Surging Mutual Fund Targets Geared ETFs

December 16, 2015

New York (Reuters) – In a year that is shaping up to be the worst for hedge funds since at least 2011, one little-known long/short mutual fund manager is beating some of Wall Street’s biggest names at their own game.

David Miller, 35, is doing so largely by using options to short leveraged exchange-traded funds, which are ETFs that offer two or three times the daily positive or negative return of an index and that have become increasingly popular among hedge funds and other traders as the broad U.S. market has flatlined. Leveraged ETFs have seen inflows of $9.5 billion this year.

Fund Up 47%

In what may be a cautionary tale for investors who have been drawn to leveraged funds, Miller's $155.6 million Catalyst Macro Strategy fund, has posted returns of nearly 47% over the last year by focusing on their flaws. That performance makes Miller's fund the best performer among all actively managed equity funds tracked by Morningstar this year, and nearly 20 percentage points greater than the next-best-performing fund.

The average hedge fund, by comparison, gained 1.1% over the same time, the lowest return since the average loss of 5.4% in 2011, according to BarclayHedge.

At the heart of Miller's strategy is a bet against what he calls “structurally flawed” ETFs. He has a list of approximately 100 such ETFs, nearly all of them leveraged, that he uses as the basis for his trades.

Compounding Eats Away Returns

Miller's base case is that most leveraged ETFs are poorly designed because the nature of compounding wipes out their gains over time.

An investor who puts $100 into a two-times leveraged fund realizes a gain of 20% if the index it tracks goes up 10% in one day. Yet if the same index goes down 9.1% the next day to fall back to its starting point, the same investor who had $120 will realize a loss of 18.2%—or $21.84—and be left with just $98.16.

Miller uses options to hedge his holdings, focusing on making bets that an ETF will have choppy trading rather than sprinting off in any direction, a strategy that he says limits his losses.

For example, he has a net short position on both an ETF that offers a triple positive return of an index of Russian stocks, say, the Direxion Daily Russia Bull 3X (RUSL), and one that offers a triple negative return of the same index, the Direxion Daily Russia Bear 3X (RUSS), based on the idea that Russian stocks tend to be volatile.

Indeed, both funds are down this year significantly, while their underlying index, the Market Vectors Russia ETF index, Market Vectors Russia (RSX | B-71), is up 22%. The bullish fund is down 28% while the bearish fund is down 66.9%.

Chart courtesy of StockCharts.com

Find your next ETF

Reset All