Danger: Leveraged ETFs

by Doug on Aug.19, 2009, under Equities

Even Fidelity has denounced them. So has Schwab.

“Leveraged products are complex, carry substantial risks and are intended for short-term trading,” a warning to customers on Fidelity’s Web site said. “Most reset daily and seek to achieve their objectives on a daily basis. Due to compounding, performance over longer periods can differ significantly from the performance of the underlying index.”

Many brokers are putting restraints or downright not offering them.

FAIR Canada Executive Director Ermanno Pascutto said: “The longer you hold a leveraged or inverse Exchange Traded Fund (ETF), the greater the likelihood that you will lose money, regardless of which direction you bet.”

The Financial Industry Regulatory Authority (FINRA) in June (2009) issued a reminder to brokers and advisers, urging them to use care in selling inverse and leveraged ETFs. FINRA states that they are “unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets.”

What is a leveraged ETF?

These ETFs use borrowed money to amplify their return, whether positive or negative. They follow a well-known index but their movement is 2 or 3 times the amount, depending on the ETF.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Since most leveraged ETFs reset each day, it is difficult to gauge long term returns; twice the daily return of an index is not twice the annual return. This means the ETFs double the daily value, not necessarily the annual value.

What’s the difference? Assume that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

How does a leveraged ETF work?

In order to deliver 2x the results, management must hold half the assets as debt. For example, if the fund is 10m in the fund, the fund must borrow 10m in order to invest 20m, or 2x, the amount in the underlying daily return of the index. Instead of borrowing, the fund uses financial derivatives, such as swaps, options, and futures.

Every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. In order to attain 2x, a corrective action must be taken. And this action is to buy or sell millions of dollars of shares every day, dramatically raising transaction costs of the fund and short-term capital gains.

Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the fund’s asset base, making it much harder to recover gains in the next market upturn. Note that this situation is called the constant leverage trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets.

How have leveraged ETFs performed?

Not very well over the long term. Here is one example (as of 30 June 2009):

		Ticker	5 yr annual return	Last Bull	Last Bear	Expense ratio	SD
ProFunds	UltraBull	ULPIX	-14.31%	30.75%	-39.64%	1.50%	31.16
Vanguard	S&P 500 index	VFINX	-2.32%	18.84%	-17.30%	0.20%	18.96