"Inverse Treasury" Fund gets sold - for now

We sold our inverse Treasury holdings after Friday's good economic news was accompanied by falling interest rates, instead of causing rates to increase - as would normally be expected.

The investment has been on the verge of being sold for months. Though long-term rates have been fairly stable since the purchase of this fund in mid-2009, the fund itself has not been able to demonstrate that same investment stability. Instead, it has seemed to experience much higher holdling costs than the fund's stated expense ratio would seem to suggest. We believe that the cost of maintaining the fund's short position in Treasury bonds must have caused the drag, which we've estimated to be as high as 1 percent per month.

In most investments, if the underlying investment idea is neither moving up nor down, the fund stays pretty even. With this inverse Treasury fund, which uses futures investments to maintain its investment position, there is a steady "leak" from portfolio value that makes it an unacceptable long-term investment vehicle. This is likely true of most "inverse" funds, which suggests that inverse funds should most often be used tactically - in the worst of a sell-off - rather than strategically, waiting for a "sell-off" to happen.

Our investment in the fund was predicated by a concern that the nation's huge borrowing needs would result in higher borrowing costs in the ever more frequent Treasury auctions. Instead, banks have stepped up and appear to be buying up the new issuance. In addition, millions of dollars flowing into bond mutual funds have also funded the purchase of treasuries at the auctions. This morning's Ned Davis research included a note that in April, alone, $486 million was added to the iShare long-term Treasury ETF, increasing assets in that fund by over 21 percent.

With this amount of money flowing into treasuries, a short-treasury position could remain out of favor for awhile. Add to that, difficulties in the European credit markets and increased market volatility that are raising the stature of the dollar as a "safe" reserve currency, another factor which tends to keep interest rates lower, the notion that we will experience a run on the dollar, and that market pressures will force interest rates higher, seems to run contrary to current market trends.

Our concerns about the U.S. government borrowing requirements may be right, ultimately, but it's not at all clear that this is a near-term problem. Further, given the amount of "leakage" we've experienced, where high transaction costs transfer wealth from our pockets into those of the futures traders, we could no longer justify holding a position which hasn't been an "outperformer" for several months.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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