Five Facts Every Investor Should Know About Leveraged ETFs

by on September 30, 2010 | ETFs Mentioned:

In recent years, few corners of the investing world have been the subject of as much controversy, misinformation, and confusion as the leveraged ETF space. Last summer these securities received widespread coverage from the financial media, much of it either implying directly or alleging that leveraged ETFs were flawed investment vehicles designed to dupe average investors out of their money. That prolonged debate over the merits of leveraged funds was somewhat frightening–it highlighted the ignorance of some well-respected publications–but the end result seemed to be an increased emphasis on investor education and a clearer understanding of what leveraged ETFs are and are not designed to do.

Now it seems that conclusion may have been a bit naive. Some state securities regulators are including leveraged ETFs on their watch lists of “investor traps,” lumping them in with variety of investment scams. And recent stops on the conference tour have included some eye-opening moments, including journalists rambling on about leveraged ETF “tracking error” over multiple trading sessions and uninformed statements from financial professionals about how leveraged ETFs should perform.

It’s clear that there is still a lot of confusion surrounding leveraged ETFs, and unfortunately many of those held out as experts on the topic are still struggling to get their heads around these products. In an attempt to counteract some of the misinformation on these products, we offer up five cold hard facts about leveraged ETFs [also see Why Everything You've Heard About Leveraged ETFs Is Wrong]:

1. There Are Two Types Of Leveraged ETPs

Some investors don’t realize that leveraged exchange-traded products come in many forms, and that some of the seemingly subtle nuances can have a major impact on product performance. The most important distinction relates to the frequency with which leveraged products rebalance exposure. Many of the ETFs from ProShares and Direxion seek to deliver daily results that correspond to a specific multiple of the daily return on an index. In order to accomplish this objective, these funds reset their exposure on a daily basis. As such, daily leveraged ETFs aren’t designed to deliver amplified returns over any period of time longer than a single trading session; performance over multiple sessions depends not only on the change in the underlying index, but on the volatility of that benchmark during the same period.

There are also a number of products that seek to deliver leveraged returns on a specified benchmark, but rebalance on a monthly basis. For example, the UBS E-TRACS 2x Monthly Leveraged Long Alerian MLP Infrastructure (MLPL) provide two times leveraged long exposure to the compounded monthly performance of the Alerian MLP Infrastructure Index. That means that leverage is reset to 2x not on a daily basis, but rather once per month.

The rebalancing frequency may seem like a minor detail, but it can result in a dramatically different risk/return profile in certain environments and for certain asset classes. Consider the ProShares UltraShort Dow Jones-UBS Crude Oil (SCO) and the PowerShares DB Crude Oil Double Short ETN (DTO), two products that offer -2x leveraged exposure to oil prices (the underlying indexes are not identical, but are generally similar). SCO resets exposure daily, while DTO resets monthly. Not surprisingly, the correlation between these products is nearly perfect, but the returns are not identical:

The difference in performance is more than 20%, attributable partially to the differences in the frequency of rebalancing.

2. Leveraged ETFs Are Simple Products

Somehow investors and regulators have fallen under the impression that leveraged ETFs are mysterious black boxes, and that predicting the returns of these securities requires an advanced degree. While there are some complex nuances to leveraged ETFs, the general concept is actually very easy to grasp, as is the methodology used to accomplish the stated investment objectives. Daily leveraged ETFs seek to deliver daily returns equal to a multiple of the daily change in a specified benchmark. If the S&P MidCap 400 gains 1% on the day, the ProShares UltraShort MidCap 400 (MZZ) should lose about 2% on the day. Then the exposure is reset, and the fund will do the same thing (deliver a return equivalent to a multiple of the underlying index) the next day. That’s it–nothing that should be beyond the grasp of any investor. Even beyond a single holding period, predicting the return to leveraged ETFs is a simple computation if the closing value of the index for each day is known.

In order to deliver amplified returns, leveraged and inverse ETF make use of swaps and other derivatives–securities that are currently the focus of an SEC review. These tools might sound scary to some investors, but the reality is that the process of setting the required exposure and delivering the required results isn’t all that complex (more on this below). Within the world of derivatives, there is a spectrum of complexity and riskiness; the securities used by leveraged ETFs are relatively safe, liquid, and straightforward [see Seven Surprising ETF Trading Stats].

3. Leveraged ETFs Get “A” For Execution

The last year has seen a number of parties file lawsuits–some of which have since been thrown out–alleging that leveraged ETFs have failed to perform in a manner consistent with their stated objectives. Countless journalists and members of the media have taken the liberty of simplifying the nuances of compounding and daily resetting of leverage into a statement along the lines of “leveraged ETFs don’t perform how they should.”

But despite a tremendous amount of coverage indicating otherwise, leveraged ETFs actually do a very good job of accomplishing their stated objectives. The disconnect exists between how leveraged ETFs say they will perform and how some investors expect them to perform. But the blame for that falls on the investors who failed to do their homework–or read the first point above. The truth is that leveraged ETFs–including both daily and monthly products–accomplish their stated objectives with impressive efficiency.

Consider the Direxion Daily Large Cap Bull 3x Shares (BGU), which seeks to deliver daily returns equal to 3x the daily change in the Russell 1000 Index. Since this ETF began trading in late 2008–nearly 500 trading days–the average daily performance as a multiple of the iShares Russell 1000 ETF (IWB) is 3.1x. The median multiple is 3.0x, and the daily multiple has been between 2.5x and 3.5x about 80% of the time. The statistics are similar for other leveraged products, regardless of asset levels or trading volumes [see all the ETFs in the Leveraged Equities ETFdb Category].

4. Timing Matters

While leveraged ETFs do an excellent job of accomplishing their stated objective, it’s important for investors to remember exactly what that objective is. These funds will deliver amplified returns of an index for a single trading day, but the effective multiple on a leveraged ETF (e.g., 3x, -2x, etc.) changes throughout the day (or throughout the month in the case of those with a monthly rebalancing timetable). That means that an investor buying into a leveraged fund between leverage resets won’t necessarily experience returns equivalent to the daily/monthly exposure multiple.

Suppose that the ProShares UltraPro S&P 500 (UPRO), which seeks to deliver daily results equal to 300% of the change in the S&P 500 Index, starts the day at $100 and the S&P 500 starts the day at 1,000. By noon the S&P 500 has lost 5% (dropping to 950), and the price of UPRO has dropped 15% to $85. An investor buying in at midday must realize that the effective leverage at the time of purchase has increased because the underlying index has declined. If the S&P 500 recovers to finish the day where it started (gaining 50 points, or about 5.3% between noon and the close), the gain realized on the position would be about 17.6% ($15 on an $85 investment), or almost 3.4x the change in the underlying index during that period. That scenario of course works both ways; if the S&P had lost another 50 points to close the day down 10%, the loss on the position in UPRO would be greater than three times the movement in the underlying index for the time the position was opened [also see Leveraged ETF FAQs].

The same phenomenon holds for monthly leveraged ETFs as well; when buying into a product between the beginning and end of the month, the effective leverage established may have deviated from the stated multiple. Towards the end of a month (or the end of a trading day in the case of a daily leveraged products), the effective leverage can deviate significantly from the target for the period [Direxion displays the effective leverage for its monthly leveraged mutual funds; by September 28, the effective leverage offered by the Monthly NASDAQ Bear 2x Fund (DXQSX) stood at -294%.]

5. Compounding Works Both Ways

Another misconception regarding daily leveraged ETFs is related to the performance of these products over multiple trading sessions. Because daily leveraged ETFs reset exposure daily, the compounding of returns over multiple sessions will likely lead to results that differ from the return calculated by multiplying the leverage coefficient by the change in the underlying index (an occurrence that leads some to conclude that these products don’t perform as they should). When markets are volatile, it is possible for a 200% or 300% leveraged ETF to deliver negative returns, even if the underlying index increased; that’s what happened during the unprecedented market volatility of 2008, igniting the leveraged ETF controversy in the first place. If markets oscillate between positive and negative returns, the compounding effect can create a drag on return. That’s because the daily reset would increase exposure preceding “down” days and decrease exposure preceding “up” days (or more accurately, exposure would be increased at the end of “up” days and vice versa).

“Return erosion” is a very possible outcome when holding leveraged ETFs for multiple trading periods. But so is “return enhancement,” which results from trending markets and leads to multi-period returns on leveraged ETFs that are actually more favorable to investors than the simple product of the stated multiplier times the change in the underlying index. The impressive equity market rally during September provides an excellent example of this second scenario. For the four weeks ended September 28, the iShares MSCI Emerging Market Index Fund (EEM) had gained 10.7%. The Direxion Daily Emerging Markets Bull 3x Shares (EDC), which seeks to deliver daily returns equal to three times the daily change in the MSCI Emerging Markets Index, gained 33.5% during that period. EDC’s bear counterpart (EDZ) lost only 27.8% during that stretch, well less than three times the loss on the underlying index during the same period. For investors in either fund, the daily resetting of exposure worked in their favor during this stretch [Joanne Hill and George Foster wrote a well-researched, thorough piece on this topic].

Investing in leveraged ETFs over multiple trading sessions is a risky activity, and requires diligent monitoring. But it isn’t necessarily the portfolio suicide some have made it out to be.

Harnessing The Power

Leveraged ETFs obviously carry significant risk, and they certainly aren’t for everyone. Investors with a long-term focus and a buy-and-hold strategy probably don’t have any business investing in these funds. But for those who take the time to do their homework and understand the nuances, these products can be incredibly powerful tools that can be used for hedging as well as speculating on market movements. Beware that there are a lot of misconceptions out there; getting down to the facts can be a tough task [for more on this see The Shocking Truth About Leveraged ETFs].

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Disclosure: No positions at time of writing.