Daily Investment Interpretations

May 11, 2009

2009-5-11:  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 "daily" 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.
The 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. EEM 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.
The Proshares UltraChina Fund, UGPIX
    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 share. 
Obtaining 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.
The First Case: The $35 January, 2011, FXI call, VHFAI
$35 January, 2011, FXI call, VHFAI 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 lots). 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 option for $7 + $28 = $35 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).
The Second Case: The $20 January, 2011, FXI call, VHFAT
The $20 January, 2011, FXI call, VHFAT 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 $0.87 a share. Wow! That's quite a price drop! If we cost-share by putting up $15 of the $35 cost for the stock, we can cut the option fee from $7.00 to $0.87! So what will happen if FXI rises another $35 a share to $70 a share? We paid $15.50 a share. We'll pretty well lose our $0.87 a share options fee, so our shares will rise $35 - $0.87 = $34.13 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 = 3.17... 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.)
Managing Risk
    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 portfolio.
    This is only one high potential-return tactic. As time permits, I'll add others. (This is a labor-intensive process.)