Sunday, December 17, 2006

Are Money Managers Hedging Their Bets With The ProShares Ultra ETFs?

The ProShares Ultra ETFs enable traders and investors to leverage the movements of the major equity indices. For each 1% that an index moves, these ETFs will move 2%. This provides ETF traders with a degree of leverage normally associated with the trading of futures. Note that a pattern daytrader who qualifies for 4x leverage can reach 8x with the Ultra ETFs.

A unique feature of the Ultra ETFs is that they include separate trading instruments for long and short market exposure. By buying an inverse (short) ETF, a trader makes 2% when the underlying index falls by 1%. The non-inverse (long) Ultra ETF, of course, would rise 2% if the market rises by 1%.

Here are the symbols for the three most liquid Ultra ETFs:

NASDAQ 100: QLD (2x long); QID (2x short)
S&P 500: SSO (2x long); SDS (2x short)
Dow 30: DDM (2x long); DXD (2x short)

My initial idea was to compare volumes for the long vs. short Ultra ETFs to see if they functioned like call volume and put volume among options. In other words, by tracking participation in the Ultra ETFs, we might have a new sentiment indicator.

I'll save that idea for a later date, however. My first look suggested that something else is up with the Ultra ETFs: total volume. But not just all volume: volume in the inverse (short) ETFs. Check it out:

I went back to 7/13/06, which is when I show trading histories for the three Ultra ETFs above (N = 110 trading days). I then compared the average volumes for the ETFs for the first half of the sample and for the second half. Here's what I found:

NASDAQ long (QLD) volume: up 51%
NASDAQ short (QID) volume: up 217%

S&P 500 long (SSO) volume: up 15%
S&P 500 short (SDS) volume: up 69%

Dow 30 long (DDM) volume: down 29%
Dow 30 short (DXD) volume: up 88%

Clearly, we're seeing much more interest in the short product than the long one, an interesting finding in a rising market.

What's more is that this interest is correlated across the Ultra ETFs. I went back to November 1st, which is roughly when we first saw a burst of new volume in the short products, and correlated the daily volumes in the inverse Ultras. The correlation between the NASDAQ inverse volume (QID) and the S&P 500 inverse volume (SDS) was .60. The correlation between the NASDAQ inverse volume (QID) and the Dow inverse volume (DXD) was .87. The correlation between the S&P 500 inverse volume (SDS) and the Dow inverse volume (DXD) was .43. All are healthy, positive correlations. This suggests that when there is buying interest in one inverse ETF, there tends to be buying interest in the others.

Correlations in the daily volume of the long ETFs is also positive and significant: around .50-.60.

What are we to make of the growing interest in the inverse ETFs and the correlated volumes of all six of these Ultra ETFs?

My take is that they are being used as hedging devices by money managers. Many managers who have been buying stocks like banshees this fall have been hedging their bets with these Ultra inverse products. They are getting the best of both worlds: they can say that they participated in the rally and they can extend their stock ownership over longer (capital gains) periods, while at the same time hedging their general market risk.

Over the last five days of relative market strength, volume in the inverse NASDAQ product has exceeded volume in the long product by 5:1. Volume in the inverse S&P ETF has exceeded volume in the long product by over 3:1. There have been no dips in the ratios of short:long volumes in the Ultra ETFs as there have been among equity put/call options.

Bottom line: At least among some money managers, their bullishness may be a mile wide and an inch deep. At the same time they're buying stocks for year end gains, they're making sure their tails are covered. Other managers may be more selective in their bullishness, preferring specific issues, but protecting themselves from overall market risk. In any event, in the Ultra ETFs, we have an interesting tool for examining the behavior of these managers. As the market has broken to new highs, they've stepped up their participation in the inverse ETF market.


Wcw said...

Interesting again, but this time I feel you have an unsupported hypothesis. Let's check other data.

One, relative total volume. Of the three short ETFs, only the QQQ is showing real volume. QID's volumes are in the millions, the other two in the hundreds of thousands. This is the opposite of what you would expect under your mooted scenario. If "managers" were using them as "hedging devices" the volume would be in the manager bogey, the S&P.

Two, total volume versus futures. Per day in November, the CME traded 7000 full Nasdaq-100 contracts and 300,000 E-minis, representing $12 billion. Even at 4m shares a day, QID represents $0.4B notional QQQs. Again this is the opposite of what your hypothesis wants: comparable volume, not a vanishing fraction.

Three, efficiency. These ETFs are pathetically inefficient by comparison with futures. Every year they swallow 95bps of your cash, and pay out no interest. A short futures contract not only saves on expenses, but also pays out interest on your margin balance and bakes in a short rebate besides. A manager who lives and dies by his 100bps of alpha isn't about to cough up that much in expenses alone and give up his 5% short rebate besides.

I think the more reasonable hypothesis is that these names, especially QID, are attracting retail interest. Retail customers mostly don't have commodities accounts, and even E-minis aren't tiny at ~$36,000 notional each. Most retail investors are uncomfortable with options. Most retail investors are, however, comfortable with ETFs.

I think the increasing volume on these fish represents adoption by retail clients, and the relative volume should function as a sentiment indicator for same. Put it together with something like the ISEE, which in the options marketplace may represent sentiment by slightly more sophisticated clients, and maybe you'll have an interesting indicator.

A measure of institutional sentiment, though, I don't see.

Brett Steenbarger, Ph.D. said...


You make good points. Of course, the volume in the ETFs nowhere near approaches the volume in the futures, and it would be silly to assume that *all* the hedging of money managers is being done in the ETFs.

BUT, the growth of inverse Ultra ETFs relative to the long Ultra ETFs does not at all match the equity put/call ratio data, which *are* sensitive to the sentiment of the retail customer.

I do think you're right in that it's inefficient to use these as longer-term hedging vehicles. If, however, one wanted to lock in gains to the end of the year, it strikes me that this would be one way to accomplish that purpose for an equity-only manager.

I was initially leaning toward the "adoption" notion you mention: that the growing volume represents increasing acceptance of the products by the trading public. But that doesn't account for the asymmetric growth of the inverse ETFs. The volume on those has grown much larger than the volume for the long ETFs--even though the products are young and total volume is not huge.

I appreciate your feedback and I may indeed revise my hypothesis about these products as more data come in. I just don't think retail traders are sophisticated enough to fade the markets' moves to new highs and concentrate their hedging on the highest beta index.



Wcw said...

I see the asymmetry of the growth as an indication that the client base is retail. It is much harder to get short than to get long as a retail client. As a result, I would expect retail demand for digestible short products to swamp that for long products, which exist in a much more competitive arena.

However, it's quite possible your analysis is right and mine wrong. Perhaps there are enough managers whose mandates are restrictive but whose clients won't notice a short ETF slipping in and out of their portfolios to make for an institutional constituency.

What predictions do each make that we can check? In my scenario, I would expect volumes on these ETFs to rise until they saturate their markets, which should happen more quickly on the long side than the short. I would not expect year-end discontinuity, as you might see if managers took off their hedges as they close their calendar years. I would expect volumes to follow price, so increase if the Qs drop and dry up if they rally. A couple months more data will help.

Brett Steenbarger, Ph.D. said...


Again you make good points. I may have another post on this topic later today. It strikes me that the term "money manager" might be too vague; perhaps I should have been more specific. I used the term generically because I did not want to single out hedge funds, investment banks, pension funds, or mutual funds. All of those institutions are too large to account for the volumes we're seeing in the Ultra ETFs.

Rather, there are many small money managers (brokerage firm advisers, financial planners) who invest people's money for them and who have an equity-only mandate. Their clients, rightly or wrongly, don't want their money in futures or options.

At least two of these managers that I know personally are using the ETFs on behalf of their clients, including for hedging purposes. I have heard of others doing the same in my online searches and conversations.

We could wonder if these represent "smart" or "dumb" money within the investment management world, but if they're attuned to hedging at market highs, they can't be too stupid. The retail traders right now are bullish, both in the surveys and in their put/call behavior. I would be very surprised if they're fading new index highs with these inverse ETFs.

I agree with you that volumes in these vehicles should continue to expand. That's been the history of successful ETFs--and I do think some of that expansion will come from retail traders.

It is the *asymmetric* expansion in the ETFs that are short the market--contrary to current retail investor sentiment--that has me curious. It does seem to me that such hedging would enable these smaller money managers to lock in annual gains, protect against market risk, and help achieve capital gains for their clients.

You're right that additional data should clarify the issues. I really appreciate your pushing me to think hard about these patterns. Thanks!


Anonymous said...

Excellent conversation here.

I have been keeping eye on these six ETF's for a couple months now. I've noted the volume rising too, but I just thought it was due to these products coming to the attention of the trading public. As a small active retail investor, if we do see some downward action I'd be more comfortable going long something like the qid (which eats a bp) than individual stocks.

Also, the word on the street is that Santa is bring me a copy of your new book.

Cheers I enjoy the blog.

Brett Steenbarger, Ph.D. said...

Hi Mike,

Thanks for the comment, and please thank Santa for his support as well!

I was going to write another post about this, but maybe I'll just add my 2 cents worth here, building on a comment on the Commitments of Traders report sent to me by a perceptive reader.

IF you examine the COT data from the CFTC, you'll notice that around the market bottom in early July the "non commercial" participants in the market were net short the S&P emini futures. Throughout November and the first two readings in December, they have been net long.

The "commercials" were net short also early in July and have stayed net short in the S&P 500 eminis. Their ratio hasn't changed greatly during the market rise.

In the NASDAQ 100 eminis, the non-commercials were very short early in July at the market bottom and have been pretty evenly balanced long and short through November and December.

The commercials, however, were modestly long at the market bottom in July and have steadily added to their short positions. From July to early December, their long position barely budged, but their short position doubled.

This is the same pattern we're seeing in the Ultra ETFs: a ramping up of bearish volume as the market has risen--especially in the NASDAQ. And it's coming from the commercials, not the non-commercials.

It seems to me that these commercials--often thought of as "smart money"--are hedging their bets during this market rise, particularly in the NAZ.


Trek said...

Hi brett,
As far as your swing trades, for instance if you're shorting the current market and expect to hold 1-5 days, do you use a stop loss? And if so what is an appropriate stop for trading the NQ eminis?

thank you for the wonderful blog.

Brett Steenbarger, Ph.D. said...

Hi Trek,

Thanks for the comment. My current short position is not really a swing trade. I may hold it for awhile.

If, however, I view it as a swing trade, then my stop is already at breakeven given the market's afternoon decline. I certainly would be out if we moved above Friday's highs.

My target would be the recent support in the 1800 area on NQ. The reason I'm suggesting it might be more than a swing position is that I'm entertaining the idea that we could take out that whole support area and really get some selling. But I'll take it day by day and assess market strength/weakness before making that determination.

The important thing with any swing trade--and any trade--is to have a good risk/reward ratio. When a trade goes your way from the start, it gives you a free look at a possible big market move. If the market moves back to breakeven, you're out: that's the worst that can happen.


Anonymous said...

2006 was “The Year” for Chinese stocks. A seemingly unquenchable investor thirst for all things Chinese helped propel the Shanghai Composite Index to a 130% gain for the year, followed closely by the Hang Seng China Enterprise Index*. Even though we explained in the previous Chinavestor Newsletter (December 2006 issue) that Shanghai’s stellar performance in 2006 is somewhat misleading because compilers of the Shanghai Composite Index include IPOs right from their debut day, giving the mainland index a regular and artificial boost, the triple digit gain is still remarkable. The interest in China spurred Hong Kong‘s Hang Seng Index to a 34% gain in 2006. The China Enterprise Index, which comprises major Chinese companies, or H-shares, such as PetroChina or China Life Insurance, nearly doubled in value.
Thanks to the composition of the Xinhua China 25 Index, which basically has the same components as the China Enterprise Index, U.S. investors could capture the stellar performance of the Chinese stock universe. FXI** nearly doubled its value, far outperforming the PGJ***, not to mention the Dow.
What do we expect in 2007? Will this trend continue? If so, how to get the best out of it?
First of all, investors have to realize that most of the spectacular index gains are attributed to large cap stocks. We expect to see their strong momentum to carry well into 2007. These large cap stocks make up the Hang Seng China Enterprise and the Xinhua China 25 Indexes composition and as a result, we think these will do well in 2007.
As we have previously argued, the Shanghai Composite is biased and artificially boosted the way IPOs are calculated into the index performance. With a strong IPO pipeline, Shanghai is expected to perform well in 2007 though not as spectacular as in 2006. Mega IPOs like ICBC’s $20 billion plus are unlikely to occur as the banking sector went public by 2006.
If history can predict future, the Halter USX China Index (PGJ) will most likely underperform its ETF peer, FXI. We have always preferred FXI and have been vocal about it. Still, PGJ is expected to cheer investors alongside China’s overall economic growth.
In addition, we expect the Hang Seng to beat the DJIA in 2007 again. The Hang Seng Index is fueled by a 29% annualized increase in industrial profits, not to mention China’s economic expansion of over 10 percent in 2006. This marks the fourth straight double-digit annual gain.
Looking at these indexes from a historical perspective, the following chart is worth a million words.
The green line represents the China Enterprise Index known as H-shares (.HSCE), the orange stands for the Hang Seng (.HSI), the red for the DJIA (.DJI) and the blue for the Shanghai Composite (SHCOMP).
The chart reveals that the H-share Index far outperformed any other major benchmark over the last five years. In addition, Shanghai’s 130% gain in 2006 helped it to surpass the DJIA and close in on the Hang Seng yet it is just in sync with the overall performance of those major indexes.
This chart suggests that gains of the Hang Seng and Shanghai Indexes are attributed mainly to companies making up for the H-share Index. Who are these mysterious H-shares?
Most foreign investors interested in China’s companies prefer to trade H-shares, or mainland companies that list in Hong Kong, Shanghai and New York, and comply with international accounting and governance rules.
Companies from the H-share index that are listed both in Hong Kong and New York and thus are readily available for U.S. investors are: Aluminum Corp. of China (ACH) (2600.HK); China Life Insurance (LFC) (2628.HK); Guangshen Rail (GSH) (0525.HK); Huaneng Power (HNP) (0902.HK); PetroChina (PTR) (0857); Shanghai Petrochemical (SHI) (0338.HK); Sinopec Corp. (SNP) (0386.HK) and Yanzhou Coal (YZC) ((1171.HK).
The rest of the stocks, making up the H-share Index, are not listed in New York but include blue-chips like Bank of Communications (3328.HK), Bank of China (3988.HK), Datang Power (0991.HK) and China Shenhua (1088.HK) - just to name a few.
Still, investors can capture basically the same growth of the China Enterprise Index or H-shares and play the Chinese craze by investing in the ETF tracking the Xinhua China 25 Index: the FXI. As the following chart shows, there is extremely strong correlation between the performance of the H-share index (.HSCE) and the FXI. The chart tracks the FXI since its inception on 10/14/2004 along the H-share index.
Top ten stocks of FXI holdings are:
China Mobile 10.98%
PetroChina Co 8.81%
Bank of China Ltd 7.41%
China Life Ins. 7.33%
CNOOC Ltd 6.15%
BOC Hong Kong 4.22%
Sinopec 4.18%
Citic Pacific Ltd 4.15%
Ping An Ins. 4.05%
China Telecom 4.01%

The advantage of FXI over individual stocks is that since FXI represents 25 underlying stocks, it carries minimal company specific risk.

Brett Steenbarger, Ph.D. said...

Thanks, China Trader, for that analysis and for the blog link--