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I thought I knew how hedge firms worked - well sort of - but what's with this reverse index tracker crack?

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Tue Mar 25th, 2008 at 04:05:40 PM EST
[ Parent ]
OK, rewind:
An ETF is a fund whose shares trade like stocks, but which has a "value target" that is very well met (and a usually a sponsor bank that holds & adjusts bid/ask order on the market to keep the share value in the target range).
All sorts of ETF exists, with target values usually replicators: they replicate the quote of a well known index or economic indicator (DJIA, S&P, Gold ounce, Front Month Crude Oil, etc...)

The reason they are reliable in their replication is that very stupid failsafe strategies enable them to do so (like: buying physical oil and gold to replicate commodities, buying the whole basket of stocks to replicate a stock index).

Now actually sponsor banks have smarter ways of replicating, with options of rolling maturities (there is less locked capital involved). E.g. if you buy both put & call options of same strike and maturity, you have made a "converse" or "synthetic forward" of the underlying: the portfolio value varies just like the underlying, save for an additive constant. With listed options on major indexes, there is no liquidity issue.

Thinking of it, they realized you can buy more complicated combinations of liquid options, so has to have any kind of delta you want (well, low delta value have a more reliable targeting). Delta being the partial derivative of the value of the fund, with respect to the value of the underlying. E.g classic ETF have delta=1 (for 1% change in value of the underlying being replicated, the fund portfolio changes of 1%), but reverse ETF have a delta<0: they go up when the index go down (of course, they also go down when the index is up).

I hold a leveraged reverse ETF with delta=-2. Every time CAC is down 1%, I gain 2%. In this case, "leverage" does not imply debt. It is only delta-leverage, and it is achieved by picking puts and calls in different parts of the (strike,maturity) space than a classic ETF.

Pierre

by Pierre on Wed Mar 26th, 2008 at 06:29:50 AM EST
[ Parent ]
Thanks for this explanation.  To put it in really layman's terms, you are using part of your funds to lay a bet that the market will go down.  When the market does go down, you win your bet, and this compensates for the losses you suffer in the rest of your (non-inverse portfolio).  If the market goes up, you lose your bet, but this is compensated for by the gain in the rest of your portfolio.

So basically it is a method of dampening the volatility in share prices, and reducing your overall exposure to risk (and reward).  It allows you to to keep your investment in the market even when you think it is likely to go down in the near term.

Given that much of market volatility is driven my market sentiment rather than real changes in the performance and prospects of the underlying companies, it seems a sensible strategy to adopt - particularly if you think the risks remain on the downside.  

Of course the $Million question is now - is the balance of probability - now on the up or on the downside - particularly in the Euro area.  I remain a bit of an optimist that the Euro area can adjust and prosper at a reduced rate of Growth - whereas the US still has some way to fall before there is any sustained bounce.  Is that similar to your reading?

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Mar 26th, 2008 at 08:16:36 AM EST
[ Parent ]
Except right now I'm all short/bearish. I have no other equity investments, all the rest is medium term fixed income. I don't think European economies can really decouple, firstly, and secondly even if the shock is dampened compared to the US, it will still be a meat grinding in the euro stock market, for the following reasons:
  • one third of euro large caps are financials, with US credit exposure,
  • the industrial euro large caps are globalized companies with revenues in dollar, so their P/E in euros is bound to degrade,
  • one third of capitalisation of euro large caps is US mutual/pension funds and banks, which are about to become net sellers for the first time in 50 years (lock in the gains including forex, pay the retirees, the 401k raiders, repair the balance sheets...)


Pierre
by Pierre on Wed Mar 26th, 2008 at 08:54:52 AM EST
[ Parent ]
Agreed on all of the above, but where are the Chinese and Oil exporters going to put all their loot - the stuff they used to put in dollars? What about smaller caps and those Euro companies with almost no direct US exposure?

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Wed Mar 26th, 2008 at 09:45:45 AM EST
[ Parent ]
Small caps are not part of the headline indices.

In addition, if the financials do poorly it will strngle the credit for the real economy.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris

by Migeru (migeru at eurotrib dot com) on Wed Mar 26th, 2008 at 09:52:06 AM EST
[ Parent ]

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