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Canning Leveraged ETFs, but not leverage

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March 30, 2009 – Comments (2) | RELATED TICKERS: GE , CSCO , ABB

This is from one large brokerage to their advisors:

Investor interest in leveraged exchange traded funds has grown significantly in recent years. Leveraged exchange traded funds attempt to magnify investor returns (typically by 2 or 3 times) over an underlying index such as the S&P 500. The leveraged ETF’s typically come in two types: long or short, thus allowing an investor the opportunity to technically short an index with a long position in a short exchange traded-fund without having to put up margin requirements. However, leveraged exchange traded funds have significant drawbacks. One of the key drawbacks behind these ETF’s is the mathematics behind them. Leveraged ETF’s as they are designed today are attempting to provide leveraged returns against the index on a daily basis. Therefore, as time periods increase the dispersion between the return of the index and that, which would be returned by the leveraged ETF at 2x or 3x long or inverse the index, will grow. An example of this phenomenon can be seen in an example where we look at the S&P 500 Index. Lets assume that the S&P 500 Index climbs by 10% on day 1 then declines by 10% on day 2. In this case, an investor who purchased the S&P 500 Index would have a loss of 1 at the end of day 2 (100 x 1.10 = 110 x .90 = $99). Now, lets assume that an investor purchased a leveraged ETF, which aims to perform on a daily basis at a rate of twice (2x) the S&P 500 Index. On day 1, the ETF would climb by 20% so your initial $100 would become worth $120; however, on day 2 the ETF fell 20% bringing the value down to $96 for a 4% decline. Now, lets assume that an investor decided they wanted to take a short position and bought the 2x inverse or short S&P 500 Index Fund. In this example, the fund would decline 20% on day 1 to $80 then climb by 20% on day 2 so that the investor would be left with $96 or a 4% decline despite the index falling over the two day period by 1%. Over longer time periods, this phenomenon becomes even larger. Below, is an example of the past 1 and 2 year performance for DIG- Proshares Ultra (2x) oil & gas with DUG- Proshares Ultrashort (-2x) oil & gas as compared to the Dow Jones U.S. Oil & Gas Index:

 

1 Year2 Years

DIG- 2x oil & gas

-77.2%

-68.3%

DUG- 2x short oil & gas

-31.2%

-58.8%

Dow Jones oil & gas index

-38.8%

-24.4%

* As of 2/20/09

The fees within the leveraged ETF’s are also generally significantly higher than what can be seen in the average ETF and are generally in-line with or slightly lower than active managers. As an example, the Proshares series of ETF’s which includes the Ultra (2x) line of funds have a fee of 95 basis points for both the long and short strategies, which would be more typical of actively managed strategies. In recent months, Direxion Funds launched a 3x series of leveraged exchange traded funds, which also have a 95 basis point fee. Leveraged ETF’s are currently provided by Proshares, Direxion and Rydex as well as by PowerShares in an ETF format.

The leveraged ETF’s are generally liquid but they do run the risk of regulatory interference such as when the U.S. government along with other governments decided to ban short-selling within the financial sector in 2008. In addition, these funds are under constant scrutiny by regulatory agencies due to the belief that many investors may purchase these securities without understanding the mathematics behind them which significantly lessen the potential return for intermediate and long-term holders to achieve a positive return and also due to the threat of potentially losing all or most of the principal in a strategy in severe market environments.

Due to the significant risks inherent with the leveraged exchange traded funds such as mathematics which work against the investor in the intermediate and long term, potential regulatory issues, high fees, potential misunderstandings of the underlying principles and risks of these investments by investors and significant risk of loss of capital we are recommending advisors to proceed with caution with regards to sales of these exchange traded funds going forward.

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What I have discovered, as a non-day trader is that it is unlikely to beat a carefully selected set of investments with untraded leveraged ETFs. For example.  I own CSCO purchased at 13.99, PFE at 12 and GE at 6.81 in the Dow, and added FCX at 18, CHK at 12 and ABB at 14.  I also owned DDM from 21.10 and 18 which I luckily sold out on Friday.  My stock basket, augmented with a global asset allocation fund, and now UNG as of today, has handily outperformed the leveraged ETFs.  When I add in a few LEAPs that I plan to buy if we hold the bottom and a few covered calls, it is apparent that the leveraged ETF shortcut is simply not worth the paper it's printed on if I don't plan to trade daily (good luck to those of you who do plan to trade daily).   

I also went back and looked over performance from a number of ETFs and their leveraged cousins over 90 and 200 day periods, as well as for 2008.  Take a look at that, you'll be shocked.  In volatile markets, leveraged ETFs offer little for somebody not trading.  If we would get an extended period of time where the market moved in one direction, leveraged ETFs would work, but options would work even better, so again, I plan to use LEAPs instead of leveraged ETFs when the time comes.

So, bottom line, pick good investments, not shortcuts, hard work pays off.

2 Comments – Post Your Own

#1) On March 30, 2009 at 7:37 PM, arboretum (28.34) wrote:

Leveraged ETFs only really make sense for small-time daytraders without margin or options approval.

See my blog and some great comments below for additional reasons not to use them, including some unpleasant tax consequences.

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#2) On March 30, 2009 at 10:19 PM, nau99 (27.26) wrote:

Total agreement with Arboretum's comments... these are very short-term vehicles.  If you're jumping into these longer-term, I'm thinking going short is the best way to go since so many end up down substantially over the long-term... IF you can live with the volatility. 

They sell OPTIONS on these too... now THERE'S some leverage.  Vegas anyone?

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