"Diversifying" by going Long and Short Simultaneously

Question

I was hoping someone could take a critical eye to an idea i've had.

Traditionally it's said that one should diversify across various asset classes and ultimately types to spread the risk out based on their preferred asset allocation. In theory, one should then periodically rebalance their portfolio and potentially scalp the gains from winners and feed into the losers.

Today I was thinking... What if instead of diversifying across a basket of assets you just invested in two ETFs:

1. TNA - Goes 3x long
2. TZA - Goes 3x short

For shorter term periods could you simply hold these two, and rebalance them on say a weekly time frame?

Another idea I had was that since traditionally the market goes up you could over weight the long position.

Thoughts?

thanks!

Answer 1

FINRA (Financial Industry Regulatory Authority) has an excellent article on the risks of leveraged ETFs, including this detailed example that spells out exactly why these ETFs don't track the index over time, and why your proposed strategy is guaranteed to fail (my emphasis below).

Here’s a hypothetical example: let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do—it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return.

Their article is the clearest explanation I've seen to date of why the average investor should avoid these funds.

Answer 2

The goal of diversifying your investment portfolio is to hold multiple classes of investments such that when one goes down, another goes up in an uncorrelated way and vice-versa.

If you hold something long and short at the same time, won't your profits and losses exactly negate each other? I believe they will track too closely (if not perfectly) to be useful for diversification.

Answer 3

Not sure what you are accomplishing by doing this. You are incurring a higher margin. Since they track the same index, any combination of TNA and TZA will offset each other and reduce to a single position in either TNA or TZA with some cash as a hedge.

Answer 4

I've tried this on indexes across different horizon and found it tricky to profit. All it does is to reduce your net exposure and it would be better in my opinion simply to take a smaller position to begin with. Plus having both long and short really messes up my thinking!