Why SRS is down

Voltron says:  good explanation for why SRS is down.  See my comments in the middle and at the end.

 

IYR and SRS: When Opposites Attack

Adam Warner  Jun 11, 2008 1:45 pm   Inverse fund performance sometimes needs some explaining.

The more of these you look at these Inverses, the uglier it gets. Here's iShares Dow Jones US Real Estate (IYR), down about 5% over the past six months.


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So how about the UltraShort Real Estate ProShares (SRS), the Double Inverse of this? It's up 10%, right? Well, not exactly. It's down 12%. I'm sure there were some dividends over this stretch, but that can't quite make up this shortfall.


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David Merkel is not optimistic about the Triple Funds coming down the pike. I'm afraid to mention my "Duodecaphonic Inverse ETF," currently in the pipeline.

So what's going on? It could be bad management, but Woodshedder has a simpler explanation.

Let's say they're both $100. And then on Day 1 IYR rallies 1%. SRS will go down 2%, or $2 to $98. Then on Day 2, IYR dips back 1% to 99.99. SRS should then go up 2%, to $99.96. No one will really notice, but obviously this adds up.

On the flip side, an extended move in one direction will cause the combo to lift. Let's say IYR goes up 1% a day for five straight days. IYR is now 105.10, SRS is 90.39. You can even throw in some reversal days and get similar results.

Voltron says: SRS has 2x leverage, but IYR does not, so if you bought 2 shares of IYR (a bet that the index goes up) and 1 share of SRS (a bet that the index goes down)  In the previous scenario (up 1% for 5 days)  The two trades would not cancel out, you would actually make $0.59.  This is due to “negative convexity” or “non-linearity” of the SRS payout.

The bottom line though, is any round trip to "unch." will cause a loss in the combo over that particular time frame.

Why is this important? I mean, after all, it's essentially a directional bet, no?

Well, if nothing else, it implies an Inverse Fund is not likely your best alternative over the course of time, when compared with something like simply shorting the regular ETF, or using puts and/or calls.

 

Voltron says:  So if there is an extended move down in the real estate index, you’ll profit, but if the index whipsaws around (price volatility) you may take some lumps.  But compare the alternatives:  If you short, you have unlimited downside risk.  If you buy puts, you actually benefit from price volatility but you also have to get the timing right, which is difficult.  Given that and the convenience, in the long run I still think ETFs are like SRS a good tool.  SRS’s negative convexity isn’t a good thing, but it’s worth it to not have to worry about timing or unlimited risk.