Why Short SLV When You Can Go Long ZSL?

April 21, 2011

Silver’s at 31-year highs and SLV is hard to borrow. Maybe inverse funds aren’t so bad after all.

With silver testing 31-year highs at $45 an ounce yesterday, plenty of investors were calling the top. On Wall Street, calling the top usually means shorting, and that’s where it gets interesting for SLV.

The street was buzzing yesterday as Goldman Sachs was forced to put the iShares Silver ETF (NYSEArca: SLV)—the go-to way to get silver spot exposure—on their hard-to-borrow list. In other words, enough people were trying to short SLV that they ran out of easily-available inventory. But in ETF land, where inverse funds providing the short return of an asset abound, why bother tracking down shares of SLV to borrow? Why not just go long ZSL, the ProShares UltraShort Silver fund (NYSEArca: ZSL)?

Plenty of investors did just that. Over $61 million flowed into the ProShares fund yesterday on expectations of a drop in silver. But it’s important to understand that the fund behaves differently than a true short position.

For one, the ProShares fund isn’t just an inverse fund, it’s inverse and leveraged. The ETF provides -200 percent of the return of silver on a daily basis, upside down. That leverage factor makes things a little complicated: The effect of compounding on leveraged ETFs can mangle returns, especially in trendless markets. It also makes the time period over which investors hold the investment especially important. In this case, the 2X exposure is reset on a daily basis, so holding periods longer than a single day are subject to path-dependent results.

To get a concrete example of how ZSL behaves, let’s take a look at another time when silver looked like it had topped out: December 2010. Back in late 2010, silver was trading at around $30 and dropped steadily after Dec. 31 to $26.29 in late January. That’s a healthy 13 percent gain for anyone shorting it. So how did those holding ZSL do?

Descripción: C:\Users\SF Bloomberg\Documents\My Dropbox\Bloomberg\Devin\Blog\ZSL vs. SLV December.jpg

Investors in ZSL did more than twice as well as those shorting SLV. Since it’s a -2X leveraged fund, you might expect twice the return of shorting silver, or 26 percent. But ZSL did even better than that, returning nearly 28 percent. Why? The effects of compounding on the steady drop in silver.

In this case, the compounding worked for investors. In trending markets, the path dependency works in your favor with levered and inverse ETFs with a daily reset. But buyer beware:  The daily reset works against you in wandering, volatile markets. Silver is definitely a case where volatility could be an issue; daily returns have seen substantially more volatility than the S&P 500 for the past year. But over this particular period in January, the trend was your friend, and ZSL worked magic.


Even while silver has rallied in the rest of 2011, ZSL has been a better way to be wrong—to be a silver bear. If you put your own 200% percent levered short trade on SLV in January 2011, with silver up 50 percent on the year, you’d be wiped out today. ZSL, however, would have staunched the bleeding, leading you to “just” a 63% percent loss on the year because of the compounding.

Figure 2

Despite the fact it’s “worked” for these periods, it’s important to recognize just how wrong things can go. In a sideways market (instead of these strongly trending ones), the compounding can absolutely destroy returns.

Figure 3

In this example from a couple of weeks in mid-November 2010, SLV dropped 3.6 percent over the period. A naive investor in ZSL might expect double that return—7.23 percent—but ended up with just 4.5 percent. And that’s just over a few weeks– longer holding periods are subject to erode returns even further in volatile markets.

In this case, at least, the package of convenience the inverse ETF represents is likely to continue to draw assets. Investors should just make sure they know what they’re getting into.


Find your next ETF

Reset All