Ultra ETF Tracking Error
Research for Online Investors

by John Dalt

5/29/09

One of the conversations I have with many friends and subscribers is my firm belief in managing your own retirement or investment accounts.  In fact, this is the reason for GaltStock, to help individual investors make safe decisions for the future.  Managing your own money can be fun and profitable if you use discipline and proceed cautiously in your investment decisions.  You should read articles under Investor Resources at our website for insight and rules that you should always keep in mind.  Some important articles are on Trailing Stops, Four Legs of Wealth, and ETF’s Better Than Mutual Funds.  There are other articles to assist you, but these three will help get you started.

Today I want to amplify some information on ETF’s.  These are great trading vehicles, but more importantly, SOME of the ETF’s are great investment vehicles with a low average 0.08% expense fees.  The alternative many investors use are mutual funds, these investment vehicles carry an average management fee of 2.2%  A mutual fund cost 27 times the expense ratio of the average ETF, is the cost worth the benefit?  Can you manage your investments, cut costs, and improve your return?  I believe you can, if you are cautious and always keep two rules in mind:

1. Return OF money.
2. Return ON money.

Every time I favor number ‘2’ over number ‘1’, in other words get greedy, I pay for it.  SPY (S&P 500) should be any investor’s favorite.   SPY tracks the index, pays 3%, and with elementary trading rules will return good results.

ETF’s offerings expand to fit demand; there are ETF’s that follow individual sectors, reverse ETF’s, and ETF’s for foreign markets. There are ETF’s for every imaginable investment desire.

Let's look ULTRA ETFs. Most of these seek to ‘double’ the daily movement of the underlying security or sector. The important word in this description is ‘daily’ not ‘double’; these are not long-term investment vehicles! It seems like this should not present a problem, but simple math will explain how “tracking error” will erode your equity in a choppy market. The figures below explain:

                                   Index                          X 2

Starting Price            100.00                        100.00
-10%                           90.91                          83.33
+5%                            95.46                          91.66
- 7%                            89.21                          80.40
+12%                          99.92                          99.69

In four market fluctuations of less than 20%, an investment in an ULTRA ETF just lost .23% in ‘tracking error’. This little test explains why I like to ‘short’ Ultra ETFs. In spite of the market movements, Ultra’s always get worth less. The wilder the market, the more the erosion, or ‘tracking error’. Imagine the thousands of transactions that occur in one day, the multiple fluctuations in price that are inherent in just one day. Now multiply that over many days or months, these are NOT long-term investments. These are trading vehicles. If you are going long with any ULTRA ETF, it should be held only for the short term, and hopefully while it is moving in one direction. Even for a short-term position, why not short an ULTRA ETF to take advantage of the ‘tracking error’? Take any advantage available! For example, to trade on the rise of the S&P500 you could buy the SSO Ultra ETF; this ETF seeks to double the daily movement of the S&P500. To take advantage of the tracking error, short the SH (ULTRA short S&P500). This Ultra ETF seeks to double the daily movement of the S&P500 inversely. As the 500 goes up, SH goes down twice as fast. You short sale it and buy back at later for less! The ‘tracking error’ will give you a little extra profit!

For more on UTRA ETF’s, you may want to re-read our previous article under Investor Resources titled “Ultra ETF’s”.

If you are managing your own long-term investments, why not join our Long-Term Portfolio service?  You get a recommended quality stock every two weeks, with a set buy price.  We monitor it for you; send you a weekly recap of market action, and alerts if a material event happens that affects our holdings.  At only $49 per year, a steal, and only .5% of a $10,000 account.  Less than ¼ of what a mutual fund would charge you in fees, and it only costs $49 if you have a million!  I need to work on my fee structure!

The market continues to confuse even the most nimble trader, which I am not.  There is wide anticipation of a pull back; many investors are waiting to commit funds to the market until it occurs.  Rather than becoming a self-fulfilling prophecy, it has become the driver to higher prices.  Traders have taken short positions in anticipation of a sell off.  When it does not materialize, they are forced to buy back their shorted shares or cover (guilty).  The result is a small amount of buying pressure pushes stocks up; short sellers begin to cover which really adds rocket fuel to the push higher.  After the short covering is over, the stock begins to drift back lower; short sellers become encouraged and enter again, repeating the process over again.

This explanation for the trading range we have been in for the last three weeks is not meant to be inclusive of all the market sentiment and forces at work, but a simplistic view.  Add in the influences of inflation, dollar debasement, poor earnings, GM bankruptcy, North Korea, and interest rate increases and you get a more complete picture of what is driving the market.  The difficulty is perceiving the influence each of these has on trader’s attitudes.

We should also reference the invisible hand of the Plunge Protection Team, this shadowy group enters the market with strategic buys to turn the market when sell-offs are underway. Look no further than our favorite connected bank, Goldman Sachs (GS). GS, along with others, protect positions and sectors. This is not altogether altruistic because in many cases they have other positions to protect. There is no doubt that a small group of connected bankers enter the market in coordinated action, to curry favor with Uncle Sugar. This favor is valuable, as seen last fall when GS was bailed out and protected by TARP funds and the AIG rescue that sent billions indirectly to GS through CDS’s that GS held.

With all the talk about money today, we leave with this quote:

"I spent a lot of money on booze, birds, and fast cars, the rest I just squandered."----George Best

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions. It may contain errors and you should not make investment decisions based solely on what you believe you have read here. Do your own research, it is your money. If you lose it, it is your responsibility, not ours or your grandmothers! The editor may or may not have a position in any securities discussed. The editor may have held a position in a security earlier, or in the future

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