Friday, December 30, 2011

2011 market investments and learnings from ETF instruments

2011 was the first year I was really invested in ETF's. I learned a lot about them but the lessons took too long to get. But there were major learnings. It is a well known fact that they were designed to be used for short periods of time and not to just buy and hold like traditional stocks. However that is easier said than acted upon, especially if you bought some and the market moved in the opposite direction you had expected.

Let me give you an example using the Russell 2000 index, symbol RUT, and comparing it versus the ETF's which represent the Index, TNA, the 3x Ultra Pro ETF and TZA, the -3x Short ETF. This means that on a given day where the Russell moves up 1%, TNA should move up about 3% while TZA should be down 3% on the same day. This is all well and good in practice of a given day, but if you do not sell on that given day and lock in your profit while looking for more the next day and possibly the next day after that, then you will be surprised at the cumulative effect that will have on your portfolio.

For 2011, the Russell 2000 has lost 5%. One would expect the following. TNA should be then down 15% and TZA should be up 15%, but that's not what really happens. Let's see what you would guess the numbers should be before I reveal them? Take a guess! Well the chart below is a chart of the Russell and TZA, which one would have thought would be up 15% for the year. Here's the chart:

Now let's look at what you would have expected for TNA versus what actually occurs. In the chart below I have the Russell plotted against TNA.

The 3rd chart is a plot of only TNA versus TZA for the 1 year period.

It took me a while to realize I needed to trade these ETF;s when I made any good profits and get over trying to get back to my average purchase price, but when I did I actually made some good moves thanks to the volatility of the market during the year. My best advice is don't buy and hold these or other ETF's for long periods of time or you will eventually lose your money. I suspect many others don't understand these ETF's and it has been a painful lesson to learn. I hope these charts make it very clear and that the smae mistake is not repeated in 2012.

So what time duration seems to correlate closely or to say it another way, how long should you keep these ETF's. Here is a chart below of only 3 months comparing the Russell, symbol RUT, to TNA. During the last 3 months, RUT gained 16% and one would expect that TNA should be up 3x that amount or 48%. Well in fact, TNA gained only 39% as is seen in this chart below. So you will lose even in short a time as 3 months. Here's the chart:

The next chart is of the RUT versus TZA for the same past 3 month time period. As you might expect with a 16% gain of RUT that it would create a loss of 48% of TZA. Well as you can see the loss was greater than 48%. The loss was in fact 52%.

In summary, even a 3 month time period will cost you bigger losses or less gains than you might have come to expect. The shorter the timeframe the better the correlation.

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