May 11, 2009
Whoa! Hold the phone! Both the Proshares Ultra Emerging Markets Fund,
UUPIX, and the Proshares UltraChina Fund, UGPIX, are designed to generate
twice the daily
gains and losses of their underlying indices. (See the April 16th
installment for a discussion of the failure of these ultra funds to
deliver twice the returns of their underlying indices.) That innocent-sounding word
doesn't sound important but it turns out that it is. Proshares warns
against buying and holding their Ultra funds for extended periods of time.
The Ultra funds are designed for short-term traders. Long-term, the Ultra
funds don't at all appear to deliver twice the gains and losses of their
underlying indices. Let's take a look at the numbers.
Proshares Ultra Emerging Markets Fund, UUPIX
The Ultra Emerging Markets Fund UUPIX
bottomed at $4.26 a share, and is running around $10 a share today. This
gives it a current-price-to-valley ratio of $10/$4.26 = 2.35.
hit bottom at about $18.25 last November 20th, and has spiked as high as
$32 a share on May 4th, yielding a ratio of $32/$18.25 = 1.75.
This means that UUPIX is delivering a "performance ratio" of
only about 2.35/1.75 = 1.34,
which is a long way from the 2:1
ratio it's supposed to be providing. While UUPIX would have to more than
quintuple to reach its October, 2007, peak, simple extrapolation would see
it failing to recover more than about half its former ($54)
peak, delivering only another 2.35
boost and topping out at $23.50.
It's important to note that the emerging markets have
already risen about 75% above their bear-market bottoms, and would only
need to rise another 75% to reach their previous bull-market peaks. In
other words, they're about halfway back to their October, 2007, tops.
Proshares UltraChina Fund, UGPIX
bottomed at $3.18 on March 2nd and peaked on Friday at $7.75, so it's
risen by a factor of $7.75/$3.18 or 2.43.
The iShares TR FTSE (China) Index FXI
isn't exactly identical to the index UGPIX uses, but it's close enough. It
has gone up from about $19 a share last October to about $38 a share last
week, so it's up by a factor of about 2.
This means that UGPIX has delivered only a little more than owning the FXI
index itself when I would have expected it to have delivered twice FXI's
gain .. to have 4-folded.
The China Index is also somewhere in the neighborhood
of halfway back to its 2007 peak, and might be expected to rise about 100%
from where it closed tonight (at $34.36 a share) to about $70 a
Ultra Fund Performance Using Call Options
Fortunately, there are alternatives to these ultra
funds, one of which is
the use of LEAPS (Long-term Equity Anticipation Securities). And for this,
based upon several years of sometimes-painful experience, I'm looking now
at the $20, January, 2011, FXI call (VHFAT) and the $35 January, 2011, FXI
call, VHFAI. The strategy involved goes like this.
First Case: The $35 January, 2011, FXI call, VHFAI
$35 January, 2011, FXI
sells at this moment for $6.90 bid, $7.10 asked. OK. Let's say we pay $7.00
for one option (which is really $700
for an option on 100
shares of FXI,
since options are sold in 100-share
Our option gives us the right to buy 100 shares of FXI for the next 20
months (until January, 2011) for exactly the $35 price for which FXI is
selling today. So the $7 is the fee we pay to purchase this 20-month
option. Obviously, if FXI is still selling for $35 a share in
January, 2011, when the option expires, we'll have paid $42 a share for a
$35 ETF, and have lost $7 a share. But if FXI doubles to $70 a share,
(which I think may happen), then our option would jump by $35
a share - $7 a share
for the option cost... in other words, by $28
a share on an option for which we paid $7.
In other words, we would be able to sell our
$7 + $28
a share, 5-folding
our money. I'm oversimplifying this a little, but this is probably pretty
close to what will happen. (I'll defer an explanation of how, and how much
I'm oversimplifying this until I discuss the second case (below).
Second Case: The $20 January, 2011, FXI call, VHFAT
$20 January, 2011, FXI
sells for $15.40 bid, $15.70 asked. OK. Let's say we pay $15.50
for one option. Our option gives us the right to buy 100 shares of FXI for
the next 20 months (until January, 2011) by paying an additional $20 a
share. In other words, we've already partially purchased our shares of FXI
by paying roughly $15 a share right now. FXI is selling at this moment for
$34.63, and we're going to pay $15.50 a share plus another $20 a share if
we actually decide to buy our 100 shares, or $35.50 a share. Then the
options cost going this route drops from $7.00 a share to $35.50 - $34.63
a share, or
a share. Wow! That's quite a price drop! If we cost-share by putting up
cost for the stock, we can cut the option fee from
$7.00 to $0.87!
So what will
happen if FXI rises another
a share to
a share? We paid
a share. We'll pretty well
a share options fee, so our shares will rise
$35 - $0.87 =
a share, bringing them to
$15.50 + $34.13 = $49.63
a share on
options which we bought for $15.50. Our gain factor will be $49.63/$15.50
not as good as the 5-folding that we got buying the $35
January, 2011, FXI call, VHFAI, but still respectable.
What Happens If FXI Goes Down in Price?
Now let's look at what happens if a year from today,
FXI drops in price from about $35 a share to about $20 a share.
Our $7.00 call option will be worth about $0.75 a
share, while our $15.50 call option will be worth about $4.50 a share.
Neither outcome looks terribly attractive, but with the $35
"at-the-money" call, you'll retain about 1/9th of your original
value, whereas with the $20 "deep-in-the-money" call you'll
salvage a little less than 1/3rd of your original investment.
When this happens, you can, if you wish, sell your
options for whatever paltry price they'll bring and then buy calls a year
farther out (January, 2012). (These 2012 calls aren't available today.)
Because gains can be so large using these call options,
one way to play this is to invest only a small fraction of your money in
these aggressive calls, keeping the remainder in very conservative
investments such as money market funds or very conservative
dividend-paying stocks. For example, suppose you invested 25% of your
portfolio in the $35, VHFAI calls described above, with the other 75% in
money market funds or in conservative dividend-paying mutual funds. If FXI
doubled, you would double the value of your portfolio. If FXI collapsed,
the most you could lose would be 25% of your portfolio.
In other words, you
would be weighing what I would consider a high likelihood of a 100% gain
against, at most, a 25% loss.
If you wanted to
double your portfolio using the more-conservative $20
VHFAT calls I've described above, you
would have to invest 40% of your portfolio in VHFAT to double your
This is only one high potential-return tactic. As time
permits, I'll add others. (This is a labor-intensive process.)