A Skeptic on Leveraged ETFs

I am a skeptic on leveraged ETFs in one way. My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.

To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index. There is also slippage from rolling futures from month to month.

Here’s my challenge, and I may do this myself, or, though I encourage others to do it: Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage. If there is no friction or fees, they should do as well as T-bills. My guess is the higher the leverage, the lower the aggregate returns.

Let the games begin. Does anyone want to run this analysis before I do it, say, six months from now?

Comments

[Big Sky Walker:]

Leveraged ETFs sure beat options in every respect if that's what your looking for.

2008 Nov 28 10:30 AM

[bsharvy:]

As an investor, I'm mainly concerned with biased slippage. If the ETF underperforms in one direction but not the other, then there is a change in the risk. If the mis-performance is equally bearish and bullish, I'm not so concerned.

2008 Nov 28 10:03 PM

[a believer:]

I've run the analysis and the slippage on the main vs. short index ETFs (simple sum-of-the-two-stock prices) is horrendous and getting worse, minus 20% to minus 30% per year.

I suspect that the slippage on the 2X ETFs is even worse, especially recently.

So no, not a good investment or heding strategy. Day-trade onty.

2008 Nov 29 01:02 PM

[trader58:]

I agree it's a bad investment. That said I think they are a great trading vehicle especially since traders or investors rarely catch the tops and bottoms of a move in whatever timeframe they are trading. I like trading the SDS and RSU back and forth and have done pretty good so far but like any leveraged vehicle they can get you into trouble alot faster, especially the SDS. Like all trading it all comes down to money management.

2008 Nov 29 11:02 PM

[Hedged In:]

Tracking error of leveraged ETFs relative to their underlying indexes depends what time period you're using. The 2x leveraged ETFs are supposed to deliver 2x the *daily* performance of the underlying index; that means that over longer periods of time their performance won't be 2x the underlying index.

This works to your advantage if the underlying index moves strongly in your favor. For example, when the market dived over a period of a few weeks, the 2x inverse ETFs were massively more profitable than shorting the plain index ETFs.

Here's what happens if the underlying index drops 3% every day for 10 days. The first column shows the value of the underlying index and thus a regular ETF; the second column shows what happens to a 2x inverse ETF tracking that index:

100 100
97 106
94 112
91 119
89 126
86 134
83 142
81 150
78 159
76 169

The underlying index is down from 100 to 76 -- a 24% decline. But the double inverse ETF is up 69%.

But now look what happens if the index goes nowhere over a 50 day period, up 3% one day, down 3% the next:

100 100
103 94
100 100
103 94
100 99
103 93
.
.
.
98 92
101 87
98 92
101 86

Over a 50 day period, the underlying index is up 1%, but the double inverse ETF is down a massive 14%.

Bottom line: Leveraged ETFs are great for sharp market moves, but do really badly if the market is broadly flat but with volatility.

Together with the other disadvantages pointed out in the article (the cost of rolling over futures etc.), this also makes them great for short term trading, and bad for long term investing.

2008 Dec 01 06:52 AM

[Prudent Man...:]

Leverage is a double edged sword especially the magnitude of owing debt in a position going against you. What happens if the ETF has a call for margin?

Unless you have the answer you should, like any other investment that you do not understand all of the risk, avoid. Pure PRUDENCE!!

2008 Dec 02 11:46 AM

[Wall Street...:]

Interesting idea, if what you mean is that levered ETFs park 100% of their money in T-bills and use it as collateral to buy the swaps. So, like you say, if you remove the return you should get the t-bill rate. The question is, do the advisors pay for the swaps out of their advisor fees or the fund assets. I'd imagine the latter. So another interesting question is, doing your analysis, would you discover the cost of these contracts and how they change over time.

2008 Dec 02 09:38 PM

[Wall Street...:]

You mean they should do as well as T-bills because the assets are usually parked in t-bills as collateral for the swaps. This is fact that may be lost on many of these readers who may not understand what you're getting at. What would be more interesting to me is what the cost of the swaps are and how they change with the market. Like you say, if you remove the performance from the index you should get the friction, and that would be the swap cost plus fees. I don't imagine they pay the swap costs out of the advisor fee. It also may be interesting to see if some providers get better swaps than others. If it's better to short and etf of use a levered product.

2008 Dec 02 09:43 PM

[Wall Street...:]

sorry, thought my first comment got lost on the internet :)

2008 Dec 02 09:44 PM