Surging Mutual Fund Targets Geared ETFs

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

To be sure, the strategy is not foolproof, and carries risks of its own, including high trading costs incurred from frequent options trading and the risk that a leveraged ETF goes on a prolonged run beyond Miller's strike price, leaving him on the hook for theoretically unlimited losses.

At the same time, the U.S. Securities Exchange Commission proposed a rule on Friday that would force ETFs to limit their derivatives exposure, potentially forcing most tripled-leveraged ETFs to shut down. In that case, Miller said he would be forced to pivot his options strategy to focus on "inconsistencies" in the futures market for commodities.

Hedging Losses With ETFs

So far, Miller has been able to hedge away most of his losses. He has a net short position on the ProShares Ultra VIX Short-Term Futures ETF (UVXY), a fund that returns two times the daily performance of the S&P VIX Short-Term Futures Index.

The fund shot up more than 11% on Dec. 9 this year. Yet Miller is willing to look past such daily losses and focus on the long-term tendency of leveraged ETFs to "decay," he says. The same fund he has a net short position on, for instance, has a 78% decline year-to-date.

Fund experts say Miller’s strategy of using options to short leveraged ETFs is unique, but does not have a long enough track record to be judged as anything more than a fluke.

“This is quite rare to find any fund that is using this as part of their strategy,” said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.

At the same time, Miller's short track record is its own risk, he says. His strategy "has worked out excellently this year for this fund, but it's still only one year of performance," he added.

Miller, meanwhile, says he has such a long list of what he calls poorly thought-out ETFs that he feels no need to hope that the fund industry keeps introducing more of them.

“There are so many terribly designed products out there already,” he said.