Case Study - BBUS and BBOZ: The First One's Always Free

Those who have been dabbling in stocks during the most recent period of volatility will undoubtedly have gained invaluable experience in the market during the Feb to April downturn and subsequent uptick. In summary, from 19 Feb to 23 Mar, the S&P 500 lost 33.9%, making it the fastest crash in history. This was followed by growth of 17.5% from 24 to 26 Mar, being one of the biggest three day gains for almost a century. It would not be an exaggeration to say that what we lived through was truly extraordinary. What was even more amazing was to watch the market response to these violent movements. 

As my readers will now have discerned, my investment strategy has been a fairly conservative one where I dollar cost average twice a month, largely into index funds and by exception individual shares where they appear to be of exceptional value and worthy of the additional risk involved. Whilst I stuck to my plan throughout, I have found it to be infinitely fascinating to watch the response of average retail investors who succumbed to the dark side and were burned hard by the market. 

In observing the people around me and a plethora of online forums, there were two main poisons which decimated portfolios, one was Put Options, the other was Inverse Indices. Today's topic of discussion will revolve around two highly popular inverse indices, BBUS and BBOZ. 

 

The simple way to explain inverse indices is that it is exactly what the name purports, an inverse of an index fund. While BBUS is a leveraged inverse of the S&P 500, BBOZ is a leveraged inverse of the ASX 200. By utilising futures contracts, every 1% lost in the relevant index results in a 2% to 2.75% gain for the holder. As you can envisage, this became a highly attractive investment vehicle to make some gains during the intense drop. Although it may sound like a good idea to buy when the market is falling, there are a number of reasons why a beginner or even novice investor shouldn't touch these products.

Market Timing

When you buy into index or a fairly stable blue chip share, it is almost an inevitable outcome that the shares will go up in the long run. Since BBUS and BBOZ are inverse indices, they obviously go down in the long run as demonstrated in the chart below.



When you look at the prices for BBUS in the last several months the returns look extremely attractive after the fact. If you bought on 20 Feb for $2.67 per unit, this would have become $6.63 by 23 Mar. However, given the state of the economy on 20 Feb, who would have been able to foresee the impending crash and buy into BBUS? Very few. Given the uncertainties surrounding the impacts of coronavirus on the economy and subsequent fall out, most people held onto their portfolios for at least several days until a downward trend was established when it was somewhat higher in price. I know of at least one friend who put their whole portfolio into BBUS at peak for $6.63.

Given investor psychology surrounding the Dunning Kruger effect, even the investor who bought in at the peak was determined that the falls were not yet over and any minor dips constitute bear market rallies and the big crash has yet to come. Of course the media also fanned flames during this period, hyping up death stats and forecasting the end of civilization as we know it, but the unsavvy investor failed to realise that this was already priced in when the market tanked. As a result of this, they consistently held on whilst their portfolio was was violently wiped out.

As of today, BBUS currently stands at $3.39, almost down to what it started on. Are we in the middle of a massive dead cat bounce and the big crash is still coming, or whether we are in for a V shaped recovery? I don't know, which is why I will continue with my dollar cost averaging. Short of being able to accurately time future market movements, it would be imprudent to purchase such a risky vehicle. Having said that, if you are able to accurately foresee the future, why wouldn't you just maximize your gains on minimal cost by buying next week's lotto ticket and min maxing your profits.

Compounding Risk aka. Volatility Decay

Another reason why leveraged inverse indices shouldn't be held for an extended period of time, but isn't apparent to most until demonstrated by a worked example.

For simplicity, let's do two worked examples on the following parameters:

• Starting portfolio is $10,000
• Every day the market moves up or down 1% (10% in the other simulation) returning to parity every second day
• For simplicity we will take the leverage of inverse index at a multiple of 3.

As you can see, whilst market returned to parity every second day, the value of the portfolio was gradually reduced, whilst the results were subdued when volatility was small, when movements were violent, decay was also extremely brutal. Given the fluctuations of the last several months, I have no doubt that quite a few people suffered considerable losses from volatility decay.

For further clarity, consider the fund strategy that BetaShares proposed for both BBUS and BBOZ whereby returns of 2% to 2.75% for every 1% drop are only for any given day, thereby indicating that those returns cannot be expected to continue for periods over one day.

Expenses

Due to the nature of inverse indices attaining their benchmark leveraged returns through use of complex mechanisms like derivative contracts, the associated expenses of high fees, high transaction costs and re-balancing costs also eat into returns considerably. Although simple, for someone who puts money into ETFs for their low management costs, this is clearly reason why inverse ETFs should be considered with a grain of salt.

Conclusion

The last months have provided me with precious insight into the workings of the human mind and how the fear of loss coupled with greed to make gains have pushed innumerable investors to the dark side. From moderate gains during the remainder of the bear market to the eventual wipe-out with the recent rally, millions have been lost on the market because The First One's Always Free and the lure of quick gains is intoxicating. For this, I am grateful to have held firm to my resolve and weathered the storm.

It has also provided a practical example to ボーイフレンド as to why retail investors often under perform when compared to index returns.

As a final point, for those who are wondering. Mr A, who got bored of checking on his brokerage account and continued to DCA through the dip on a preset diversified spread has now returned to -13% on his portfolio whilst the market is still at -20% from peak, outperforming everyone that I know personally.

By 小福