A Small Cap Alternative to Leveraged ETFs

In the midst of this historical recession, the question remains whether or not we have reached “the bottom.” Eventually, the focus will shift from finding the bottom to finding the best way to take advantage of a new expansionary period.

One investment vehicle that is sure to get attention will be the leveraged ETF. Investors trying to play catch up might purchase an ETF that seeks returns two or three times that of the overall market. As many portfolios lost almost 50% in 2008, investors will be looking for ways to take on excess risk to obtain returns that will get their portfolios back up to levels last seen at the end of 2007.

However, investors need to be aware of what they are buying. Those looking to make substantial long-term gains by investing in a fund that attempts to double an index’s daily return need to take a close look at the fund’s objective before investing. Many investors hold the common misconception that leveraged ETFs will have long term growth that is proportionate to the fund’s leverage amount.

Unfortunately, this is not the case when investing for the long run with these leveraged funds. For example, the Proshares Ultra S&P500 ETF (SSO), per the fund’s prospectus, “seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the S&P 500 Index.” Because the fund concentrates on achieving this leveraged return on a daily basis, the long-term results will deviate from 200% the Index return. Take, for example, the following: a one-day return of +8% for the S&P 500 and then a return of -8% the following day.

A $100,000 investment will equal $99,360 (-0.6%)
Day 1 (+8%): (100,000*.08) +100,000 = 108,000
Day 2 (-8%): 108,000 - (108,000*.08) = 99,360

However, the leveraged return will end up with just $97,440 (-2.6%)
Day 1 (+16%): (100,000*.16) +100,000 = 116,000
Day 2 (-16%): 116,000 – (116,000*.16) = 97,440

With this increase in daily volatility on the up and downside, the long-term result is not a proportionate leveraged return. As more time passes, more deviation occurs. This is evidenced when looking at the returns of leveraged funds for the calendar year 2007 (click to enlarge):

Leverage vs. Alpha

For investors seeking a long-term approach during the next bull market history has shown that a small cap ETF may be a better approach. Small caps have historically overwhelmingly outperformed the broader market during periods of market expansions.

In 2003, the SPY, which tracks the S&P 500, was up 28.18% for the year. The iShares Russell 2000 Index (IWM), was up 47.58%, a gain of nearly 1.7 times the S&P.

Looking back further to the period of 1991-1994, another period of market expansion, the total return on the S&P 500 Index was 39.08% while the Russell 2000 gained 89.38%.

Alpha (or performance over a benchmark) over a long time horizon is best achieved by asset selection not leverage. Leveraged ETFs generally offer much less than double the performance of the underlying index, but small caps outperform the overall market by as much as 2:1 during periods of market expansion.

This is a clear example of the fact that more is not always better. Diversification of non-correlating assets is the best approach to constructing a portfolio and therefore, a smart strategy for the bulls in 2009 may be to invest in small cap ETFs instead of leveraging up on a broader average.

Comments

[captmike:]

Very good comments about the potential pitfalls of leveraged funds aslong-term investments.

Don't forget that these funds pay distributions over the course of the year, diluting capital and hitting the owner with a potential tax liability as well.

When investing, it really helps to understand exactly what you're investing in.

Jan 04 09:55 AM

[traderjohn2:]

The difference between SPY and IWM looks rather small to me. Consider:

stockcharts.com/h-sc/u...

Jan 04 10:13 PM

[traderjohn2:]

The difference between SPY and IWM looks rather small to me. Consider:

stockcharts.com/h-sc/u...?
s=iwm:SPY&p=W&...

Jan 04 10:18 PM

[Ghostdog:]

Hey Bobby, If you think this bear market is over as you claimed on WGN news today, probably to shill one of your books, I will sell you a boat load of whatever you want this fall and watch you wet your pants as I watch the DOW drop to 4000K
Later, Tater

Apr 21 02:12 PM