The Truth About 3x ETFs and Long Term Investing (Or, Don’t Use a Toaster to Cook a Turkey)

by on April 29, 2009 | Updated November 1, 2012 | ETFs Mentioned:

With last week’s announcement that ProShares has requested that the SEC allow it to provide up to 300% leverage and 300% inverse exposure to 37 different indices, it has become apparent that despite a generally risk-averse economic environment, leveraged ETFs are enjoying a tremendous surge in popularity. In November, rival ETF sponsor Direxion made the jump from 200% coverage, the previous high among levered ETFs. These securities may seem like a golden ticket to an early retirement, but before you go plowing your nest egg into BGU or TNA, let’s take a deeper look at how these funds actually work [see Free Report: How To Pick The Right ETF Every Time].

3x ETF Objectives

First, it’s important to understand how exactly 3x ETFs are able to amplify daily index returns by up to 300%. According to its prospectus, Direxion’s Daily Total Market Bull 3x Shares ETF “seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 3000 Index.” In order to obtain these returns, this ETF creates long equity positions by investing at least 80% of its assets in equity securities comprising the Russell 3000 Index. This aspect of the ETF’s investment strategy is obviously pretty standard – and it certainly isn’t going to generate daily returns of 3x the target index. To accomplish this, 3x ETFs invest in futures contracts, options on securities, indices and futures contracts, equity caps, collars, and floors, swap agreements, forward contracts, and reverse repurchase agreements. If these instruments sound complex, it’s because they are. Essentially, 3x ETFs use a variety of complex, exotic financial instruments to generate multiplicative returns, both positive and negative.

A Lesson in Leverage

The temptation to invest heavily in 3x ETFs over the long-term is understandable. If the market trends upward in the long term (which, despite ample recent evidence to the contrary, it does), why not invest in a leveraged fund that will amplify these positive returns over time?  The answer is all about exposure. Returns of 3x ETFs are predictable relative to the index only if held for less than one day. Over longer periods, even as short as a week, these ETFs can and will vary from their underlying indices, sometimes significantly. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]

In order to provide multiplicative daily returns, leveraged ETFs react to gains by increasing market exposure and react to losses by decreasing market exposure. Since a leveraged ETF’s exposure is equal to its target amplification (e.g., 3x) multiplied by its assets, increases in the benchmark assets pushes up the value of the fund’s net assets, resulting in an increase in exposure equal to a multiple of the increase in net assets. Conversely, a decline in the benchmark leads to a decline in net assets and a multiplicative reduction of exposure. Following each gain, a relatively smaller loss is required to return the fund to breakeven. Similarly, following each loss, a relatively larger gain is required to get to breakeven.

Put another way, leveraged ETFs respond to gains by becoming more aggressive and respond to losses by becoming more defensive. In markets that follow a consistent trend, this feature can result in gains or losses that exceed the stated amplification target. In markets that lack direction, however, leveraged ETFs can (and often do) experience diminished (or even inverse) returns despite returns relative to the underlying index.

So What Does All This Mean for My Money?

Consider a simplified example in which an index increases from a value of 100 to a value of 125 over 5 trading days:

Leveraged ETF Performance in an Upward-Trending MarketIn this upward-trending market, the index increased by 25%, indicating an expected return on the 3x ETF of 75%. However, due to increases in the level of exposure of the ETF, a buy-and-hold strategy on leveraged ETFs results in a greater amplification factor than targeted by the fund (keep in mind that this holds for a downward-trending market as well!).

Now let’s consider a volatile but flat market, with daily fluctuations but no change in the underlying index over the sample trading period.

Leveraged ETF Performance in a Nontrending MarketDespite no change in the underlying index, a 3x ETF results in a negative return of 4.5%, since increases in exposure were followed by losses and decreases in exposure were followed by gains.

In reality, “nontrending” or “jigsaw” markets are just as common as rainy days in April. In perhaps the most drastic example, The Wall Street Journal’s Tom Lauricella points out that ProShares fund designed to return twice the opposite of the Dow Jones U.S. Real Estate Index was down 50% in 2008, while the index itself was also down, about 43%.

“Short-Term Investments For Long-Term Goals”

Despite the fact that they are designed for short-term, sophisticated traders, 3x ETFs are becoming increasingly popular among individual investors who see them as long-term performance enhancers or hedging instruments. While leveraged ETFs offer an opportunity to enhance intra-day returns, anyone holding these funds for more than a day may be disappointed with the results.

To their credit, ProShares and Direxion provide ample warnings about the discrepancies between daily and long-term returns in their marketing materials, and have actively discouraged long-term investors from utilizing their products. Leveraged ETFs may provide a short term burst, but will burn out over the long run, exposing buy-and-hold investors to undesirable levels of risk. As Direxion’s marketing chief Andy O’Rourke quipped, holding a leveraged ETF for longer than a day is “like using a toaster to cook a turkey.”

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