ProShares SDOW ETF: Take advantage of the next leg of the bear market

0

Klaus Vedfelt/DigitalVision via Getty Images

Thesis

ProShares UltraPro Short Dow 30 (NYSEARCA:SDOW) is a leveraged inverse ETF. According to fund documentation, SDOW

[..] seeks a return equal to -3x the return of its index (target) for a single day, as measured from one NAV calculation to the next. Due to the composition of daily returns, holding periods longer than one day may result in returns significantly different from the target return and ProShares returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.

The target index in this case is the Dow Jones Industrial Average. SDOW hits its stated target via swaps and futures and is up over +60% year-to-date. Like any leveraged product, the ETF is a short-term trading tool rather than a buy-and-hold investment. Since the stock market, over longer periods of time, is trending upward, leveraged inverse products like SDOW are bound to lose value as buy and hold investments. To that end, the SDOW has declined by more than -80% over the past three years.

We are now officially in a bear market for the S&P 500, with the Dow very close (the Dow is only down -17.5% at the time of writing). Nothing goes down in a straight line, and the current bear market has already seen a very furious rally. There is more to come as conditions become oversold in equities, but the general direction is to the downside. In order to immunize one’s portfolio without realizing capital gains and to maximize capital efficiency, the SDOW product can be used. For example, an investor who holds $150,000 of DIA can hedge any further bearish moves via a $50,000 purchase of SDOW. Clear objectives and exit points should be set, as over long periods of time SDOW tends to lose money and it is only a trading tool rather than a buy and hold investment.

Market environment

The market has been tough this year with soaring inflation and the Fed forced to raise rates in a decelerating economic environment according to leading economic indicators. In our view, inflation is not going to subside anytime soon with the summer travel season kicking into high gear and the supply of oil and agricultural commodities unresolved. The Fed is forced to do something, and the “something” increases unemployment and pushes back the demand side of the equation. We don’t think it will be a V-shaped recovery and it will take time for the tightening of financial conditions to work its way through the economy and inflation numbers. That should prompt the Fed to raise rates even if the economy’s undertide weakens. A bear market is downward price action that moves in waves rather than a straight line. An informed reader can choose where we are in the cycle:

bear market

Bear market cycle (DailyFx)

We believe we are currently experiencing another bear market rally that will run out of steam soon enough, as inflation data is “hot” and leading economic indicators are weak.

Performance

The SDOW is up by more than +60% over one year:

while searching

Cumulative return since the beginning of the year (Looking for Alpha)

Note that it does not represent an exact -3x performance against the Dow Jones Index (DIA) due to the inverse return based on daily total returns. Due to the compounding effect and the different basis, the results deviate from a pure performance of -3x this year on the positive side for an investor in SDOW. The Dow Jones is down -17.5% year-to-date (at the time of writing), hence the SDOW would have been 3 x 17.5% = +52.5% up on a clean performance basis of 3x.

Its leveraged nature also exposes the massive volatility built into this product. We can see how the total return went from +44% to +20% in one week during the latest bear market rally. Don’t expect straight line performance here in the SDOW. Also expect that once the market bottoms out at some point in 2022, the short cover rally can be very violent and wipe out a significant portion of SDOW’s gains. Set clear entry and exit goals for SDOW in mind and stick to them.

On a 3-year basis, the ETF is down more than -80%, which illustrates why SDOW is a short-term trading tool rather than a long-term portfolio construction tool:

come back

Total return over 3 years (Looking for Alpha)

Like any leveraged product, SDOW is not suitable for long periods. A retail investor should set clear goals and timelines for entering and exiting the product with a well-defined strategy in place. Over long periods of time, the stock market has proven to have an upward trajectory, which means that SDOW will always lose value if held as a buy and hold instrument for more than 2 years.

Assets

The fund achieves its stated objective by using index swaps and futures:

holding

Assets (fund website)

Since most swaps are done through clearing houses, counterparty risk is fully mitigated. The (very unlikely) failure of one of the counterparty banks would have no impact on the vehicle.

Conclusion

SDOW is a leveraged inverse ETF offering -3x the daily performance of the Dow Jones Index. From a capital perspective, SDOW represents an effective way to immunize an investor’s portfolio against the potential next step down in the current bear market. SDOW is a short term trading tool rather than a buy and hold investment and a retail investor should set clear entry and exit targets for the instrument.

Share.

Comments are closed.