The Other Side Of The Leveraged ETF Coin

by on August 31, 2009 | ETFs Mentioned:

Leveraged ETFs have taken a beating in the financial presses lately, mostly the result of misconceptions about the intended uses and users of these funds. Most of the criticism has focused on the performance of leveraged ETFs when held for multiple trading sessions. Because leveraged ETFs seek to amplify the return on their underlying benchmarks on a daily basis, the returns generated by leveraged ETFs over time do not depend solely on the change in the underlying index, but in its volatility and the direction of the market as well.

Leveraged ETFs (I’ll assume a bull leveraged ETF throughout this article) increase their exposure as the underlying index increases, and vice versa. Therefore, in trending markets, leveraged ETFs tend to deliver a return greater than the target multiple of the benchmark’s gain or loss. But in volatile, oscillating markets, leveraged ETFs may deliver a return that is less than the target multiple of the index return. In extreme circumstances, leveraged ETFs can generate negative returns, even if the underlying index records a gain.

In recent months, many equity markets have experienced unprecedented volatility, meaning that the latter situation playing out in many leveraged ETFs. The result has been a heated debate over the merits and perceived flaws of leveraged ETFs, multiple warnings from regulators, and even a few frivolous lawsuits seeking to recoup losses suffered by investors who didn’t take the time to figure out how leveraged ETFs work. These undesirable results can be avoided by developing and implementing a simple rebalancing plan (see our Free Guide to Leveraged ETF Investing for more details), but apparently some investors haven’t taken the time to consider this.

Leveraged ETFs aren’t for everybody. In fact, they aren’t for most investors. But that doesn’t mean they’re flawed products, and it certainly doesn’t mean they’re a scam of any sort. These products require that investors have the ability and willingness to monitor their holdings on a regular basis, and investors need to have a thorough understanding of the underlying mechanics of these funds.

Other Side of The Coin

While the performance of leveraged ETFs in oscillating markets has received a great deal of media coverage, there’s been little attention given to these funds when the markets move consistently in one direction. On Friday, The Dow dropped about 36 points, ending an eight-day winning streak. During that winning streak, DIA, which tracks the blue chip index, added about 4.6%. ProShares UltraDow 30 (DDM), which seeks to return 200% of the daily return on the DJIA, gained 10.2% during the eight-session rally, a whole percentage point more than the simple sum of the target daily multiple (i.e., 200%) and the return on the underlying index.

Date DDM Price DDM Gain DIA Price DIA Gain
August 17 $33.55 0.0% $91.61 0.0%
August 18 $34.14 1.8% $92.30 0.8%
August 19 $34.68 3.4% $93.13 1.7%
August 20 $35.18 4.9% $93.79 2.4%
August 21 $36.38 8.4% $95.05 3.7%
August 24 $36.46 8.7% $95.13 3.8%
August 25 $36.68 9.3% $95.48 4.2%
August 26 $36.75 9.5% $95.46 4.2%
August 27 $36.98 10.2% $95.82 4.6%

The performance of leveraged ETFs in trending markets is rarely discussed, but is an important attribute of these funds, and one that should be included in any discussion about their merits.

As of press time, there were no reports of class action lawsuits demanding that investors return profits above 200% of the Dow’s gains during the 8-day run.

Disclosure: No positions at time of writing.