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Avoid Leveraged ETFs That Undergo Reverse Stock Splits

I don’t care for leverage and the portfolios of these funds consist only of swaps contracts on their underlying indexes, making them very unattractive to me.

— Ben Shepherd, Global ETF Profits

The stocks of strong companies go up in price. Sometimes, the stock price goes up so much that the company decides to split its shares so that a share is more affordable for the average investor. A typical stock split is 2-for-1. For example, if you had 100 shares of a $150 stock, after the 2-for-1 split you would have 200 shares of a $75 stock. Stock splits can be much more than 2-for-1 as was the case with the 50-for-1 stock split of Warren Buffett’s Berkshire Hathaway Class B (NYSE: BRK-B) shares in January 2010.

Stock Splits

As I discussed in Cash vs. Stock Dividends, a stock split is a form of stock dividend where the company issues additional shares to its stockholders. Issuing new shares is similar to the Fed printing money; it’s a form of inflation that debases the value of each share and makes them worth less. Cutting up a corporate pie into more slices doesn’t change the size of the pie — it simply reduces the size of each slice. Consequently, a stock split is a purely cosmetic corporate action that has no bearing on a company’s actual business prospects. The impetus for a stock split (e.g., a sharply appreciating stock price), however, is a sign that a company is doing well and may continue to do well.

Reverse Stock Splits

The reverse is also true. The stocks of weak companies go down in price and sometimes they go so far down that the company decides to do a reverse stock split. Many institutional investors are not allowed under their charters to purchase stocks trading under $5 per share, so companies do whatever it takes to keep their share price at $5 or above. In a reverse stock split, a shareholder gets fewer shares rather than more and the value of each remaining share is higher. Recent examples of reverse stock splits are American International Group’s (NYSE: AIG) 1-for-20 reverse split in July 2009 and Proxim Wireless’ (Other OTC: PRXM.PK) 1-for-100 reverse split in May 2010.

Companies that Undergo Reverse Stock Splits Underperform

Academic studies have found that companies that engage in reverse stock splits on average underperform the overall market going forward. A 2005 paper by professors at City University of New York (CUNY) concluded that “reverse stock splits tend to be strong indicators of poor performance afterward.” Look at the following data which measures the relative performance of reverse-split stocks six months after the split:

Time Period

Median Subsequent Six-Month Underperformance

1982-1989

-27.15%

1990-1999

-32.66%

2000-2003

-12.64%

Interestingly, underperformance didn’t start until 30 trading days after the reverse split and the maximum underperformance occurred in the 50th trading day after the reverse split.

Leveraged ETFs are Likely to Undergo Reverse Stock Splits

What got me thinking about reverse stock splits was a recent press release from ProShares, the ETF firm that specializes in leveraged ETFs. As I have previously written, leveraged ETFs and ETNs that engage in daily rebalancing are horrible long-term investments because of the constant transaction costs associated with futures trading and the contango effects that go with it. Consequently, it comes as no surprise to me that ProShares recently decided to have 20 of its leveraged ETFs undergo 1-for-4 and 1-for-5 reverse stock splits as of February 25th:

Leveraged ETF

Reverse Stock Split Ratio

Options?

UltraShort MSCI Europe (EPV)

1-for-4

Yes

UltraShort MidCap400 (MZZ)

1-for-4

Yes

UltraShort Technology (REW)

1-for-4

Yes

UltraShort SmallCap600 (SDD)

1-for-4

No

UltraShort Russell MidCap Growth (SDK)

1-for-4

No

UltraShort Industrials (SIJ)

1-for-4

Yes

UltraShort Russell2000 Value (SJH)

1-for-4

No

UltraShort Russell MidCap Value (SJL)

1-for-4

No

UltraShort Financials (SKF)

1-for-4

Yes

UltraShort MSCI Mexico Investable Market (SMK)

1-for-4

No

UltraShort Russell2000 (TWM)

1-for-4

Yes

Ultra DJ-UBS Crude Oil (UCO)

1-for-4

Yes

UltraShort Silver (ZSL)

1-for-4

Yes

UltraShort DJ-UBS Commodity (CMD)

1-for-5

No

UltraShort MSCI Pacific ex-Japan (JPX)

1-for-5

No

UltraShort QQQ (QID)

1-for-5

Yes

UltraShort DJ-UBS Crude Oil (SCO)

1-for-5

Yes

UltraShort Russell2000 Growth (SKK)

1-for-5

No

UltraShort Semiconductors (SSG)

1-for-5

Yes

UltraShort Telecommunications (TLL)

1-for-5

No

Consider Bearish Option Trades on Leveraged ETFs

Based on the academic research, over the next six months I would definitely avoid all of these leveraged ETFs and would actually consider making bearish option plays on some of them. Since relative underperformance doesn’t manifest itself for 30 trading days (42 calendar days), we still have time to put on the trade and the best time is around April 8th (Feb. 25th plus 42 days). As previously stated, the maximum underperformance occurs 50 trading days (70 calendar days) after the reverse split, so I would look to sell a bear call spread on April 8th that expires in May or later.

If you look at the performance of the nine ProShares leveraged ETFs that underwent a reverse stock split last year on April 15, 2010, you’ll discover that eight of the nine have lost money since then — compared to the S&P 500 ETF’s (NYSE: SPY) 10.9% gain during the same time period.

Two of the more liquid leveraged ETFs that underwent a reverse stock split this past February 25th include UltraShort QQQ (NYSE: QID) and UltraShort Russell2000 (NYSE: TWM), so I would consider those ETFs for the bear call spread option trades. For an example of a bear call spread, see my recommended trade on Netflix (NasdaqGS: NFLX) in Best Option Trades for 2011.

Invest in ETFs with the Help of Global ETF Profits

Global ETF Profits co-editors Ben Shepherd and Yiannis Mostrous avoid leveraged ETFs like the plague. Rather, they focus on low-cost ETFs and ETNs that are most likely to outperform the overall market going forward. In fact, Ben and Yiannis have identified 25 ETFs in a multitude of different industries that are in buy range right now.  

For a list of their favorite ETFs best positioned to appreciate in value, consider giving Global ETF Profits a try today!


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