onsdag 15. april 2009

Why bull and bear funds loose on market fluctuations

Bull and bear funds are a type of leveraged exchange traded funds (ETF's) which aims to deliver double the returns and losses of an underlying index. This way you can earn higher returns on a smaller investment, if the market moves in a favorable direction. The disadvantage is however that the leverage rebalancing that most such funds do at the end of the day, destroys value. You can however avoid that problem.

From October 17th 2008 until February 19th 2009 there was no change in the Oslo Stock Exchange Benchmark Index (OBX). The market fluctuations in this period nevertheless reduced the values of the bull and bear funds by up to 35%.

Return October 17th - February 19th :


OBX:0%
XACT Bull: -21%
XACT Bear:-33%
DNB Bull:-21%
DNB Bear:-35%



These are money out of the window for investors speculating in these products, since one can achieve the same exposure without such losses. Bear and bull funds are therefore only good for very short term speculation. If you have a horizon of more than a few days, you can however leverage the investment without loosing on market fluctuations.


The reason that you loose on these funds is that the manager systematically buys when prices are high and sells at low prices. This is illustrated in the graph "Trading loss of a Bull fund"

The solution may be to buy the underlying futures that the funds use yourself, and make your own bull or bear fund. The problem for the funds is that they are committed to hold the leverage ratio and the risk fixed, so that they at the end of each day sell when the index goes down and buys when it goes up. If you buy the future directly, you do not need to make such considerations, as shown in the figure "Trading with futures". Future trading also has the advantage that you need much less liquidity than the funds. Amateur investors should however know that the risk can be substantial, and so one should be careful to not over do it.

Anyway, here is how.

How to make your own bear/bull fund:
You can relatively easy avoid the entire problem of losses due to rebalancing that you have in the leveraged funds by buying and selling the relevant index futures yourself. Most indexes are traded as futures, and it is common that you can buy contracts that last for up to 6 months. Buying and selling futures are usually done through on-line brokers exactly the same way as stocks, so check with your broker whether they offer futures trading.

Most likely, before you are allowed to start trading, you will need to sign the following contracts:

  • Derivative trading contract
  • Leverage limit contract
Once you are allowed to trade futures by your broker, you can achieve exactly the leverage you want, and there will be no costly middle man or management fee. As a future trader you should however be aware that:

  • Possibility for high risk: There is no payment when entering the contract. However a small amount on your balance is locked as collateral. Hence, it is the size of this margin that determines the amount you can trade for.
  • Margin payments: In contrast to stocks, where losses are realized on sale, the losses are subtracted from your account every day, and the gains are paid in.
  • You may lose everything: If you do not have the money to cover the margin calls, your contract is terminated. If you have $10 000 on your broker account, buys index contracts for $100 000, and the index falls by 10%, you're broke.

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