With volatility levels skyrocketing to historical highs in 2008, the introduction of leveraged exchange-traded funds [ETF] was a godsend for traders. Or was it?
A leveraged ETF allows investors the ability to gain instant leverage against the underlying index/sector on either the long or short side. Until recently, all leveraged ETFs offered 2-to-1 leverage, but in the fourth quarter, Direxion launched ETFs that now offer an unthinkable 3-to-1 leverage. It is clear traders are willing to take on more risk because within a month of launching their first 8 ETFs, Direxion's vehicles are trading over 1 million shares per day.
UPSIDE TO LEVERAGED ETFs
The obvious upside to leveraged ETFs is the ability to utilize leverage without using margin and borrowing against your own money. The second pro has to do mainly with retirement accounts that cannot short stocks; the leveraged short ETFs allow for traders to make money in down markets. There is also the hedging argument that the leveraged short ETFs can hedge a long-term portfolio of stocks.
While all three sound like great arguments to use leveraged ETFs, especially the short vehicles, I will now tell you why they are not all they are cracked up to be.
BE VERY CAREFUL
First of all, I have used and will continue to use leveraged ETFs for our clients and subscribers to the newsletter, The ETF Bulletin. However, they are now only used for short-term strategies that may include a day trade, swing trade (few days), or short-term hedging against a market sell-off.
Keep in mind that leveraged ETFs offer the 2-to-1 leverage based on the daily price action of the underlying index/sector. For example if the S&P 500 falls 2% in one day, the ProShares UltraShort S&P 500 ETF (SDS) should gain 4%. The performance is rarely perfect on a daily basis, but will be very close. My concern arises after a trader holds the ETF for several days or even weeks.
Assume the S&P 500 gains 4% on Monday and SDS therefore will fall 8%. On Tuesday the S&P 500 falls 3.8% to end the two days flat. SDS will rise by 7.6%, leaving it down 1% after the same two-day period. Even though the S&P 500 is flat, SDS will be sitting with a 1% loss in just two trading days. This phenomenon is explained by the larger moves made by the leveraged ETF and the fact that when you fall by a certain percentage, it takes a bigger gain to get back to even. A loss of 20% will require a 25% gain to get back to even; a 50% loss must rely on a 100% gain to breakeven. The daily numbers are not of that magnitude, however over time the 1% here and there adds up. Below are some real numbers that you may find very surprising.
Since the end of August through December 19th, the S&P 500 has fallen 30.8%. Many traders would blindly assume that SDS should have returned 61.6% because that is double the inverse of the index, right? Oddly enough, SDS only gained 37.3%, nearly 25% below what many would have thought in less than four months. The ProShares Short S&P 500 ETF (SH) during the same timeframe gained 25.9%; according to the company SH should give investors the inverse performance on a 1-to-1 daily basis. If you had to choose one over the other, SH is clearly the choice because it does not underperform by much in the good times and when the S&P 500 rallies it will take less of a hit. The reward-to-risk is clearly in the favor of the short ETF versus the leverage ETF if the strategy is to hold over a long period of time.
To give my synopsis further validity I used the same timeframe as above this time concentrated on the financial sector. The SPDRs Financial ETF (XLF) lost 42.9% from the end of August through 12/19. During the same period, the ProShares UltraShort Financial ETF (SKF) lost 5.4% and the ProShares Short Financial ETF (SEF) gained 16.0%. This set of numbers is very tough to digest because if you bought SKF the last day of August knowing the financial sector would fall 43% in the coming months, a 5.4% loss would be disappointing. There are two explanations for the underperformance of SKF. First, SKF does not track the exact same basket of stocks as XLF; however the entire financial sector got crushed and therefore is not a good excuse. Second, the many large daily swings in SKF left it fighting an uphill battle, losing a percentage point here and there to the underlying index.
Within the timeframe analyzed above there was a five-day period in November that saw amazing volatility. The performance of the five days beginning 11/19 for XLF was: -10.5%, -10.7%, +3.1%, +15.2%, +5.8%. The returns for SKF were: +21.4%, +17.8%, -7.0%, -28.7%, -10.3%. Over the five-day period, XLF was up 0.4% and SKF lost 29.9%. The volatility from day to day caused SKF to greatly underperform over a short five-day timeframe. The numbers suggest that leveraged short ETFs may not be the best option for swing traders and they are merely a day trading vehicle.
In the end, the leveraged ETFs, in particular the leveraged short ETFs, are great products that can be used by day traders and those investors that understand their true performance. Please be careful when trading or investing in the leveraged products.
Disclosure: Long SDS and SKF.
