Sunday, January 11, 2009

Few Tidbits from the Weekend Financial Papers: Inverse ETFs/ better off with Dem or GOP Pres?/ TIP pricing

At some point after I started to invest in Proshares double short ETFs, I read an article about how those ETFs could diverge from the indexes tracked by them, with the divergence increasing as the holding period increased. I  was not aware that any could become as far off track as the Proshares Ultrashort FTSE/Xinhua China 25 apparently went last year.  

I have never invested in that one and have no reason to do so.  As explained in this Barron's article, the problem has to do with "diverging base-index values".   

That is, once the index falls and rises, and the leveraged inverse ETF moves in the opposite direction, then the ETF and the index lose their common original mathematical relationship after one day.  This problem is made worse by extreme volatility up and down of the index being tracked. I have seen some problems with SDS and TWM but nothing anywhere close to what is described in this article for FXP where, if this article is correct, the Chinese market lost 34% but the ultrashort did not rise 68% but lost 56%.   

Another problem with the double short inverse ETFs is the extremely large dividends paid in 2008.   

I use them very cautiously as hedges, and limit myself mostly to SDS and TWM. I currently have no position in any inverse ETF for the reasons discussed in prior posts. 

Some previous articles that I read on the subject of tracking errors include the following:

There was an interesting observation made by the market strategist for Federated Investors in the Mutual Fund section of Barron's.  If you had invested $10,000 in the market starting with Hoover and kept it in the market only during the terms of Republican Presidents, the investment would have grown to $12,000 and $51,000 if you excluded Hoover. That would be for W only through mid October 2008 so it would actually be a little worse. If you had done the same for only the Democratic Presidents, your investment would have increased from 10 grand to $300,000.

I would not vouch for the accuracy of those figures.  But I would argue with anyone suggesting that the reign of W and the Angler have been positive for U.S. investors.  

The NYT had a couple of articles where the person interviewed recommended buying treasury inflation protected securities, making the same points previously made in these posts.  The point being made by them is that the spread of the TIP over the comparable maturity non-TIP treasury was less than 1%, and that you would have to assume 8 years of deflation to justify such a narrow spread for a ten year maturity.  Simply put, you were not paying much to have the inflation protection. 

Some links to my prior posts on the same subject:

I would just add a caveat to explain one reason why I have not been buying TIP aggressively.  The question to ask yourself is whether the comparable 10 year treasury is being priced correctly?  It is entirely possible for both the 10 year treasury and the 10 year TIP to both lose and the less than 1% differential which is discussed in these articles is off a very low base yield price for 10 year treasuries.  Still, since I own no five and ten treasuries, I am willing to own TIP.  If I owned a ten year treasury, I would sell it and buy a ten year TIP.  And that is about all that can be said about these low yielding treasury bond investments now in my opinion.  

A sharp fall in price of the 10 year treasury, for whatever reason, a rise in inflation expectations, a popping of the bubble, a flight from dollar denominated assets, or whatever, will likely precipitate a fall in the ten year TIP too.  A slower rise in inflation expectations may give the TIP some buoyancy by increasing the spread over comparable treasury maturities and hence cushion the negative price impact from whatever is causing the drop in price of treasuries. 

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