S&P 500 Leverage and Hedges Options - Part 2

In my last post (Part 1 of this article), I looked at alternative ETFs that could be used as hedges against the corrections that we have seen during that long 2 year bull run. Looking at the results, it seems that for short (less than a month) corrections, a VIX ETF like VXX could actually be a viable candidate to hedge or speculate on the way down. Another alternative ETF was TMF, a long Treasuries ETF which banks on the fact that when markets go down, money tends to pack into treasuries viewed as safe instruments. In some cases, TMF even outperformed the usual hedging instruments like leveraged ETFs. There could of course be other factors at play since some of 2014 corrections were related to geopolitical events which are certainly positive for the Treasuries market. In times of uncertainty, nothing sounds safer than US Notes and Bonds. Dollar based ETFs were too inconsistent to be considered for hedging although they generally beat the market during these corrections.

In this post I want to look at instruments that should do well in the long periods where the market was up. The idea is once again to leverage your assets by investing in instruments that will beat the market by a large margin. I am not looking at derivative instruments like futures or options which can add leverage to already leveraged instruments, but the simple ETFs that can be bought and sold in any account including IRA and 401-K.

So what are my candidates for this study. First the standard leveraged ETFs (as they relate to the S&P 500):

SSO - A long 2x ETF tracking the S&P 500
UPRO - A long 3x ETF tracking the S&P 500

And some alternatives:

TMV - A 3x short Treasuries (20+ years) ETF
UUPT - A 3x long Dollar ETF
UDNT - A 3x short Dollar ETF
XIV - A short VIX ETF

Since the long Treasuries ETF did well during corrections, I want to look at the short Treasuries ETF during the rallies. The dollar ETFs were inconsistent as short instruments, but I will include them in this study as well in order to be thorough. And finally, I'll look at XIV, a short VIX ETF since VXX did so well as a hedge.

Let's look at our first rally of the year - February 4 to March 10. The first chart looks at absolute performance.

This second chart looks at performances relative to the market.

Colors are - Red (S&P 500), Blue (SSO, Green (UPRO), Pink (TMV), Turquoise (UUPT), Black (UDNT) and Gray (XIV).

The first conclusion is that once again, the leveraged ETFs perform as they are supposed to. The market is up about 7% and the 2x and 3x ETF are up 15% and 23% respectively which matches (or beats) their leverage ratio. Being long the dollar during this rally was not a good investment. But being short was not profitable either. I am afraid that this confirms the fact that the correlation between the markets and the dollar is not very strong. We'll see what happens in the next periods.

Surprisingly, being short Treasuries was not a big winner either. It didn't lose any money, but trailed the market toward the end of the period. Also something to be examined further. The big surprise again is the VIX ETF. Over the length of the period, it matches the return of the 2x ETF. But in the very short term, it's beats every other instrument. It benefits from the the fact that the VIX generally spikes during corrections, but comes down very quickly. Since XIV is inversely proportional to the VIX, it does produce these quick spikes up as well.

The next rally we are looking at is the period between April 14 and July 2. Again, the first chart shows the absolute performance while the second one shows the performances relative to the market. The colors are the same as the previous set.

As with the previous set, the dollar ETFs are inconsistent. Not gaining much and not losing much. These instruments still don't show much usable correlation with the market. Not much to say about the leveraged ETFs. The market is up about 8% in the period and the 2x ETF returns an expected 16% (a bit more) while the 3x ETF returns over 25%, slightly over the leverage ratio. This shows that during shorter periods, these ETFs do not suffer from the decay that they show during multi-year periods.

Surprisingly, the short Treasuries ETF is the worst performer. So again, not a very good choice if you are looking to outperform the market. But the biggest surprise is the VIX ETF. XIV is up over 50% in that 2.5 months period. It beats the 3x ETF by a large margin. Prolonged rallies without large corrections do erode the VIX considerably and XIV is a big beneficiary. Could the VIX ETF be a winner on the up side as well?

The next rally was shorter - about 3 weeks from August 7 to August 27. Based on what we saw in the first set, it should benefit the VIX ETF as the VIX crush is quick and violent.

Again, the charts show absolute and relative performances with the same color scheme.

And XIV doesn't disappoint, beating the market by 18% in 3 weeks and even the 3x ETF by 8%. It sounds repetitive, but the leveraged ETFs still perform as expected while the dollar ETFs show inconsistency again. The biggest disappointment so far is the short Treasury ETF which doesn't correlate as well with the market in rallies as the long ETF did during corrections.

The next period is a little longer and show the biggest gains in the market which should benefit the leveraged ETFs. Same chart parameters as before.

As expected, good performances from the leveraged ETFs. The long dollar ETF matches the market almost exactly but more a factor of external geopolitical influence than correlation. Being short the dollar was obviously a bad choice! Especially in a leveraged instrument. The short Treasuries ETF did not lose money and tracked the market nicely in the first 2 weeks but quickly lost steam probably also influenced by external factors.

And the winner is once again XIV, although not by as much as the last 2 sets but still significantly.

The last set we will look at are the last 2 weeks of 2014 where we had a nice little Santa Claus rally. Charting parameters are still the same.

The leveraged ETFs still perform as expected. And the long and short dollar ETFs return the exact same results as the last rally - the long ETF matching the market, while the short one losing a lot of ground. The Treasury ETF is very inconsistent, up big at some point but ending up about even.

This time, XIV doesn't keep pace with the 3x ETF but still does better than than the 2x ETF. A bit surprising as shorter time periods would tend to benefit the VIX ETF.

Conclusions

As in the previous post, the dollar ETFs proved to be too inconsistent to be of any value hedging or leveraging the market. In a future post I will study how they correlate to the spot dollar and how an investor could profit from the leverage factors that these ETFs offer.

The biggest disappointment was the short Treasuries ETF. The long ETF did show some promise in 2014 but it's also possible that it benefited from external events that boosted investments in US Treasuries. In a future post, I will also look at how these leveraged ETFs correlate to the underlying instruments.

The leveraged ETFs perform exactly or better than their leverage factor would indicate even on longer periods as decay doesn't seem to have any impact. These instruments are the most predictable ways to leverage your assets during rallies. You know exactly what to expect.

The biggest winner in 2014 was XIV, the short VIX ETF. It did benefit from long rallies where the VIX lost significant percentages. Being long XIV during the rallies yielded a combined 142% during 2014. That's a pretty good return no matter how you look at it! Of course, that implies a perfect timing which is impossible. But careful investment would still have yielded a nice return.

It's difficult to draw definite conclusions yet as I have only studied these ETFs in one main environment - a relentless bull market. It would be interesting to see how these ETFs perform in the reverse conditions. Maybe the topic for another post!

In Part 3 to be posted next week I will look at timing methods that could have been used in conjunction with the 2 VIX ETFs (VXX and XIV) to produce the best possible return. It looks to me that allocating some of your assets to these 2 ETFs could be a smart choice.

S&P 500 Leverage and Hedges Options - Part 1

Following my post on the ETFs tracking the VIX and looking at some of the performances achieved over the last 4 years or so, I decided to compare traditional leveraging and hedging options for the S&P 500 with some alternatives. In Part 1, I will look at ETFs for protection against a correction. Part 2 will look at leveraging for going long.

Usually, investors looking for leveraging or hedging use the following instruments:

1. Leveraged ETFs
2. Options
3. Futures

Futures are not the easiest instrument to trade for the long term and are probably better day traded as swings in the wrong direction can lead to very large losses. Options can actually be also bought and sold on leveraged ETFs so in essence, adding leverage to already leveraged instruments. They look like the ideal instrument, but trading options requires a lot of education. The casual investors might not be aware of premium decay which means that you can bet in the right direction but still lose money as your option loses value, expiration dates and other characteristics of options. There are 2 more possible issues:

• On long dated options, the spread between the bid and ask can be wide especially with more illiquid leveraged ETFs. That can rob the investor of a good portion of the investment.
• Some IRA and 401K accounts will not let you trade options. 

For these 2 posts, I will only consider leveraged ETFs since they can be traded in a regular or retirement account. There are many leveraged ETFs for the S&P 500 on the market but I will look at the most actively traded. They are:

SSO - A long 2x ETF tracking the S&P 500
UPRO - A long 3x ETF tracking the S&P 500
SDS - A short 2x ETF tracking the S&P 500
SPXU - A short 3x ETF tracking the S&P 500

Since I also want to look at alternative options (looking for possible correlations) that might be overlooked, I will add the following ETFs to the comparisons:

TMF - A 3x long Treasuries (20+ years) ETF

TMV - A 3x short Treasuries (20+ years) ETF

UUPT - A 3x long Dollar ETF 

UDNT - A 3x short Dollar ETF

XIV - A short VIX ETF

VXX - A long VIX ETF

These might look out of place but there is a correlation between all these instruments and it makes for an interesting study. First, let's look at the standard ETFs in comparison to the underlying instrument over the last 3 years:

I am choosing the last 3 years for this study not because it a long term bull market, but some of these ETFs are recent and I cannot make longer term comparisons. For reference, the ETFs are in the same order at the top of the graphic as they are in my list. Nor surprisingly, the long leveraged ETFs do very well over that period given the fact that the S&P500 is up over 55%. The short ETFs are just crushed in the same period. We'll see how they do during periods of weakness over the last 3 years for reference. 

What is more interesting is the performance of some of the ETFs. If we use the S&P as baseline for performance, we get the following chart:

The 2x ETF behaves as expected, doubling the underlying instrument. But the 3x ETF gets much better results than we would anticipate, up over 250% in the same period. And there is not much difference between the 2x and 3x short ETFs. The losses are somewhat consistent with the leverage factor but aggravated by decay. More so with the 2x ETF. This could be the results of the asset mix as well.

Clearly, in a long bull market like the one we have been experiencing, that 3x ETF makes a very good investment. 

Let's look at the result of the alternative instruments for a comparison.

For reference, the chart also follow the list above. Clearly, VIX ETFs look like they have potential for leverage and hedging. The long VIX ETF gets obliterated in this long bull market as the VIX hit some long time lows. As I have posted many times on PSW before, VXX also suffers from decay due to the underlying VIX futures.  But look at XIV, the short VIX ETF. At one point, it was up over 550%! We'll need to compare with the 3x S&P 500 ETF for a clearer picture, but it looks like we might have a good candidate there. The leveraged treasuries and dollar ETF don't seem to have the volatility for long term plays. And the correlation doesn't seem clear. We'll look at shorter periods to get more information. Using the S&P as baseline, we get the following chart:

Dollar and treasuries ETF do overperform the market at times so there might be sceanrio where they are an option. But this chart really outlines the potential for XIV.

Hedging for Corrections

Let's look at the short periods when the market took breathers last year. There were very few big ones though. Earlier in 2014, we had a short 5% correction. What hedge would have paid off best then:

And with the S&P 500 as baseline:

The symbols are SDS, SPXU, TMF, UUPT,UDNT and VXX. Here are some observations:

• Both dollar ETFs outperform the market with the short ETF actually ending slightly better. The correlation is not clear in that set. 
• The short Treasuries ETF does pretty well, up 15% and outperforming the index by over 20%.
• The short leveraged ETF do their jobs, pretty much doubling and tripling the index loss as expected with the leverage factor. 
• But the big winner in that short period is the long VIX ETF VXX. It's up about 29% and outperforms the index by a whopping 35% in 3 weeks. It does take a while to get started, but as the index goes further down, the gains accelerate.

We need to look at more corrections to draw some definite conclusions so let's look at the next one between July 23 and August 7.

And with the S&P 500 as baseline:

Symbols are in the same order as the previous chart.

• Long treasuries and long dollar ETFs do outperform the market again by 6 and 7% respectively. Not the best of hedges, but safe places to park your money!
• The leveraged ETFs perform as expected, returning performances in line with their leverage factors.
• But the winner is once again VXX and by a 10% margin like during the earlier period.

Let's look at 2 more 2014 corrections to see if the trend holds. We had another longer and deeper correction in September:

And with the S&P 500 as baseline:

Symbols are in the same order as the previous chart.

• No big surprise with the leveraged ETF again. Their performance in short periods of time seems to be reliable. 
• Being long the dollar does seem to provide some protection although it does not have very high returns. 
• The long Treasury ETF is a big winner in that period as money flowed from the market to treasuries. It even outperformed the leveraged ETFs in that month.
• And once again, VXX is a huge winner, outperforming the second best ETF by over 20% and beating the market by 55% in one month!

The final correction I want to study was in December:

And with the S&P 500 as baseline:

• Being short the dollar worked better than being long as opposed to the other times.
• The short Treasuries ETF outperforms the leveraged ETFs again although not by much.
• Leveraged ETF are consistent with the previous periods.
• But look again at VXX! Getting double the performance of the second best ETF.

Conclusion

It is difficult to draw conclusions over only 4 sets. Especially given the fact that these periods were very short since the market has been up almost the entire year. The dollar ETFs are not reliable enough to make good edges. They will not lose you any money mostly, but they won't make you much either. The leveraged ETFs perform as expected offering good protections against short-term corrections. We would need to look at longer down periods to see what kind of damage decay does to these ETFs. The long Treasuries ETF does outperform the leveraged ETF in 2 out of 4 sets and does offer some level of protection. There are some outside factors at play such as the geopolitical situation which does influence the flow of money. Still, seemingly a safe alternative to the usual hedge options. But it seems that we have a winner with VXX. In these short corrections, it outperforms even the 3x ETF by a wide margin. The problem with VXX is the long term decay though. The VIX goes through quick spikes and long periods of calm which are deadly to VXX. If you look at the long term chart above, you can see that VXX is the worst performer over the last 3 years. But as a short term hedge, it clearly has a lot of potential! Now it's all in the timing.

I will check some corrections from previous years and update this post with that data to see if these conclusions hold over time.

Part 2 will look at the longer periods of 2014 when the market was up. I will post that sometimes this week.