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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.
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..."
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
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