Wednesday, August 13, 2008

BEARX: The Armageddon Fund

It's time to talk about the biggest risk factor for Proshares Ultra ETFs like SSO and SDS.

These ETFs, and all of the other leveraged and inverse ETFs like them, use derivatives, which means they are not invested in actual stocks. Derivatives include things like options, futures, and swaps, which are contracts between two parties that set forth rules for one party to pay the other party in the future, depending on the price of a stock, commodity, market index, etc.

I've thought of a quasi-analogy for comparing derivatives and stocks which I hope will make this easier to understand. Buying a racehorse is kind of like buying a stock. If the horse that you own wins a race and collects a prize, that's like having the stock pay you a dividend. If you then sell the horse for more than you paid for it, that's like buying a stock low and selling it high - you've made a capital gain.

But you can also make money by betting on a horse in a race. The only trick is that you need other people to bet against that horse - otherwise, whose money will you take when the horse wins? Now, at the racetrack, all of the bettors have to pay their money ahead of time, so you know that the winning bets will indeed collect their rewards. Thus, you can make money on a horse without ever buying it, selling it, or collecting any of the prize money.

Derivatives are the stock market equivalent of betting on a horse. For every person who makes money on the winning side of a derivative, there is someone on the other end who loses that same amount of money. The problem is that, unlike the racetrack, there is no central holding area where all of the potential derivative payouts are kept. Most of the time this isn't a problem, but in the event of a stock market crash accompanied by a major financial meltdown, it's possible that some derivative participants on the losing end will run out of cash before they meet all of their payoff obligations to the bearish derivative "winners."

Thus, derivatives buyers, and ETFs like SDS that use derivatives, may see people on the losing end default on their obligations, much as banks are seeing homeowners default on their mortgages. These derivative contracts would then be devalued or "written down" just as mortgage-backed securities have been. Inverse ETFs like SDS, which use derivatives to move in the opposite direction of the market and to magnify their price swings, might not go up in price during a major crash. In fact, if there were a major financial catastrophe, SDS might actually go down in price during a market crash when it should be skyrocketing.

Scary stuff indeed.

But there is a way to make money during a catastrophe without having to bet with derivatives: it's called shorting. Shorting a stock seems rather strange and complicated at first, but it's actually pretty simple. When you short a stock, you replace someone else's stock holdings with cash by selling their stocks on the market (that's why it's also called "selling short"), and then agreeing to replicate the price motion of their former stocks by either adding your own cash to their account if the price goes up, or taking money from their account if the price goes down. Shorting is easy to do in practice with an online account, because you don't have to actually manage any of the things I just described; all you have to do is click "sell short" to open a short position. If you short stocks and the market crashes, the simple result is that you end up taking money from the people who think they own the stocks. There's no contract involved. The cash which is owed to the short seller is actually sitting there in an account, and is not just an I.O.U.

For those of us with tax-free or tax-deferred retirement accounts, shorting isn't allowed, but there is one mutual fund out there that you can still buy that will do the old-fashioned shorting for you. It's called the Prudent Bear Fund (ticker symbol BEARX) and I'm recommending it as the "Armageddon Fund."

Now, BEARX isn't an ETF, so this is not a day-trading vehicle. In fact, BEARX penalizes investors 1% if they cash out less than 90 30 days after buying it, but that small penalty would be well worth the price if we ever experienced a simultaneous crash in stocks and derivatives. So, I may end up using BEARX instead of SDS if things start to look really bleak. Keep this in mind when the next wave of negative financial news arrives.

Update: Thanks to some helpful comments here, I have identified a better Armageddon fund.


Jim Driscoll said...

There's also GRRZX, the Grizzly Fund, which is like Prudent Bear, but more agressive, with a shorter track record. Those two are where I'm holding much of my 401k - and getting creamed right now, let me tell you - but that's OK - I've got long term pessimism on my side, I'm sure I'll be up on the year.

In the event of a meltdown that kills the ProShares ETFs (which is pretty much Armageddon), don't forget that to short, you need a margin account - and your stocks are held in that margin account, which means that if your broker goes under (which isn't unlikely if Proshares is reeling) you don't get treated the same way as someone who owns the stocks outright - though I'm a bit fuzzy on what does happen. (Any elaboration welcome, I've been trying to figure that bit out.)

In summary - if you think that things are bad enough to threaten SDS, get out of the market, and buy little shiny coins you put in a box. And maybe some ammo.

Love your blog.

John from Colorado said...

Excellent analysis and explanation of derivatives. I had done some research on the the structure of ultrashort and short ETFs and read some interesting articles in that regard. ProShares for example states that "A fund will be subject to credit risk with respect to the amount it expects to receive from counterparties to financial instruments entered into by the fund or held by special purpose or structured vehicles." It then goes on to describe how the fund may be affected by counterparty bankruptcy. It also says it "typically" enters into transactions with counterparties whose credit rating is investment grade. Well, I'm not sure that is very conforting given the credit rating organizations recent track record. Some companies who form ETFs disclose the intermediaries (Goldman, Morgan Stanley, Merrill Lynch, etc). Again, I'm not sure that is very reassuring given the recent state of affairs with Bear Stearns, et al. Personally, if I'm in SDS and things get too "good", I'll cash out, hopefully before things collapse.
A side note; I am struggling to be more patient with the market. Early this morning I was kicking myself for not getting into SDS earlier in the week after more bad financial news and SDS going higher. However, it does appear the bear rally has some life. Does it help to cheer on the bull? I'm sending all bullish investors positive energy.
John from CO

Jody said...


Thanks much for the GRZZX recommendation and for the pessimist humor! Actually, you're not the first person who's recommended investing in firearms. I hope it doesn't come to that.

Looking at the GRZZX chart, it's actually OUTPERFORMED SDS since the October market high! It's hard to believe you're losing money with that.


Believe me, waiting it out is difficult for me, too. That's the main reason that I stick to the objective market indicators, because my emotions almost never make the right decision. The market is still making higher highs and higher lows since July 15, so this is still a rally. However, short-term sentiment is already on the optimistic side, so the next decline will have energy behind it when it arrives.

Remember, you can always buy a little bit of SDS now to help you sleep at night. Even if it turns out to be an early purchase, I'm confident it would eventually be a winning position.

Anonymous said...

Once again you amaze with your direct, simplistic, easy to understand explanation of market factors.
This blog needs to be in a book.
The difference between BEARX and SDS is now quite easy to understand.
Ques: what factors would have to be in play in order for you to switch from SDS to BEARX? Are there any models out there such as trend lines, etc, that would say switch to BEARX?
The KD

Jody said...

The KD,

That's the problem: we've never had such an extensive derivatives market before, so any massive implosion would be the first of its kind. I doubt the problem would show up on any of my market radars. We'll just have to keep our ears and eyes open for unusual financial news.

Jim Driscoll said...

Looking at the GRZZX chart, it's actually OUTPERFORMED SDS since the October market high! It's hard to believe you're losing money with that.

Well, my company only allowed access to any fund with the 401k just recently - at the end of the last leg down. So guess what I did - that's right, I bought at the (recent) bottom.

As you've pointed out before, it's a bear market, so my plan is to just leave it in there until the bear market finally looks over. Which I'm guessing will be 2011, at best. I suspect that this time, the market will bottom out and stay there for at least a few months, trading in a range. So I suspect that there should be plenty of time to get out.

Oleg said...

Great article, it was very insightful. I was expecting Ultra short funds to use derivatives, but was surprised to find out that even unleveraged short funds use them as well. I just naively assumed that they just shorted index stocks.

As far as BEARX goes, I was surprised to see you pick this fund, or any "managed" mutual fund for that matter. BEARX is not really an index fund. Its prospectus indicates that it seeks capital appreciation at all times. Depending on the market analysis, the fund manager may choose to short or long positions, or even buy gold. If you trust the find manager to make these decisions, that's fine. But you are in charge of your own investment strategy and predicting the market timing. So, it seems that BEARX will work for you only if your prediction of market moves is consistent with the predictions of the fund manager. About a year ago you turned down BEARX, because its heavy exposure to gold was not something you were comfortable with.

What gives?

Jody said...


I agree that BEARX is far from an ideal fund - that's one of the reasons why I was ambivalent about it as a defensive fund last year, and why I haven't been using it (yet) during this bear market.

Here's the problem: there are only 2 U.S. funds that I know of that primarily short stocks: BEARX, and GRZZX (thanks, Jim!) Sure, as long as derivatives stay solvent, I will stick with SDS and not bother with BEARX or GRZZX. But, if derivatives start to show signs of weakness as I described in this post, then those two stock-shorting mutual funds will be just about the only ones that will go up in value at about the same rate that the market declines. As imperfect as they may be, they will still be superior to the derivative-using alternatives.

It's true - BEARX already has some long positions in gold-related stocks (as I talked about in that earlier post), and they leave open the possibility that they may increase their long exposure in the future, but BEARX is moving opposite to the market right now, so it's obviously still a short fund for the time being. The dividend yield of the S&P is only about 2%, and I doubt that the BEARX managers will start going long anywhere below 3%.

Regarding gold and BEARX, Jim makes a good point that "shiny coins" are a safe investment during the worst times, so BEARX's gold exposure might actually give it a an additional leg up.

linc campbell said...

What I am about to say may be as full of hot air and steaming bull crap as possible, but it seems to be the case. With no further adoo...

The down side of the "shiny coins" and precious metals argument is that if the rest of the world runs head on into hard times as it appears to be doing (if it has not already hit said times), then the dollar improves on a relative basis and all commodities will head cheaper regardless of whether or not the dollar is improving on an absolute basis. Conversely, if the world hits hard times and sends the dollar better in relative terms and the dollar strenthens in its own right, then commodity prices will fall as geometrically as they have risen.

That illustrates only one part of the problem right now in terms of predictive measures: diversified volitility. I'm not a technical analysis wonk, which I'm not (alhtough I am trying to learn), I would think this is the most difficult portion of the last five years in terms of charting potential entry and exit points. By the way, I use wonk as a non-pejorative.

Jim Driscoll said...

Linc -

Yes, the dollar is still the world's reserve currency. As things dump in the rest of the world, the dollar will go up relative to other currencies. Where it goes relative to things like precious metals will depend heavily on how much currency debasement the central banks perform trying to fix the deflating economy.

There's a very real risk that the dollar will cease to be the reserve currency - just as happened to the Pound Sterling, back in grandpa's day. Just because something's been one way for 90 years, doesn't mean it'll be that way for another 90. There are three candidates to replace the dollar - 1) the Euro (unlikely, they're going to have it worse than us) 2) oil (again unlikely, because use falls in a downturn) and 3) gold (the most likely, but still a bit of a long shot).

If you're seriously considering about the collapse of the derivative market, a significant flight from fiat currencies is not off the table as a consequence.

As for Gold's current free fall (I'm buying more at 650, btw): hedge funds are dumping gold because they have to. Forced selling == lower prices. Eventually, the hedgies will be out of the trade... And then we'll see what happens next.

I'm predicting an exciting September? Remember that many of our best crashes happened mid-September to mid-October.

As for BEARX and GRZZX - I've recently found references that they also invest in derivatives sometimes - derivatives like QID and SDS (short term only, but still). Presumably they'll get out of the trade if they see the same things we do, but if there's a derivative crash, nothing in a market account is truely safe.

linc campbell said...

Jim -

I agree with everything you said. Hard to disagree with truth though.

For good or for bad FIAT is probably here to stay, although a good discussion of that is best left to a better forum than this comments section.

EricTheRon said...

To be free of emotional errors on these things, remember this: option counterparties are "more senior" than even the bondholders of the companies (banks etc.) So not only would the stockholders have to be wiped out but all the bondholders too, in order for counterparty risk to be a reality. This is why "Investment Grade" is pretty good for counterparty risk. Mind you, funds might be tied up while a bankruptcy was handled, but your counterparty (ETF etc) would probably be made whole, and you with it.

J. Wilson, Ph.D. said...

Thanks for that information, ETR.

I'm still not satisfied though, because if the last few months have taught me anything, it's that (1) I can't fully trust the ratings agencies, and (2) the officials who are supposed to protect investors from scams can't even see a $50 billion Ponzi scheme right under their noses.

In the long run you may prove to be correct about the safety of leveraged ETFs, but right now I'm not willing to take that risk.