Surprising Truths About Leveraged ETFs

by on September 16, 2009

Leveraged ETFs have been bashed quite a bit in the financial press quite in recent months, as investors who haven’t quite been able to grasp the complexities of these products have lashed out at issuers for offering what they view to be defective products. A great deal of the complaints about leveraged ETFs (which, unfortunately, may lead to unnecessary, ineffective legislation) are based on anecdotal evidence, misconceptions, and outright falsehoods.

Leveraged ETFs do an excellent job of achieving their stated objectives, which is to provide amplified returns on well-known equity and fixed income benchmarks. In a webinar earlier this year, Index Universe’s Matt Hougan (one of the brightest guys in the ETF space) noted that “over 600 days of trading history … [one-day tracking] was pretty much perfect.” (see a more thorough discussion of misunderstandings about leveraged ETFs here)

So what’s the best way to respond to these types of criticisms? ProShares thinks the answer is boatloads of data. After all, the numbers don’t lie.

In a webinar to be presented by Index Universe later today, ProShares’ Joanne Hill is slated to present the findings of a comprehensive study conducted on leveraged ETF returns. Hill (and co-author George Foster) analyzed 50 years worth of data, calculating hypothetical returns on various leveraged ETF strategies over thousands of possible time periods.

So what did ProShares find? You’ll have to tune in for the webinar (or read the full write-up in the current Journal of Indexes) to get the complete story, but here’s a few of the highlights:

  • Target return differences for 2x and -2x leveraged funds over 2-day, 7-day, and 30-day periods are nearly always less than 10 basis points
  • Hypothetical target return differences are highest during periods of high volatility, including 1988 and 2008 (aka, the time period during which most confusion over leveraged ETFs arose)
  • For 2-day holding periods, hypothetical 2x S&P 500 funds had a realized beta of between 1.75 and 2.25 more than 99% of the time. For 7-day and 30-day periods, beta was within this range 96% and 90% of the time, respectively.

The point that the study drives home is this: we have just experienced a period of record volatility. To judge the merits of leveraged ETFs by their performance over this period is short-sighted. Compounding returns can work both for and against investors, depending on the prevailing trends in the market.

Even during periods of high volatility, leveraged ETFs shouldn’t be ruled out. Hill and Foster touch on a concept that is familiar to almost all investors, but typically not associated with leveraged ETFs. By devising and implementing a rebalancing plan, leveraged ETFs can be used to produce amplified returns over extended periods of time with extreme precision (see our Free Guide to Leveraged ETFs for a more thorough discussion of rebalancing).

Today’s webinar should be very interesting and is a “must-see” event for financial advisers and individual investors who are confused about leveraged ETFs or have been scared off by horror stories and lawsuits. As I write this, spaces are still available (click here to sign up – the presentation is free), but I can’t guarantee they will be later today.

Disclosure: No positions at time of writing.