Investors love exchange-traded funds because ETFs give them access to markets that would otherwise remain closed to them. In particular, many investors have embraced special types of ETFs that use various forms of leverage in order to magnify market exposure or to place bets on how various measures of market internals, such as volatility, will behave.
The dangers of leveraged ETFs are well known, and even if you avoid the double or triple exposure that some leveraged investments offer, specialty offerings like volatility ETFs can lead to equally painful results. Yet if you’re just a casual observer of these funds, you might not even notice the long-term devastation that they can cause. That’s because of a little-seen move that many such ETFs make by doing reverse splits of their shares. Although the funds don’t try to make a big secret of it, doing reverse splits can still be misleading for those who aren’t aware of the practice.
Reverse splits and volatility ETFs
The latest example of this phenomenon comes from the volatility ETF realm. Late last month, ProShares announced that it would do a reverse share split on two of its popular funds, ProShares Short VIX Short-Term Futures (NYSEMKT: SVXY) and ProShares Ultra VIX Short-Term Futures (NYSEMKT: UVXY). Effective Sept. 18, the short volatility ETF will trade on a 1-for-4 basis, meaning that investors who previously owned 400 shares of the ETF will then own 100 new shares at a price four times higher than where it trades immediately prior to the reverse split. A similar thing will happen with the ultra volatility ETF, except the reverse split ratio there will be 1 for 5.
The reverse split for the short volatility ETF should come as no surprise to those who’ve followed the volatility ETF market over the past year. Back in February, an explosive move higher in the volatility index caused a competing short volatility ETF to shut its doors completely, and the ProShares offering lost 80% of its value in a single day. Despite ups and downs since then, the ProShares ETF is still down almost 90% from where it started at the beginning of 2018. A 1-for-4 reverse split will be sufficient to get the share price a lot closer to where it was before the February drop.
Yet the ultra volatility ETF’s reverse split is more surprising. That ProShares fund benefited from the same volatility spike that hurt its short ETF counterpart, almost tripling between the first of the year and its February high. Yet over the course of the remainder of the year, a return to relatively low-volatility conditions has taken away all of those gains and more, leaving the ultra volatility ETF down almost 20% year to date.
Reverse splits are par for the course for many leveraged and volatility ETFs. For instance, for the ultra volatility ETF, this will be the ninth reverse split in six and a half years, with past split ratios ranging from 1 for 4 to 1 for 10. To put the splits in perspective, if you’d had 6 million shares of ProShares Ultra VIX Short-Term Futures ETF at the beginning of 2012, you’d have only five shares today — and you’ll have only a single share left after the coming reverse split takes effect later this month.
That’s a somewhat extreme example, because the market was squarely against the Ultra VIX ETF during that time frame. The Short VIX ETF did three conventional 2-for-1 splits over the same period, turning each original share into eight shares currently — and two after the coming reverse split.
Yet when you look at other leveraged ETFs, you can see similar phenomena for both bullish and bearish funds. Since 2010, the bullish ProShares Ultra Silver has done two splits, one regular and one reverse, that have resulted in total in a net 1-for-2 split ratio. The bearish ProShares UltraShort Silver, meanwhile, has had a more dramatic 1-for-100 net split ratio, done over three reverse splits and one regular split. For oil, ProShares Ultra Bloomberg Crude Oil has had three reverse splits resulting in a net 1-for-40 ratio, while ProShares UltraShort Bloomberg Crude Oil has a more modest 2-for-5 ratio during the 2010s.
Know the risks
It’s not entirely fair to judge these ETFs based on their long-term performance, because the funds themselves are the first to say that they’re intended for short-term use rather than long-term holdings. Most such funds have pegs to daily benchmarks that are designed for traders to use.
Yet countless investors have used some of these ETFs as long-term holdings. Short volatility ETFs were great plays for several years until they lost most or all of their gains in one fell swoop because of a single bad day.
Reverse splits serve to keep the share prices of leveraged and volatility ETFs higher than their long-term returns would suggest in many cases. If these ETFs weren’t allowed to do reverse splits, then it would be much clearer just how much money they had lost over the long run.
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