To The Moon

General Overview

If you are planning an all-out assault on the Dow Jones Industrial Average in 2023, you may be too late to the party. Vintage 2022 has been one to forget, marked by geo-political jitters, inflationary pressures, extensive risk off sentiment and restrictive monetarypolicy. If you were managing risk in 2022, you probably have had a rough year.

But spare a thought for money managers who have binding constraints in the investor policy statements. These terms which lay-out a general road map, strategy, and limits to how a portfolio manager is going to allocate your cash are the backbone to any client-manager investment relationship.

For long only portfolios, the pain was possibly more antagonizing – they couldn’t simply wire money to Alameda Research and start shorting ES minis. So how do long only portfolio managers cope when an equity storm is onthe horizon? Granted, they can take long positions in asset classes with historically negative correlations to risk assets.

Traditionally, that has been positions in fixed income, some commodities, and certain currencies. But as volatility increases, those correlative powers seem to fade.

For large money managers holding hundreds of millions of $ under management, the immediate and most efficient response would be short positions on the ES-mini or even the big boy, SPX. But then again, we would be breaking our investment rules. So what other possibilities are there?

Queue exotic, often leveraged, ETFs designed with long-only money managers in mind. ProShares UltraPro Short Dow 30 (NYSEARCA:SDOW$Dow30 Bear 3X ETF(SDOW)$ ), that I havecovered previously, provides holders the possibility to be synthetically short the Dow Jones Industrial Average while technically being long. Aimed specifically for short-term positioning or hedging out risk, this fund has been designed with constrained money managers in mind.

But before we start – am I bullish or bearish? Well, neither. This here is an ETF designed for a specific use at a given time. Using it incorrectly is likely to result in big risk exposure and losses, so it remains important to understand the ETF’s underpinnings. Let us find out more.

Tradingview

5 years of price action on (SDOW) emphasizes the funds built-in self-implode mechanism. It also shows how volatile the package can be during spikes in volatility.

Product Recap

SDOW is a 3x daily short leverage fund inversely correlated to the Dow Jones Industrial Average. Simply said, when the Dow30 goes down, this goes up providing a useful tool for capital allocators with a near team bearish views on US equity markets.

It is extremely important to reiterate that this ETF is not a buy and hold security. Given its design, and the fact that equity markets generally go up more often than down, the ETF is holistically designed to implode. Only reverse splits in the ETF price ever stop this from terminally reaching zero.

For portfolio hedging, it is important to take this into account. While it does provide some risk-off exposure to the Dow Jones Industrial Average, it can only essentially be held for short periods.

The Dow Jones 30

The Dow Jones Industrial Average is a price-weighted index, implying higher priced equities will provide bigger influence in movements of the overall index. The index includes 30 large-cap, blue chip US stocks, excluding utilities and transportation companies.

The biggest index weightings include health care (+22%), information technology (+20%) Those 30 companies presently hold a price-to-earnings ratio of ~15x, and an average market capitalization of $300B. The index is one of the oldest on US public markets with possibly only the Dow Transport Index being older.

ETFDB.com

Fund inflows have been surprisingly high into the end of the year, perhaps highlighting investor sentiment into 2023.

Fund inflows into (SDOW) have been surprisingly high over the last couple of months. Perhaps a sign of calm before the storm? In any case, the fund has amassed an additional $484M over the past year - sizable for a fund presently holding just shy of $820M in total assets under management. In any case, the standout here remains that meaningful positioning appears to have been taking place into the end of the year.

Risk

It is worth reiterating here that (SDOW) is a heavily leveraged product. 3x leverage implies a range of standard risks linked to the synthetic underpinnings of the fund to develop that artificial lift. In this instance, a cocktail of derivatives – namely swaps, US treasury futures and even the US dollar.

The negatively correlated returns on the Dow30 are engineered synthetically. That also means that most of the underlying derivative contracts are traded over-the-counter signifying counterparty risk.

It is also important to highlight that 3x negatively correlated returns are a target, not a guarantee. And while the underpinnings are likely to be more robust than Do Kwan’s stable coin peg with the $USD, risk does exist here that artificially designed financial constructs could unwind during bouts of severe market volatility.

Daily resetting also means that over time, the returns will not provide a perfect negative 3x correlation with the Dow Jones Industrial Index.

Spreadsheet by author

Historical analysis - SDOW

Key Takeaways

SDOW is a product which is premised about short positioning. It aims to provide money managers, particularly with long mandates, the opportunity to reduce risk exposure by a short-term long position in the ETF.

Its leveraged and exotic nature means holding fees are hefty, but this was never designed for long-term retention. Options markets exist which help customize risk management and provide additional optionality.

All in, this is a valuable part of any money manager's tactical toolbox.

Source: seeking alpha