The SEC’s recent decision to take a closer look at the use of swaps and other derivatives by exchange-traded products and mutual funds has once again thrown leveraged ETFs under the microscope, as regulators begin examining the tools and strategies employed by these products to accomplish their objectives. During the study, approval of any ETFs that “particularly rely on swaps and other derivative instruments to achieve their investment objectives” will be halted, a move that will bring expansion of two of the fastest-growing corners of the ETF market–leveraged and active ETFs–screeching to a halt.
The decision also brings back memories of last summer, when leveraged and inverse ETFs came under intense scrutiny for their performance during the tumultuous markets of late 2008 and early 2009. As the popularity of leveraged ETFs surged–several of these funds became among the most actively-traded securities in the world–some rather serious allegations were made surrounding their objectives and efficiency. Reports of financial advisors and individual investors realizing big losses on products held during the volatile downturn trickled out, and leveraged ETFs were painted as mysterious black boxes that delivered wildly unpredictable returns.
In some ways, the heightened focus on leveraged ETFs was a positive development for investors. Educational materials explaining the underpinnings of leveraged were viewed by a lot more eyeballs and got a lot more clicks. But there was also a lot of overreaction, mudslinging, and misinformation spread as well. Somehow the failure of financial advisors to understand how these products actually worked–a rather serious violation of professional duties–translated into the fault of the companies that develop and offer the products. In a culture that sues McDonald’s for making us fat, perhaps we shouldn’t be all that surprised. But unfortunately, a good opportunity to educate investors was squandered.
ETFs are still a relatively new innovation, and there are some complexities of leveraged ETFs that may not be immediately obvious from a cursory glance at the fund name. So in general, the more attention and education, the better. But sometimes it seems as if the investing public came out of last summer’s “discussion” less informed than it went in. The lawsuits filed against leveraged ETF issuers are amusing for their inaccuracies and, in some cases, embarrassing grammatical mistakes (although it’s unlikely those named as defendants are laughing much). And despite all the literature published on the subject, there are still a lot of investors who maintain misconceptions about leverage and leveraged ETFs.
Perhaps the biggest misconception relates to the performance of leveraged funds when held over multiple trading sessions. Because most leveraged ETFs seek to deliver amplified results on a daily basis, the relevant multiple (i.e., 2x, -3x, etc.) will only be achieved by those who buy a fund at market open and sell it at the market close. When leveraged ETFs are bought and sold within a trading session, the percentage return delivered will depend on the performance of the relevant benchmark both before and after the purchase. And when leveraged ETFs are held for multiple trading sessions, the ultimate return realized will depend on both the change in the underlying benchmark and path taken during that period.
Because most leveraged products operate with a focus on daily results, they will increase total exposure after a winning session and decrease exposure after a losing session. In oscillating markets–when wins are generally followed by losses and vice versa–this compounding of returns can quickly erode value. But in trending markets (e.g., when stocks head steadily higher), compounding can lead to returns greater than the simple product of the daily target multiple times the multi-session return on the underlying index.
The final two quarters of 2008 and first quarter of 2009 served as a powerful illustration of the first scenario. Seesawing markets sent both bull and bear leveraged funds down sharply over the period, and the adverse effects of buying-and-holding during this stretch got a lot of attention from both financial journalists and government regulators.
Occurrences of the second scenario don’t make nearly as good of a story, and it’s surprising how many investors view the concept of leverage working in their favor as a mathematical impossibility.
March was a good real life example of a trending market. Stocks headed steadily higher throughout the month, with the S&P 500 gaining ground in 17 of the 23 trading sessions. The effect of this path on leveraged ETFs was predictable (to some at least), but still likely surprising to those who think multi-session investing borders on insanity.
|SPY||S&P 500 SPDR||S&P 500||5.7%|
|SSO||Ultra S&P 500||S&P 500 (2x daily)||12.4%|
This “bizarre” result applied to a lot of 3x funds as well. The Direxion Daily Large Cap Bull 3x Shares (BGU), which seeks daily returns equal to 300% of the daily return on the Russell 1000 Index, finished March up about 19.5%, or 3.1 times the gain delivered by the iShares Russell 1000 Index Fund (IWB)
|IWB||Russell 1000 Index Fund||Russell 1000||6.3%|
|BGU||Daily Large Cap Bull 3x Shares||Russell 1000 (3x daily)||19.5%|
So here’s the “shocking truth” about leveraged ETFs: while holding these products over multiple holding periods is risky, it isn’t the investment suicide that some have made it out to be. Compounding of returns is a two-sided coin. During the remarkable market volatility of the recent downturn, it worked against investors in leveraged funds. During the March rally, this phenomenon worked in favor of a lot of investors.
This isn’t an invite for investors to trade as they please in leveraged funds. Use of a “set it and forget it” strategy is still reckless, and has the potential to result in some very unsatisfactory returns. But holding a position in leveraged ETFs for a few days (or even a few weeks) isn’t the guaranteed disaster some think it is.
The lesson when dealing with leverage–as always–is to do your homework and to monitor regularly.
Disclosure: No positions at time of writing.