In Defense of Leveraged ETFs

It seems to have become popular nowadays to beat up on purveyors of leveraged ETFs, most notably ProShares and to a lesser degree, Rydex, not to mention newcomer Direxion which just launched some triple-leveraged products (upping the ante on the double leverage that’s attracted attention thus far). One has to wonder how many public-relations firms are drooling as they anticipate new campaigns by the ETF providers.

The latest salvo comes from Morningstar, which titled its 1/22/09 offering Warning: Leveraged and Inverse ETFs Kill Portfolios. Come on Morningstar, don’t be shy. Tell us how you really feel! After having just recently panned Morningstar research for what appears to be too much youth and inexperience, I really had no inclination to take another shot, but having successfully used leveraged ETFs, coupled with the stridency of the tone, I felt I really had to point out the flaws in this one.

Facts are facts

What’s interesting here is that every fact asserted by Morningstar and in the other articles it cites (including one that was previously published on Seeking Alpha) is completely correct. For example, Morningstar claims that one who correctly anticipated the decline in iShares Dow Jones U.S. Real Estate Trust (IYR) since 12/31/07 would not have made a killing in the UltraShort Real Estate ProShares (SRS). With IYR having fallen about 40 percent, one would think an ultra short based on similar stocks would rise about 80 percent. Instead, SRS fell a bit more than did IYR.

Wow! If that doesn’t justify a “warning,” what does?

Something’s missing

As Morningstar asserts, “these funds have attracted billions of dollars over the past year alone.” Perhaps there’s some cosmic coincidence in the fact that I’m writing this now, after having viewed an hour or so of Boiler Room on cable last night. So I guess we have another example of the suckers running amok within the ignorant Wall Street rabble.

Or do we? Is it possible others are seeing things Morningstar is missing?

As noted, I’ve used some leveraged ETFs (ultra shorts) at various times since they’ve come out, and frankly, I’ve been satisfied with the results. And to tell you the truth, I’m feeling a heck of a lot more pain from my position in Berkshire Hathaway (BRK.B) which, by the way, Morningstar loves judging by its five-star and wide-moat ratings.

Context is king

Critics of leveraged ETFs explain how you cannot assume daily moves (even if they each come in on target) will add up as expected when assessed in the context of multi-period compounding. In other words, an ETF may deliver twice the inverse performance of the S&P 500 on a daily basis, but when you view results over the course of a year, you cannot assume it will work out anywhere close to double inverse. Whether it does or doesn’t depends on the pattern of daily movements. I’m not going to explain in detail. Morningstar and the others do this quite effectively.

My issue is with the grand conclusions (“kill portfolios”) offered by Morningstar: “If you're hell-bent on using leverage for any period of time longer than a day, you'd be better off using a margin account in almost any real-world scenario. This is not an opinion--it's a highly likely statistical probability. And interestingly enough, each successive time you bet against the odds, probabilities tend to become mathematical facts.”

Morningstar doesn’t strike me as the type of firm that would encourage people to load up on margin. Presumably, that was a back-hand way of saying it’s OK to use leveraged ETFs for day-trading. I agree. But I strongly disagree with any assertion (express or implied) that these products are too dangerous for use over periods longer than a day. I also take issue with the tendency of critics examining more than a day to lock in on any fixed holding period. And I suggest that the author has not come close to earning the right to link the phrase “mathematical fact” to the conclusion he apparently wants readers to draw.

Consistent with my own experience and based on looking at data without any sort of “hell-bent” attitude, I maintain that these leveraged ETFs have the potential to fulfill reasonable goals over the course of time periods defined by meaningful directional movements of the target (a market index, a sector, etc.).

What is a meaningful directional movement (beyond a day)?

There is no single good-for-all time answer. It depends on the market. That may disappoint those who cherish simple black-or-white answers. But come on folks, this is the stock market. If anything, anything at all, were that simple, we’d all be gazillionaires. People who need simple black-or-white answers really should stick with FDIC-insured CDs.

While I can’t give an ironclad definition of meaningful directional movement, I can provide some real-world examples.

Illustrations

For purposes of illustration, I’m going to stick with real estate, a topic that, for better or worse, is close to the hearts of many nowadays. As per Morningstar’s examples along these lines, iShares Dow Jones U.S. Real Estate Trust is the bullish play and UltraShort Real Estate ProShares is the bearish solution.

First let’s address the phrase “reasonable goals.” Expecting an ultrashort to actually deliver twice the inverse of the target is not reasonable. Tracking error is part of the picture here to a larger degree than we expect from the more classic ETFs like SPY or QQQQ. The strict definition of tracking error is based on differences between market price performance and NAV performance which, in turn, is based on the underlying index which in this day and age, will more often than not be an index nobody ever heard of that was created solely for use with the ETF in question (that being the case with IYR and SRS).

I’m going to offer a new phrase, strategic error. This will be the difference between the market price performance of SRS and twice the inverse of the performance of IYR. I can’t call this tracking error because SRS is designed to deliver twice the inverse of the index nobody cares about, not twice the inverse of IYR. But measuring strategic error with reference to IYR is reasonable because that reflects how investors think. If I want a bullish equity play on real estate, I’ll buy IYR. If I’m aggressively bearish, I’ll accept SRS as a tolerable approximation of a double short position in IYR. Strategic error will help me assess “tolerable.”

I examined daily price percent changes (adjusted for distributions) for IYR and SRS from 2/1/07 through 1/22/09. That’s 497 observations. I measure strategic error as the absolute value of the difference between the daily percent change in SRS and the daily percent change in IYR multiplied by minus two (I use absolute value because I care only about the size of the difference, not the direction).

Median daily strategic error: 0.44%

Average daily strategic error: 0.71%

Standard Deviation: 0.92%

Maximum: 7.72%

Minimum: 0.00%

The maximum figure is pretty high, warning us that we are exposed to some big-time oddball individual days. But it doesn’t happen often. Daily strategic error was equal to or greater than 1% on 104 out of 497 days. It was equal to or greater than 2% only 29 times. In assessing the average strategic error (0.71%), consider that the average (absolute) daily price change in SDS was 4.49% and the median was 2.86%.

So, what about this strategic error? Is it reasonable or excessive?

Excess, like beauty is in the eye of the beholder. In my personal opinion, it’s reasonable.

Within the 497 observations, the worst-case was 7.72%. That’s certainly bad. But as a long-time equity-market participant, I know full well there are many, many, many ways I can get smacked with even bigger and more frequent daily errors on more “respectable” investments (imagine all the hits you took when management of a company whose shares you own reduced earnings guidance).

Now lets’ get down to the main course, looking at some examples of meaningful directional movement.

click to enlarge

So what do you think?

After what the other critics explained, it should come as no surprise to see variation between target and actual SRS. But the question is whether Actual SRS is a reasonable outcome given what you had a right to expect to achieve.

Let’s look at the longest time period, 2/1/07 through 1/22/09. The strategic error is considerable, but if you were using real money, how angry or upset would you be?

Clearly, I’d have been happy that I’d have been right to not be bullish on real estate stocks. IYR lost more than 60 percent. I wish I could have achieved the better-then-100% target SRS return but instead I just broke even since the daily movements didn’t break nearly as well as would have been necessary for me to get the full-period target gain. But look at the time period. Real estate got crushed. The market got crushed. Blue chips got crushed. Lots of things got crushed.

True I’d have missed my target by a county mile. But honestly, if I were to have an opportunity to get into a time machine to buy SRS on 2/1/07 and unravel my Berkshire Hathaway purchase, heck, just try to keep me out.

Moreover, I’d have been perfectly happy to have owned SRS between 5/30/08 and 7/31/08, and between 12/31/08 and 1/22/09. As to the 5/15/08 through 11/20/08 period, holy cow: How great would that have been. These weren’t random intervals. All matched noticeable declines in IYR, meaning SRS could benefitted those who had correctly anticipated the trends.

It would have been different had I been bearish on real estate in December 2008. IYR had a nice gain. SRS, on the other hand, got drilled, much more so than the target decline. But that’s life. I’d have been wrong with a high-risk strategy. I’d have suffered. It wouldn’t have been fun, but I’d have legitimately gotten what would have been coming to me as a result of a decision to go into a leveraged short at the start of a rally.

Would I have been better off if the Actual SRS returns were closer to Target SRS. Absolutely! But they weren’t. What can I do about it? Should I hold my breath and stamp my feet? Nah, I’m too old for that. Should I forego SRS altogether? That doesn’t grab me considering that each accurate expectation would still have been nicely rewarded? (And I’m no more scared of being wrong here than I am with a lot of other things, including Morningstar five-star stocks.) I guess the only thing I really can do is have a realistic understanding of what I’m doing. Hey, that works!

Can it be said that these time periods were contrived to show what I want you to see. Heck yes! The whole point, here, is to show what could be considered meaningful directional moves. Had I been oblivious to that, I’d have been likely to get results that are all over the place.

It is not my purpose, here, to tell you to buy or avoid any particular leveraged products at any particular points in time. Instead, it’s been my goal to refute suggestions to the effect that these products are of no use to anybody (even those who properly anticipate meaningful directional moves) except day traders.

Conclusions

Consistent with what the critics of leveraged ETFs maintain, we cannot assume the target daily return will prevail when we start compounding over longer periods. But contrary to what the critics suggest, these ETFs can be used to properly execute a trading strategy over the course of a meaningful directional movement however long or brief that may be.

Ultimately, I suspect we’d find that the cleanliness of the outcome (i.e. proximity between target result and actual result) will be a function of the length of the period, the persistence of the move, and the strength of the move. (Increases in length provide more opportunities for things to get messed up by counter-trend days, increases in persistence mean we’re less likely to get as many counter-trend days as we fear, and increases in strength enhance the potential for on-trend movements to overwhelm whatever counter-trend episodes we get.)

Perhaps some day I or someone else will quantify such a function. I believe this is the task that has to be accomplished before one’s thesis could be described as a “mathematical fact.”

But we don’t have to get nearly that far for someone who understands what these leveraged ETFs are about and who knows how to align his/her expectations with these realities to benefit from their use. It’s also important to correctly anticipate trends, but that’s hardly unique to these products! And it seems to me that the error and pain to which we would be exposed if we mess up is in line with what should be expected by one who chooses to pursue volatility, and with the sort of pain we so often feel from the more “respectable” investments.

NOTE: There is another important topic that became prominent for leveraged ETFs in 2008: far less tax efficiency than had traditionally been assumed for ETFs. It’s beyond the scope of this article but it is important if you use these in taxable accounts. Fortunately for those who need to know, it’s been very well covered on Seeking Alpha. Here’s a link to the results of a “leveraged etfs distributions” search I conducted here.

Disclosure: Author owns BRK.B

Comments

[cma:]

An absurd defense which amounts the the fact that over any reasonable holding period (1 week or greater) the double leveraged ETNs are "not so bad." Why use a product which produces results that range from bad to not so bad?

Jan 25 10:29 AM

[jswede:]

I agree cma, "absurd" is about the only word for this.

the 'it didn't perform like I thought it would, but it did better than another holding, so I'm ok with it' defense is laughable.

the rest is just rehashed information.

Jan 25 11:05 AM

[Murray Gross:]

What is required to fully understand when/how/if one should use leveraged ETFs is a mathematical analysis of the characteristics or factors necessary for a leveraged ETF to perform as it should. My observation, and it is no more than that, is that less volatile ETFs, such as SDS (double short the S & P 500) and TBT (double short the Lehman 20 year Treasury index) deliver 140% to 160% of the expected return (200%) over periods in excess of six months. Granted this is far short of expectations but, nevertheless, a welcome bonus for an investment that doesn't require the use of margin.The article is too forgiving of the discrepancies delieverd by the real estate ETF. In three of the six cited time periods the results are horrible.It is more than simple frustration to call the direction of the market right and still lose money because the ETF did not perform as "promised".

Jan 25 11:51 AM

[sunny12945:]

As an investor and also short term trader I have used the double (2x) and also 2x inverse ETFs ( plus 3x variety also)and also MFunds, mainly in my Ret port folio. I also use puts as defense.

The points re extreme sentiments, direction of Mkt/sector/industry, persistence of positive/negative trends, strength of moves, investor expectation versus reality, one's conviction/execution in anticipating moves. Govt interference etc make using these instruments is predominantly an ART mixed with Sceince /Experience. I fully agree with the observation that there is no black or white answers. Know thyself is first cardinal rule.

My own anecdotal experience over 18 months has been a net positive one, in protecting my portfolio. On Dec '07 Nov 20, '08, I was +8% but ended with -2% on Dec 31st but now above the water in plus category. I learned an important lesson that counter trend rally in a BEAR Mkt can be very vicious and irrational, just as the other way around but more so!

I use both positive and negative leveraged ETFs to reduce the latter experience. Market (S&P) has been down NOW close to 45%. It is very difficult to deal with FALSE HOPES and WISHFUL THINKING so pervasive since Aug 2007 but these tools did help me to reduce the damage. Depending upon the short, intermediate and long term term trends I TILT my portfolio with appropriate strategy allocation of my assets which includes from +1 to -1. My bias is net negative in this unprecedented secular BEAR Mkt with periodic OVERSOLD Rallies! It is working fine so far so I stick with it with an open mind. I have over 25 yrs of experience investing. Knowledge flows but wisdom lingers!

TO EACH HIS OWN!

Jan 25 01:19 PM

[sbrode2:]

How much of today's volatility is exasperated as a result of the leveraged funds as we continue to reel from deleveraging of Hedge funds? The stock market used to be an avenue for any to invest, be a part of capital formation and entrepreneural success, a place where growth of the retirement nest egg would occur (remember the story of the Sears Janitor retiring a millionaire?). Now, ever more so, it is an internet casino, where traders make it as well as break it, all in the name of making a market more efficient. I think we have just crossed slightly over the tipping point, (as you hear talking heads decrying the market as unsafe for 401k's, pensions) towards the point of no confidence (SEC/Madoff) leading to less enticement for capitol formation.

Jan 25 03:21 PM

[ETFexpert:]

I love them,
use them and most importantly
make money with them. Oh, and not to mention.....
REBALANCE them.

Show me a hedged position that isn't rebalanced..... and I'll show you an "L" in the P/L.

Jan 25 06:43 PM

[gon4beer:]

I trade 2X ETF's ALL the time. If I want to make a bet that the market is going to move in a particular direction, and I'm right, then I MAKE MONEY-tracking error irrelevant. Isn't it better to make money rather than not doing something simply because there is some tracking error? The bid/ask spread on ETF's is MUCH smaller than most options, esp. when you look at the spread as a % of total price of the underlying instrument. BUT, if I were using ETF's to hedge, rather than to trade, I think the tracking error issue is much more relevant.

Jan 26 08:32 AM

[Alan Brochs...:]

Author and detractors miss the point that ETF Expert makes - rebalancing is key. Look at SKF last week and you will understand that as the market declines, your bet gets EXPONENTIALLY larger. Those who succeed with the double-leveraged ETFs and understand daily rebalancing know that huge mismatches occur very quickly in a volatile market.

Let's say you have $1mm in IYR and you want to protect it by buying SRS. You need to own $500k. If next week IYR falls 10% suddenly, your position will be worth $900K. Your hedge, though, will be worth $600K. You lose $100K but you offset it with $100K in gain. If you fail to sell $150K of SRS (i.e. leaving your position at $450k or 1/2 of the now $900k IYR), you have screwed yourself potentially. Here's why. If IYR immediately rallies back 10%, it will now be worth $990K (you have lost $10K). Your SRS, though, will decline by $120K to $480K (20% of now $600k). You are out $20K on the hedge and $10K on the original long position. And you want to blame ProShares? Had you rebalanced, you would have lost 20% of $450K or $90K that day, which is exactly the increase in value of the IYR.

Please tell me why this challenges people so greatly?

Jan 26 08:41 AM

[Tristan Yates:]

I wrote the initial article: "The Case Against Leveraged ETFs". Since then I've done more writing and analysis, and the latest is here:

www.tradingmarkets.com...

I also contributed to some of the recent Larry McDonald articles which are very good.

The take aways:
1) the cumulative product of doubled daily returns will almost certainly be lower than the underlying returns because its harder to recover from a doubled loss than the loss itself.
2) you have to pay very close attention to your index exposure because it can very quickly get out of control, making your risk exposure rise and fall dramatically
3) they have a *monster* cost of capital & expenses built in that's simply indefensible - like 7% a year.

Bottom line: Leveraged ETFs are for amateurs. If you want leverage, use options or futures or even margin (with a decent broker) like a professional.

Jan 26 01:00 PM

[Marc Gerstein:]

I think the suggestion that amateurs use leverage ETFs in contrast to pros who use futures or options is a bit over the top, especially since the bio beneath your tradingmarkets.com article describes you as the author of a book on the use of options and futures (bias? agenda?). By the way, I presume you're aware that many IRA broerage accounts are prohibited or severely restricted in the use of futures and options.

Hoping that your last paragraph was not carefully considered (we all sometimes are a bit hasty with these comments), let me address the other points:

> 2) you have to pay very close attention to your index exposure because
> it can very quickly get out of control, making your risk exposure
> rise and fall dramatically

Well yeah! Who said otherwise?

> 3) they have a *monster* cost of capital & expenses built in
> that's simply indefensible - like 7% a year.

It's the net performance that counts. If it works, I'm not going to lose sleep over expenses.

> 1) the cumulative product of doubled daily returns will almost certainly
> be lower than the underlying returns because its harder to recover
> from a doubled loss than the loss itself.

I have a big-time problem with this. Yes, the math is accurate. But I couldn't begin to count the number of times I've seen depressed securities do all they need, and more, to recover from these doubled losses. This is a point that sounds terribly intimidating on paper, but is not nearly so in the day-to-day world of investing.

Actually, the tradingmarkets article you link to uses SPY and SSO as an example. It shows a 12-trading-day loss of 25% for SPY and 45% for SPO and points out that to recover, SPY needs to gain 33% while SSO needs to rise 40%. What you didn't say was that over the next 12 trading days, SPY gained 18% while SSO gained 36%. This isn't a complete recovery, but it does much to diminish the fear you raise re: the extra burden. Seems to me like SSO has been working, for better or worse, as it should (you get rewarded if you expectations pan out, you get punished if you're wrong).

Jan 26 02:09 PM

[searcher:]

Marc, can't agree with you on the utility of these instruments for any but paired daily trades. Even if I had a crystal ball that guaranteed a trend with extremely high serial correlation, there are better nets for that school of fish.

I'm smiling while I write this, but it seems as though you've taken on the task of the debater doing the best they can with an assigned fundamentally weak case.

Jan 26 06:38 PM

[Adam J:]

"Let’s look at the longest time period, 2/1/07 through 1/22/09. The strategic error is considerable, but if you were using real money, how angry or upset would you be? "

Ummm if you are not upset that the index you intended to short was down 63% and you only made 1% then you have really lost your mind. LOL, your just not upset because you didn't lose money? There is opportunity cost your know? Clearly there was an opportunity there that you missed out on because you used the wrong tool for the job. Furthermore What if your intent on using the short was to offset a long position you had? Clearly it did not meet your objective. I really can't believe your comment.

Jan 26 09:25 PM

[Tristan Yates:]

Quick quiz:
1) If the S&P 500 falls 15%, what percentage increase do you need to recover your losses?
2) Now calculate the same for a double and triple leveraged ETF.
3) If you trade $20,000 of SSO every day and it has a built in 7% expense ratio, calculate how much you would save over a year if you switched to index futures with their built in broker margin rate of under 2%.

Jan 26 09:35 PM

[Marc Gerstein:]

Tristan,

It's well established that you know how to use a calculator and/or a spreadsheet. Now, can I suggest that you go to Yahoo Finance, download a truckload of price-history spreadsheets, and notice how frequently the supposedly intimidating task you establish for stocks actually happens; especially among leveraged ETFs, where the same leverage that pushes them down vigorously pushes them up with comparable vigor?

As to your point on expenses, like i said, I care about how much I make. I'm neither shy nor reluctant to compensate, even to well compensate, anyone who makes me better than I might otherwise be.

As to futures, you are surely aware of how difficult it can be to play these instruments without heavy margin, and how dangerous that can be, how easy it is to wipe out even if you're right merely because of an inability to ride out a fleeting adverse price movement. I'm happy to compensate an ETF provider who lifts that burden from my shoulders, and makes it practical for me to do my thing without margin.



On Jan 26 09:35 PM Tristan Yates wrote:

> Quick quiz:
> 1) If the S&P 500 falls 15%, what percentage increase do you
> need to recover your losses?
> 2) Now calculate the same for a double and triple leveraged ETF.
>
> 3) If you trade $20,000 of SSO every day and it has a built in 7%
> expense ratio, calculate how much you would save over a year if you
> switched to index futures with their built in broker margin rate
> of under 2%.

Jan 27 09:10 AM

[Marc Gerstein:]

Adam,

Targets are for finance students and those who invest risk free in Treasuries, CDs, etc. For the rest of us, the investing world is filled with missed targets, dashed expectations, etc. (My Goodness, if we haven't learned this after 2008, when will we ever get it?) Stuff happens. We have to make peace with that.

And by the way, as to the example you discuss, I was perhpas, not as precise in my language as I could have been had I wanted it to read like a legal document, where the long-form explanation is given every time. No, the index was not down 63%and no, my "official" target was not +126%.As I and other said again and again, these things are targeted to DAILY moves. The question being debated is whether we can achieve satisfactory results if these dailies are compounded up and down more prolonged periods. The +1% was compared to a highly-unofficial hope, not a formal target. And as I said, leveraged ETFs do not have a monopoly on unfulfilled hopes. The issue is how much pain one feels from the miss, compare to the many other misses we experience elsewhere.


On Jan 26 09:25 PM Adam J wrote:

> "Let’s look at the longest time period, 2/1/07 through 1/22/09. The
> strategic error is considerable, but if you were using real money,
> how angry or upset would you be? "
>
> Ummm if you are not upset that the index you intended to short was
> down 63% and you only made 1% then you have really lost your mind.
> LOL, your just not upset because you didn't lose money? There is
> opportunity cost your know? Clearly there was an opportunity there
> that you missed out on because you used the wrong tool for the job.
> Furthermore What if your intent on using the short was to offset
> a long position you had? Clearly it did not meet your objective.
> I really can't believe your comment.

Jan 27 09:20 AM

[Amateur?:]

This has been a good debate and hopefully has shown the risks and rewards of leveraged and short ETFs. I've traded SRS and SKF a number of times over the last 12 months and have been happy with the results. This is because I've treated leveraged ETFs like all other leveraged products such as futures and options - with respect and caution.

Given the longer term tracking error, these are not appropriate for medium to long term investments (without periodic rebalancing as discussed above). However, for very short term trades the performance is what is claimed on the box (except when the short ban was in place and the daily tracking error was significant).

Ideally, ProShares would offer a non-leveraged short ETF for commercial real estate. This would decrease but not eliminate the longer term tracking error. Otherwise, just short the unleveraged long ETF to gain similar exposure. This is not rocket science.

Regarding the comment - "Bottom line: Leveraged ETFs are for amateurs. If you want leverage, use options or futures or even margin (with a decent broker) like a professional."

The cost of put options on the underlying shares of SRS portfolio is extremely high and in my opinion, it is much more cost efficient to buy SRS over a short term since you don't have to pay for the volatility (you just have to live with it). Options are also much less liquid for larger trades and have higher transaction costs (large bid/offer). Futures - could be interesting but on what to gain the same exposure to commercial real estate and at what cost?

Jan 27 06:10 PM

[Tristan Yates:]

Mark, I hope you don't mind the debate. As a writer I get lots of positive and negative feedback on my articles and always enjoy it because it means my ideas are out there. I probably helped inspired your article and I'm happy to have done so. Good luck with your research and writing.

Jan 28 02:03 PM

[Kanman:]

Hi Tristan,

I've read a lot of these articles on leveraged ETFs. I'm still missing one thing. I've held DIG for a while and for the most part it's been up nicely. What's the big downside of holding on to this if it's going up? Thanks.


On Jan 26 01:00 PM Tristan Yates wrote:

> I wrote the initial article: "The Case Against Leveraged ETFs".
> Since then I've done more writing and analysis, and the latest is
> here:
>
> www.tradingmarkets.com...
>
>
> I also contributed to some of the recent Larry McDonald articles
> which are very good.
>
> The take aways:
> 1) the cumulative product of doubled daily returns will almost certainly
> be lower than the underlying returns because its harder to recover
> from a doubled loss than the loss itself.
> 2) you have to pay very close attention to your index exposure because
> it can very quickly get out of control, making your risk exposure
> rise and fall dramatically
> 3) they have a *monster* cost of capital & expenses built in
> that's simply indefensible - like 7% a year.
>
> Bottom line: Leveraged ETFs are for amateurs. If you want leverage,
> use options or futures or even margin (with a decent broker) like
> a professional.

Jan 28 06:08 PM