Leveraged ETFs are among the most actively-traded securities on any market in the world today, with some turning over several times daily and maintaining average investor holding periods of less than an hour. And their popularity appears to be on the rise, as these funds regularly top the list of monthly ETF inflows released by the National Stock Exchange. The amount of interest in these funds certainly isn’t surprising – the temptation to double or even triple the daily returns of a well-known benchmark is tempting, especially for day traders who make their living moving in and out of positions with a frequency that would make most buy-and-hold investors faint. But to generate amplified returns, leveraged ETFs utilize a number of complex strategies that don’t always ensure perfect results. But just how close do they come?
All in a Day’s Work
In evaluating the ability of leveraged ETFs to accomplish their stated objective, its important to first clarify exactly what that objective is. It sounds elementary, but the fact remains that a lot of investors still don’t understand exactly how leveraged ETFs work. These funds strive to return a target percentage (e.g., 200%, 300%, etc.) of the daily returns on a benchmark index. Due to compounding of returns and complexities of oscillating markets, returns on these funds for any period longer than one day may vary in both magnitude and direction from what would be anticipated. To their credit, the fund sponsors do an excellent job of conveying these risks to potential investors. In fact, several of Direxion’s leveraged funds now include “daily” in the fund name. So rather than evaluating performance over an extended period of time, I calculated daily performance for several funds as a percentage of the daily return generated by its benchmark index.
2x Bulls and Bears
First up is ProShares’ Ultra Russell 2000 (UWM) and UltraShort Russell 2000 (TWM). As their names imply, these ETFs seek daily performance equal to 200% and -200%, respectively, of the Russell 2000 Index. To date in 2009 (110 trading days), UWM has generated daily returns between 150% and 250% of the daily return on IWM (which tracks the Russell 2000 Index) 86% of the time. Similarly, TWM has returned between -150% and -250% of the daily return on IWM 88% of the time. Whenever leverage is introduced to a fund (ProShares Ultra ETFs utilize a variety of complex financial instruments to perform their objective), returns are never going to be perfect. But the fact that UWM and TWM fall within 50 basis points of their objective nearly 90% of the time indicates that these funds, on the whole, do an excellent job of providing the returns they advertise.
TWM’s daily returns equaled 150% to 250% of the inverse of IWM’s daily returns 88% of the time. UWM’s daily returns equaled 150% to 250% of IWM’s daily returns 86% of the time.
3x Bulls and Bears
Next up is Direxion‘s Large Cap Bull 3x Shares (BGU) and Large Cap Bear 3x Shares (BGZ). As their names indicate, BGU and BGZ attempt to provide daily performance equal to 300% and -300% of the return on the Russell 1000 Index. Since these funds are 3x leveraged (as compared to 2x for the ProShares funds discussed above), we would expect that the range of returns would expand slightly, since increased leverage adds additional uncertainty and potential for tracking error.
So far in 2009 (110 trading days), the daily return on BGU was between 250% and 350% of the daily return on IWB (which tracks the Russell 1000) 73% of the time, and was between 200% and 400% of IWB‘s daily return 85% of the time. BGZ returned -250% to -350% of IWB’s performance 77% of the time; the percentage increases to 86% of the time if the interval is expanded to -200% to -400%.
BGZ’s daily returns equaled 250% to 350% of the inverse of IWB’s daily returns 77% of the time. BGU’s daily returns equaled 250% to 350% of IWB’s daily returns 73% of the time.
2 + 2 = ???
To illustrate my earlier point that leveraged ETF returns can become distorted if held for more than one day, consider the year-to-date returns on the funds mentioned in this article. With IWB up 6.6% year-to-date, one might expect BGU to be up about 20% and BGU to be down about 20%. In reality, BGU is essentially flat (up 0.5%), while BGZ is down a whopping 42%!
It’s the same story for the ProShares 2x leveraged funds. IWM is up 7% on the year, but its 2x fund is up less than half that amount (3.3%) and its 2x inverse fund is down 36%. But again, leveraged ETFs aren’t supposed to provide amplified returns beyond a single day, so these figures are more indicative of the risks of leveraged ETFs than the performance of the ProShares or Direxion funds.