Getting Leverage. g g Going Short. Live Webinar Live Webinar May - PowerPoint PPT Presentation

Getting Leverage. g g Going Short. Live Webinar Live Webinar May 14, 2009 2:00 – 3:00 pm EDT

Definitions Definitions A leveraged ETF attempts to provide returns A leveraged ETF attempts to provide returns equivalent to a multiple (2x, 3x) of a benchmark, over a specific period of time over a specific period of time . A i An inverse ETF attempts to provide returns ETF id opposite, and often leveraged, to a benchmark, over a specific period of time . ifi i d f i

History History First leveraged ETFs First leveraged index fund ProShares 2x ETFs Rydex Nova Fund, 1.5x S&P 500 Continued Expansion 1993 1995 2000 2005 2008 First inverse fund ProFunds and Potomac (now Direxion) ( ) Direxion launches 3x ETFs Rydex URSA Fund, • ProFunds – 2 beta funds ‐ 1x S&P 500 • Potomac – 1.25 beta

Tremendous Growth Tremendous Growth Most major asset classes Range from 3x to ‐ 3x Over 100 ETFs and ETNs > $30 billion in assets 27% of daily trading volume

Tremendous Growth Tremendous Growth Leveraged/Inverse Assets Leveraged/Inverse Assets US$, Millions 30,466 30,466 17,254 4,775 April ‐ 06 April ‐ 06 April ‐ 07 April ‐ 07 April ‐ 08 April ‐ 08 April ‐ 09 April ‐ 09

Tremendous Growth Tremendous Growth 2009 Flows (through April) 009 o s (t oug p ) Long (Traditional) Short ‐ Levered Short Long ‐ Levered ‐ 4,000 ‐ 2,000 0 2,000 4,000 6,000 8,000 10,000 12,000 US$, Millions US$, Millions

Tremendous Growth Tremendous Growth April 2009 ETF Assets p 009 ssets Long ‐ Levered 2% Long ong Short (Traditional) 1% 94% Short ‐ Levered 3%

Tremendous Growth Tremendous Growth April 2009 ETF Volume p 009 o u e Long ‐ Levered 9% Short 0% Long g (Traditional) 73% Short ‐ Levered 18%

Headline Horror! Headline Horror! “Warning: Leveraged and Inverse ETFs Kill Portfolios Too many people are making sucker bets with these products.” Morningstar, 1/22/09

The Big Myths The Big Myths They deliver x% of an index’s long ‐ term return y g 1. Wrong – it’s all about holding period They have huge tracking error 2. No – they generally track very well People use them incorrectly 3. Not if you look at the volumes Not if you look at the volumes They’re ETFs, so they must be tax efficient 4. Shorting and leverage are rarely tax efficient They’re poison 5. No; they’re a very, very sharp tool in the drawer

How They Work How They Work Exposure through derivatives ‐ Swaps are the vehicle of choice The Swap ‐ Contract with a counterparty ‐ An agreement to pay a daily return ‐ Not a traded security (like a bond) y ( ) ‐ Rebalanced regularly ‐ Minimal risk – settlement gap Minimal risk settlement gap

Long ‐ Term Returns Long Term Returns

Tracking Error? Not Really Tracking Error? Not Really Compounding Path Dependency p y Leverage Drag

Short Term: No Problem Short Term: No Problem

It’s All About Timing! It s All About Timing!

It’s by design

Tracking Error? Not Really Tracking Error? Not Really Day 1: Index Level: y 100 ‐ 200% ETF Level: 100 Day 2: Index up 10% Day 2: Index up 10% Index Level: 110 ‐ 200% ETF Level: 80 Day 3: Index down 10% Index Level: 99 ‐ 200% ETF Level: 96

Complex Structure of Leverage Complex Structure of Leverage Index Volatility Index (1 ‐ yr) 300% Inverse 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% ‐ 50% 150% 646.16% 526.52% 367.83% 210.27% 82.30% ‐ 5.83% ‐ 56.92% ‐ 82.75% ‐ 94.02% ‐ 98.16% ‐ 45% 135% 462.16% 371.63% 252.06% 132.80% 36.63% ‐ 29.20% ‐ 67.72% ‐ 87.22% ‐ 95.56% ‐ 98.67% ‐ 40% 120% 333.89% 263.88% 171.20% 79.08% 4.73% ‐ 45.87% ‐ 75.48% ‐ 90.23% ‐ 96.66% ‐ 99.00% ‐ 35% 105% 241.84% 186.47% 113.21% 40.76% ‐ 17.82% ‐ 57.91% ‐ 80.87% ‐ 92.48% ‐ 97.40% ‐ 99.23% ‐ 30% 90% 174.04% 129.54% 70.66% 12.62% ‐ 34.34% ‐ 66.31% ‐ 84.69% ‐ 93.93% ‐ 97.94% ‐ 99.39% ‐ 25% 75% 122.98% 86.72% 38.73% ‐ 8.73% ‐ 46.94% ‐ 72.77% ‐ 87.75% ‐ 95.18% ‐ 98.36% ‐ 99.52% ‐ 20% 60% 83.86% 53.86% 14.16% ‐ 24.84% ‐ 56.35% ‐ 77.65% ‐ 90.01% ‐ 96.05% ‐ 98.66% ‐ 99.61% ‐ 15% 45% 53.34% 28.29% ‐ 4.90% ‐ 37.43% ‐ 63.71% ‐ 81.50% ‐ 91.74% ‐ 96.75% ‐ 98.90% ‐ 99.68% ‐ 10% 30% 29.22% 7.99% ‐ 19.99% ‐ 47.46% ‐ 69.65% ‐ 84.59% ‐ 93.12% ‐ 97.32% ‐ 99.10% ‐ 99.74% ‐ 5% 15% 9.86% ‐ 8.23% ‐ 31.99% ‐ 55.50% ‐ 74.20% ‐ 86.85% ‐ 94.19% ‐ 97.73% ‐ 99.24% ‐ 99.78% 0% 0% 0% 0% ‐ 5.81% 5 81% ‐ 21.33% 21 33% ‐ 41.83% 41 83% ‐ 61.95% ‐ 78.04% ‐ 88.87% ‐ 95.02% ‐ 98.08% ‐ 99.36% ‐ 99.81% 61 95% 78 04% 88 87% 95 02% 98 08% 99 36% 99 81% 5% ‐ 15% ‐ 18.65% ‐ 32.07% ‐ 49.84% ‐ 67.11% ‐ 81.14% ‐ 90.44% ‐ 95.78% ‐ 98.36% ‐ 99.47% ‐ 99.85% 10% ‐ 30% ‐ 29.28% ‐ 40.99% ‐ 56.40% ‐ 71.49% ‐ 83.62% ‐ 91.76% ‐ 96.37% ‐ 98.61% ‐ 99.53% ‐ 99.87% 15% ‐ 45% ‐ 38.13% ‐ 48.39% ‐ 61.93% ‐ 75.17% ‐ 85.74% ‐ 92.80% ‐ 96.83% ‐ 98.79% ‐ 99.60% ‐ 99.89% 20% ‐ 60% ‐ 45.57% ‐ 54.62% ‐ 66.57% ‐ 78.23% ‐ 87.48% ‐ 93.73% ‐ 97.25% ‐ 98.95% ‐ 99.66% ‐ 99.90% 25% ‐ 75% ‐ 51.88% ‐ 59.92% ‐ 70.50% ‐ 80.80% ‐ 88.99% ‐ 94.49% ‐ 97.58% ‐ 99.08% ‐ 99.70% ‐ 99.92% 30% ‐ 90% ‐ 57.24% ‐ 64.41% ‐ 73.83% ‐ 82.99% ‐ 90.31% ‐ 95.15% ‐ 97.87% ‐ 99.19% ‐ 99.74% ‐ 99.93% 35% ‐ 105% ‐ 61.86% ‐ 68.26% ‐ 76.66% ‐ 84.91% ‐ 91.38% ‐ 95.70% ‐ 98.15% ‐ 99.29% ‐ 99.77% ‐ 99.94% 40% ‐ 120% ‐ 65.82% ‐ 71.57% ‐ 79.13% ‐ 86.48% ‐ 92.33% ‐ 96.21% ‐ 98.36% ‐ 99.38% ‐ 99.80% ‐ 99.95% 45% ‐ 135% ‐ 69.26% ‐ 74.49% ‐ 81.32% ‐ 87.96% ‐ 93.16% ‐ 96.60% ‐ 98.55% ‐ 99.46% ‐ 99.83% ‐ 99.95% 50% ‐ 150% ‐ 72.26% ‐ 76.98% ‐ 83.17% ‐ 89.16% ‐ 93.88% ‐ 96.98% ‐ 98.69% ‐ 99.52% ‐ 99.85% ‐ 99.96%

How Long Can You Hold? How Long Can You Hold? Journal of Indexes Study, March 2009 Journal of Indexes Study, March 2009 ProShares Ultra Dow30 (NYSE Arca: DDM) ProShares Short Dow30 (NYSE Arca: DOG) ProShares UltraShort Dow30 (NYSE Arca: DXD)

How Long Can You Hold? How Long Can You Hold? 1 ‐ Day Tracking Error 0.50% DDM DOG DXD 0.25% 0 25% 0.00% ‐ 0.25% ‐ 0.50% 1 101 201 301 401 501 601

How Long Can You Hold? How Long Can You Hold? 95% Interval 1 ‐ Day Tracking Error 12.00% 9.00% 6.00% 3.00% 0.06% 0.13% 0.09% 0 09% 0 00% 0.00% ‐ 0.13% ‐ 0.06% ‐ 0.13% ‐ 3.00% ‐ 6.00% ‐ 9.00% ‐ 12.00% DDM DOG DXD

How Long Can You Hold? How Long Can You Hold? 95% Interval 1 W 1 ‐ Week Index Variance k I d V i 12.00% 9.00% 6.00% 3.00% 0.54% 0.22% 0.26% 0 00% 0.00% ‐ 0.74% ‐ 1.00% ‐ 3.00% ‐ 2.78% ‐ 6.00% ‐ 9.00% ‐ 12.00% DDM DOG DXD

How Long Can You Hold? How Long Can You Hold? 95% Interval 1 M 1 ‐ Month Index Variance th I d V i 12.00% 9.00% 6.00% 3.00% 1.94% 0.54% 0.94% 0 00% 0.00% ‐ 3.00% ‐ 2.83% ‐ 3.98% ‐ 6.00% ‐ 9.00% ‐ 12.00% ‐ 11.82% DDM DOG DXD

DXD Holding In Review DXD Holding In Review 1 ‐ Day 1 ‐ Week 1 ‐ Month 1 ‐ Year Worst Case ‐ 0.47% ‐ 6.05% ‐ 16.02% ‐ 21.73% Interval ‐ 0.13% ‐ 2.78% ‐ 11.82% ‐ 12.60% 95% 0.13% 0.54% 1.94% 23.52% Best Case 0.39% 8.09% 16.54% 52.62%

Solving the Tracking Issue Solving the Tracking Issue Day 1: Index Level: 100 Initial ‐ 200% ETF Investment: Initial 200% ETF Investment: $100 $100 Day 2: Index up 10% Index Level: 110 ETF Investment: $80 Additional Investment: $30 Total ETF Investment: $110 Day 3: Index down 5% Index Level: 104.5 ETF I ETF Investment: $121 $121 Net result: Index up 4 5% position loss of 9% on initial investment Net result: Index up 4.5%, position loss of 9% on initial investment

A Different Path: Monthly? A Different Path: Monthly? Shifting Math Shifting Math Funds should track as expected if: ‐ You get in on day 1 You get in on day 1 ‐ You get out on reset Intra ‐ period entries get different exposure

A Different Path: Monthly? A Different Path: Monthly? Day 1 Day 15 Day 30 Index Index 5% 5% 3x Return 15% Index 10% 3x Return 30% Index 4.76% 3x Return 13.04% Midmonth investor gets less exposure per dollar invested (when the month is positive), or more exposure when the p ) p month is negative.

Key Issue: Liquidity Key Issue: Liquidity It’s all about spreads It s all about spreads RTG (Rydex 2x Tech): Average Volume: ~6,000 shares Spread: 3.5% QLD (ProShares 2x QQQ): Average Volume: ~30 million shares Spread: Consistently a penny

Key Issue: Taxes Key Issue: Taxes The Rydex Problem 2008 Cap Gains The Rydex Problem: 2008 Cap Gains ETF Name Ticker Short ‐ Term Long ‐ Term Total Gains Rydex Inverse 2X S&P Select Sector Energy REC 86.61% 0.00% 86.61% Rydex Inverse 2X S&P Select Sector Technology RTW 59.46% 0.00% 59.46% Rydex Inverse 2X S&P Select Sector Financial RFN 42.35% 7.32% 49.67%