Year’s greatest fund focuses on shorting “poorly made” ETFs

NEW YORK In a year that is shaping up to be the worst for hedge funds considering that at least 2011, one particular small-known lengthy-short mutual fund manager is beating some of Wall Street’s most significant names at their personal game.

David Miller, 35, is undertaking so largely by utilizing possibilities to short leveraged exchange traded funds which are ETFs that offer two or 3 instances the every day positive or negative return of an index and which have become increasingly well-known among hedge funds and other traders as the broad U.S. marketplace has flatlined. Leveraged ETFs have observed inflows of $ 9.five billion this year, according to Lipper information.

In what might be a cautionary tale for investors who have been drawn to leveraged funds, Miller’s $ 155.six million Catalyst Macro Technique fund, has posted returns of practically 47 % over the last year by focusing on their flaws. That functionality makes Miller’s fund the best performer among all actively-managed equity funds tracked by Morningstar this year, and practically 20 percentage points higher than the next-ideal performing fund.

The average hedge fund, by comparison, gained 1.1 % more than the identical time, the lowest return because the average loss of 5.4 percent in 2011, according to BarclayHedge.

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

Miller’s base case is that most leveraged ETFs are poorly made since the nature of compounding wipes out their gains over time.

An investor who puts $ one hundred into a two-instances leveraged fund realizes a gain of 20 % if the index it tracks goes up ten percent in 1 day. However if the exact same index goes down 9.1 % the next day to fall back to its beginning point, the same investor who had $ 120 will comprehend a loss of 18.2 % – or $ 21.84 – and be left with just $ 98.16.

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

For example, he has a net quick position on both an ETF that provides a triple good return of an index of Russian stocks and one that offers a triple adverse return of the same index based on the notion that Russian stocks have a tendency to be volatile.

Indeed, each funds are down this year considerably, while their underlying index, the Marketplace Vectors Russia ETF index, is up 22 %. The bullish fund down 27.6 percent even though the bearish fund is down 66.9 percent.

To be confident, the strategy is not foolproof and carries dangers of its personal, including high trading expenses incurred from frequent options trading and the threat that a leveraged ETF goes on a prolonged run beyond Miller’s strike price tag, leaving him on the hook for theoretically limitless 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 leveraged ETFs to shut down [L1N1401IW]. In that case, Miller said he would be forced to pivot his possibilities technique to focusing on “inconsistencies” in the futures marketplace for commodities.

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, a fund that returns two times the everyday performance of the S&P VIX Quick-Term Futures index.

The fund shot up much more than 11 percent on December 9 of this year. However Miller is prepared to appear previous such every day losses and focus on the lengthy-term tendency of leveraged ETFs to “decay,” he mentioned. The same fund he has a net brief position on, for instance, has a 78 % decline for the year to date.

Fund experts say that Miller’s approach of employing choices to quick leveraged ETFs is unique, but does not have a long enough track record to be judged as something a lot more than a fluke.

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

At the identical time, Miller’s quick track record is its personal danger, he stated. His method “has worked out excellently this year for this fund, but it really is still only 1 year of performance,” he added.

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

“There are so several terribly developed products out there already,” he says.

(Reporting by David Randall, with extra reporting by Saquib Ahmned editing by Linda Stern)