.05%, while both 2x levered vehicles would return -0.20%, the 4x levered vehicles -0.80%. Shorting both the long 4x and the short 4x would return 1.59%. The contango decay as outlined above adds a large measure of downside protection. Two of three potential outcomes are positive: if the underlying sells off, or if it trades with volatility. It is no wonder these strategies are becoming more popular. The odds are in your favor. Adding a long position to protect against an upside spike lowers the risk profile of this trade even further.

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