Funds That Are Built to Die

Making sense of the new breed of ETF.

John Rekenthaler 08.03.2018
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Disposable Funds
The VelocityShares Daily Inverse VIX (henceforth to be called by its ticker, XIV), which lost 95% of its value before folding up shop last week, had me wondering: How common are catastrophic losses with ETFs? The possibility that a fund might collapse is a new thing for retail investors. Mutual funds do not melt down in that fashion, nor did the first wave of ETFs. However, the second and third waves of ETFs, often leveraged and/or investing in futures, are something different.

The answer: Over the trailing five years, 66 of the 1135 ETFs in the U.S. have annualized returns of less than negative 20%, meaning that their cumulative losses exceed 67%. In addition, more than 600 ETFs have expired. Since there were few ETFs before the year 2000, and fewer than 2200 ETFs now exist, that makes for a high and rapid death rate. Not all deceased funds were complete disasters—but most were bad at best, and some were much worse than that.

(If, at this point, you remain unafraid of fringe ETFs, consider this: 25 ETFs are down more than 40% per year. That translates to an almost 80% cumulative decline, cumulatively. Among that group, seven have annualized losses exceeding 60%. I once held an investment that fell by 60%, and that wasn’t much fun. But it rebounded the following year, rather than losing 60% again and again and again and again.)

And the stakes are rising. First came leveraged ETFs, then double leveraged. Triple-leveraged followed. Now, there are quadruple-leveraged ETFs, courtesy of VelocityShares. (Technically, these new offerings are exchange-traded notes, meaning that the issuer guarantees the funds’ payouts rather than place the proceeds into a segregated account, as with a conventional fund.) Mach 5 ETFs, no doubt, will soon be forthcoming.

Many of these funds won’t make it. When leverage gets that steep, the probability of a bankruptcy (or near-bankruptcy) becomes high. Breaking such funds' bank doesn’t require a perfect storm. A relatively ordinary crash can do the job. Such was the case with the XIV fund, which per Cliff Asness’s analysis, expired because of a “3.3-sigma” leap in stock-market volatility. Untangling the jargon, XIV died because of a once-in-eight-years event.

Possible Uses
Such funds can’t be bought and held, in the customary fashion of retirement accounts, and according to the principles of today's wealthier investor, Warren Buffett. Even if they perform wonderfully well, compounding their gains so that they grow by several hundred percent over their first few years, these highly leveraged funds are likely at some point to give it all back. After all, a fund that appreciates by 800% over its first six years, then falls 90% because of a 3.3-sigma event, is a fund that loses money for the buy-and-hold investor.

The question then becomes, Are there legitimate uses for funds that are built to die? Or, are they nothing more than abominations—Frankenstein monsters from fund providers who care not what havoc their creations wreak, as long as they can advertise that they offer something different?

My initial answer is, abominations. The best food isn’t necessarily that which is quickest to prepare, or the best cars those that are the easiest to assemble, but for investments, simplicity is a gift. Back in the day, I had a colleague who immediately dismissed every high-concept fund as being not worth her attention. That drove fund companies mad. They would accuse her of being irresponsible by not delving into the details. But she was rarely wrong.

However, while being plenty skeptical themselves, my current co-workers have suggested two ways in which sophisticated buyers might use these fringe ETFs. Both methods, critically, involve the active harvesting of early profits. (There had better be early profits; if the losses come first, these funds might not live to enjoy any later profits.) The unrealized gains that accrue to highly leveraged ETFs probably will not last, so transform them into realized gains when possible.

Two Paths
The first approach, discussed on Tuesday, is to rebalance the ETF early and often. The fund’s purpose will vary, depending upon what asset it leverages and the composition of the rest of the investor’s portfolio. Sometimes, the ETF will serve as a hedge; other times, it will be for speculation. Either way, its profits will not ride. They will be shed by rigorous rebalancing. Under such conditions, XIV would have helped a U.S. stock portfolio, despite its cataclysmic 2018 decline.

The other tactic for realizing gains is have an aggressive withdrawal strategy. Treat the ETF as an immediate annuity, by pulling assets from it on a regular schedule, beginning shortly after the investment is made. Once again using XIV as the subject, Morningstar’s Maciej Kowara measured the results for a buyer who purchased the fund at its inception, then withdrew 1.2% of the fund’s current assets (not the initial purchase price, but rather whatever the fund was worth at the time of withdrawal) at the end of each week. The internal rate of return on that investment would have been 20% annualized.

As a reminder, that 20% annualized gain would have been earned on a fund that, as measured by standard performance figures, lost money during its lifetime. The hypothetical shareholder’s experience would have been the opposite of the general rule, which is that, through unhelpful purchase and sale decisions, mutual fund owners make less money in reality than their funds do on paper. Too often, they buy high and low. In contrast, the investor who rebalanced or withdrew steadily from XIV would have sold high, often, while buying low.

These findings don’t hold if the ETF sinks, rather than soars, shortly after the investor buys it. They also would be complicated (if not eradicated) by taxes for an investor in the U.S., if the fund was held within a taxable account. Finally, any such strategy should be only for involved, experienced investors. These funds, of course, are not for everyone. That they might be for someone is what surprises me.

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John Rekenthaler  is vice president of research for Morningstar.

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