Leveraged ETFs: Too Good to Be True?

In this turbulent market, traders are often looking for the best way to capitalize on each swing. With the market giving us 200 point ranges on a near daily basis, it seems there is ample opportunity to book some great profits. And thanks to the ingenuity of Wall Street (only halfway serious there) you can now get even more bang for your buck with leveraged funds.

Leveraged Funds - What Are They and How Do They Work?

Leveraged funds are ETFs that trade just like stocks. You can buy or sell at any time during the day, and most of these funds have plenty of liquidity to make trading relatively efficient. These funds are based on an underlying index and aim to give traders daily returns that are double the returns you would get if you invested directly in the index.

So for instance if you own the Proshares Ultra S&P 500 (SSO), and the S&P were to rise 2%, your position should be up roughly 4%. There are leveraged funds available for large indices like the Dow, Russell, and S&P as well as for individual sectors such as healthcare, financials, and oil & gas.

An interesting additional resource is the inverse leveraged fund. An inverse fund actually returns the opposite of the index it represents. So if you owned the Proshares Ultrashort S&P 500 (SDS), and the S&P were to fall 2%, your position should be up roughly 4%. These ultrashort positions have become very popular as hedging vehicles, especially in IRAs where short positions are typically not allowed.

In what may be considered “taking a good thing too far,” we have actually seen a few 300% leveraged funds introduced in the past few months. In this case, $100 buys you $300 worth of exposure either up or down. While the tool can certainly be used for good, there are some important issues you must consider when using leveraged funds.

Unexpected Consequences - Drawbacks for Leveraged Funds

Aside from the obvious ability to lose money twice as fast if you are wrong, there are a few other significant problems with leveraged funds. The issues arise with the mathematics of compounding returns. Leveraged funds are set up to mimic the returns of an index and double the return (or inverse return) on a daily basis. But this can make them quite inefficient on a long-term basis.

Consider for instance the index returns for a theoretical week:

• Monday: Down 5%
• Tuesday: Up 3%
• Wednesday: Down 4%
• Thursday: Up 6%
• Friday: Down 2%

Using the returns for the index, you would end up with a 2.42% loss for the week. So if you were using a leveraged fund you would expect your losses to be 4.84% and an inverse fund might be expected to gain 4.84%. But as I’ll show you, the math doesn’t quite work that way. Consider the returns for a $100 invested in a leveraged fund:

• Monday: Down 10% - Now holding $90
• Tuesday: Up 6% - Now holding $95.40 (90 times 1.06)
• Wednesday: Down 8% - Now holding $87.77
• Thursday: Up 12% - Now holding $98.30
• Friday: Down 4% - Now holding $94.37

So you can see that with the compound interest kicking in for both losses and gains, the losses turn out to be 5.63% (significantly larger than simply double the index losses for the week). When you consider this scenario playing out over the course of a month or a year, you can begin to see how inefficient the fund can be for long-term performance.But lets look at the inverse fund. Would it actually outperform since its counterpart underperformed during this particular week? Here is the math on an inverse leveraged fund for the same period:

• Monday: Up 10% - Now holding $110
• Tuesday: Down 6% - Now holding $103.40
• Wednesday: Up 8% - Now holding $111.67
• Thursday: Down 12% - Now holding $98.27
• Friday: Up 4% - Now holding $102.20

You can see that using an inverse double return fund actually returned 2.2% which is significantly less than you would expect. The index declined 2.42% for the week. You might expect the leveraged inverse fund to gain 4.84% but instead you only received 2.2%. Again, the compound math gets in the way when you have large swings back and forth.

The current market has plenty of gyrations back and forth which makes both leveraged and inverse leveraged funds inefficient as long-term strategies. The funds make for excellent tools in protecting your portfolio on a daily basis. In fact, the ZachStocks Growth Model has booked solid gains in these positions offsetting losses in growth stock names. They can also net you some very attractive absolute returns in a short time if you predict the market’s direction correctly.

But the bottom line is to avoid using these funds as long-term positions. They were not designed to hedge a portfolio through a bear market, and will not be effective in doubling your returns for a long-term uptrend. As always, know what you are invested in, and study the details carefully.

Special “hat-tip” to Adam Warner at Daily Options Report who mixes fun and pop culture with a healthy dose of market wisdom.

Disclosure: No positions in stocks or funds mentioned.

Comments

[squark62:]

dear reader, there's been a lot of negative press recently on leveraged ETFs. one reason is because some folks fail to look deeper into the math to discover their usefulness as quantitative hedging tools. therefore take what the nay sayers spout with a grain of salt.

first of all, think about what their saying - they don't work if you buy and hold. that's just about true with anything. the fact that 2X long or short ETFs don't track their index in a linear fashion doesn't mean there is no relationship between the long and short of a particular index - SDS & SSO for example.

second, a real money manager knows - or knows someone - how pair trades work and this is precisely how these ETFs can be used long-term in a portfolio. find someone who understands quantitative analysis and you'll find out how beneficial these ETFs are to the everyday investor/trader.

Feb 27 10:42 AM

[Jake2:]

Thank you for the article. The comment above, however: "a real money manager knows, or knows someone . . . " etc., is much less clear. And what the heck is a "real money manager" anyway? Maybe Bernard Madoff could help out here.

Feb 27 01:21 PM

[AndrewBaker:]

Anyone using this website who does not already know what is being said here should not be investing their money without some professional help. Also, what has happened to math knowledge? I know there are people out there who can't count, but people who can't count investing money! Madness. This is the whole reaon we are in the state we are now, because so many people do not know about financial math and are easily hoodwinked, and just as readily think they know about investment when they have little or no idea at all in reality. This will probably wreck my approval rating, but I have to say it: most people can't manage money and don't know math enough to be let alone with their own finances.

Feb 27 02:15 PM

[Ernest Wong:]

For hedging or speculating, the eMini SP500 futures give more bang for your bucks. It has very good liquidity and low transaction costs. If you have an opinion about the direction of the Dow, why use ETFs? E-minis offer so much more...

Feb 28 03:51 PM

[User 366480:]

This article is a useful reminder of the rule that says you should understand the product you invest in . I disagree with the previous
comments, that you need to be something of a math whiz to invest succesfully. Absolutely not. And as a matter of fact, those who put us into
the current mess are math whizzes! So were the LTCM traders. All you need is the right information
on what actually works for real life portfolios, realistic expectations, and discipline. And above all stay diversified across asset classes and also to a degree across strategies. And don't forget the value of common sense.

Feb 28 04:02 PM

[Flatters:]

Here is the math on the inverse index:
Monday: Up 5% - Now holding $105
Tuesday: Down 3% - Now holding $101.85
Wednesday: Up 4% - Now holding $105.92
Thursday: Down 6% - Now holding $99.57
Friday: Up 2% - Now holding $101.56
The return is thus 1.56% and not 2.42% as stated above (the oppisite of the index loss of 2.42%). It is however true that the double leveraged inverse ETF did not deliver the expected 3.12% (2 X 1.56%) but only 2.2%. So the buttom line is that the potential loss on these leveraged ETS's is greater than 2X while the potential gains are less than 2X.

Feb 28 05:17 PM

[Uncle Foobar:]

One thing: i like watching the opening for both the SDS and the SSO starting around 6:30 am to get some ideas on where the market is heading for the day.

Foob

Feb 28 06:35 PM

[squark62:]

On Feb 28 04:02 PM User 366480 wrote:

> This article is a useful reminder of the rule that says you should
> understand the product you invest in . I disagree with the previous
>
> comments, that you need to be something of a math whiz to invest
> succesfully.

along with common sense and good judgment, in the hands of the right person math (statistics, etc) is a powerful tool for trading. psychology was the devil in the details lurching among the hedge fund managers and quants who took the plunge and crashed. when the herd mentality overtook the quants and their assumptions and boundary conditions of their models, failure was inevitable. so don't demonize math whizs for creating all the problems in the market, look in the mirror and blame greed. unfortunately it's in everyones make up to one degree or another.

Feb 28 11:45 PM

[squark62:]

sounds good but it don't know whether you can trade e-minis in IRAs for instance. i would guess not. in that case, ETFs then are the best choice with pretty much all the same advantages.


On Feb 28 03:51 PM Ernest Wong wrote:

> For hedging or speculating, the eMini SP500 futures give more bang
> for your bucks. It has very good liquidity and low transaction costs.
> If you have an opinion about the direction of the Dow, why use ETFs?
> E-minis offer so much more...

Feb 28 11:49 PM

[angry_money:]

I've been reading about the pros and cons of these leveraged ETFs for awhile now, and I finally have to ask a question that always arises in my mind...can one short them? I mean, if they are designed to decay over time, and do not deliver the returns they promise over the long run, wouldn't a short position on both sides net a positive return (say FAS and FAZ)?

I'm only asking because I assume that an efficient market would already have figured this out if it were true and taken the premium out of such a sure thing...right?

Mar 01 12:58 PM

[REITBull:]

I believe that many of these leveraged funds were created very recently (around 2007). That being said, how can assume that they are not effective as long term investments?

Also, the high volatility that we are experiencing recently has an adverse impact on these funds.

I don't believe that there is enough history on these to conclude that they are bad investments in the long run.

Mar 01 02:22 PM

[squark62:]

interesting points.

pairs trading is a form of arbitrage which is very effective but never a sure thing. without a quantitative model, finding the right balance in the portfolio will only be a fluke. math and a proactive trading platform is required for efficient arbitrage. these elements normalize the playing field. you could have the right math, but a terrible trading platform and vise-versa.

shorting leveraged ETFs can be done a number of ways. a broker may offer margin accounts the option short these instruments. or, you could by options. most proshare ETFs trade options. i think direxion ETFs have options too.

however, buying puts or calls on these ETFs is a strategy all to itself. if you engage in options trading leveraged ETFs, in my opinion it wouldn't make sense to own the underlying, perhaps only if the ETFs provider doesn't have an inverse correlated to the same index.

so, sorry. no free lunch here. :-(


On Mar 01 12:58 PM angry_money wrote:

> I've been reading about the pros and cons of these leveraged ETFs
> for awhile now, and I finally have to ask a question that always
> arises in my mind...can one short them? I mean, if they are designed
> to decay over time, and do not deliver the returns they promise over
> the long run, wouldn't a short position on both sides net a positive
> return (say FAS and FAZ)?
>
> I'm only asking because I assume that an efficient market would already
> have figured this out if it were true and taken the premium out of
> such a sure thing...right?

Mar 01 05:15 PM

[Zachary Sch...:]

Hey guys - thanks everyone for the comments! I guess I have only a couple of points to make in response:

1) My article wasn't intended to state that leveraged and inverse leveraged funds were not worthwhile tools - in fact, I use them from time to time to manage short-term risk in portfolios. However, in a volatile market with many changes of direction, these funds become less effective. The point, as many have stated, is to KNOW what you are invested in and how it will behave in various environments.

2) REITBull, I have to respectfully disagree with you. The products may only be a few months (or years in some cases) old, but they are derivatives on well known indices. Therefore, we should be able to mathematically forecast how these products will perform in particular environments because we know their properties. The vehicles are relatively liquid, and able to be replicated by trading the underlying index or basket. So the pricing should be efficient and thus predictable in comparison with the underlying.

Again - appreciate the comments and lively discussion!
Zach
zachstocks.com

Mar 03 02:55 PM

[REITBull:]

Thanks Zach, I appreciate the feedback.

Mar 03 08:34 PM