2X and 3X ETFs Are Not the Best Long-Term Hedges

As active investors continue to watch their portfolios fall, it is natural for even traditional buy-and-hold investors to not only consider liquidating existing positions, but also think about ways to hedge their portfolio (or even profit from the relentless downward trend). Since the easy short money has probably already been made, some investors and traders are turning to 2X and 3X inverse or short ETFs to juice returns.

While such ETFs have been in existence for a while, and articles detailing the uses and pitfalls have surfaced (see two recent 2009 WSJ articles here and here), it is still worth reminding investors how double, triple, and inverse ETFs are better suited for day traders, and are not perfect tracking vehicles past one day. The reason for this is that with the right type of daily moves over an extended period of time, compounding errors can result in inverse ETFs generating overall losses, even when the reference index is down considerably. Tom Lauricella's WSJ article outlines why:

For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further -- 12%. Here's why: On the first day, doubling the index's 5% gain pushes the fund's NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88.

So while a 2X short ETF will double your daily returns when the associated index is down by X, holding periods longer than one day are subject to compounding variations. Unfortunately, such compounding effects may not be the only surprise for long-term investors of index ETFs, or even those with shorter holding periods. Investors need to fully understand what is being tracked.

For instance, the popular USO ETF actually trades based on crude oil futures, and not the spot price of crude. As such, if futures prices do not increase as much as the spot price, your ETF may end up gaining less than expected. Rolling from one contract month to the next could also cause gains or losses. If the crude oil futures market is in contango (futures trading for more than spot), rolling over the futures from one month to the next could generate a large loss for the ETF, and lower gains for the investor, as new positions are purchased at a higher price [Note: for a good overview on the issues regarding the USO, see the following article].

As with all ETFs, make sure you look beyond the name, and have some idea how the price is set. The various 2X and 3X inverse ETFs may not be giving you the type of long-term hedge or position you are expecting, and the commodity ETFs may not be following the spot price as anticipated. Finally, always be sure that any index the ETF is following actually has the type of diversification and representation you are looking for. Some industry ETFs may be heavily weighted in just a few companies, or may be focused more on a specific sub-industry.

Comments

[Douglas S:]

Can you give an example of an ETF where this value destruction occurs? I've tracked multiple indexes versus both ultra and ultrshorts and while yes, they do not track exactly on par with the index, the share price value increases over a long holding period? What am I missing?
Thanks

Mar 08 09:40 PM

[Douglas S:]

Just for a quick example...UYM is trading at roughly $8 a share, 6 months ago it was trading at $22 a share, if minerals rally over the next 6 months, wouldn't my $8 per share investment be back up to $22 per share value? I see the concept of if you pick the wrong direction and the losses piling up, but how is a share of UYM different than a share of Alcoa....aside from the leverage. My brain can't handle this, lol.

Mar 08 09:54 PM

[squark62:]

douglas: one of the mistakes is to assume linear relationships between the market behavior and leveraged ETFs. the slippage and tracking errors are nonlinear down and up. in solid mechanics we'd call this hysteresis which means when pressure is applied and relieved to an object, the material doesn't go back to it's original dimensions. this inelastic or nonlinear behavior. the same thing happens to leveraged ETFs. it's the nature of the beast.


On Mar 08 09:54 PM Douglas wrote:

> Just for a quick example...UYM is trading at roughly $8 a share,
> 6 months ago it was trading at $22 a share, if minerals rally over
> the next 6 months, wouldn't my $8 per share investment be back up
> to $22 per share value? I see the concept of if you pick the wrong
> direction and the losses piling up, but how is a share of UYM different
> than a share of Alcoa....aside from the leverage. My brain can't
> handle this, lol.

Mar 08 11:10 PM

[Kevin Walmsley:]

You can look at SH and SDS. SH is the inverse S&P 500; SDS is the double-down S&P. Year to date the SH is up 39.21%. Now one might expect the SDS to be up 78%, right? Nope--YTD, SDS is up 61%.
I noticed this last year--I use a lot of inverse ETF's in my portfolio management, and noticed that the levered emerging market was actually underperforming the LONG ETF, even though the long ETF was down over 40% at the time. That's when I wised up and saw them for what they were--very good trading and hedging vehicles for the short-term, but terrible for a long-term holding.


On Mar 08 09:40 PM Douglas wrote:

> Can you give an example of an ETF where this value destruction occurs?
> I've tracked multiple indexes versus both ultra and ultrshorts and
> while yes, they do not track exactly on par with the index, the share
> price value increases over a long holding period? What am I missing?
>
> Thanks

Mar 09 12:34 AM

[BigOlDave:]

Well YCS -- ultrashort of the Yen -- is doing just fine, thank you.

Dave

Mar 09 12:10 PM

[AndrewBaker:]

Please do not use ultra or leveraged ETF unless you know the math. If a trend runs reasonably strongly over a period (say yen to US dollar over the past while {using the example above}), the leveraged effect will give a good return: so take it. However, where a market trades against your chosen trend on some days, then a greater reversal back to trend is required to get you back even. EG: Your stock index falls by 25% day 1, then rises by 33.33% day 2. Your $10,000 stock holding drops to $7,500 at end of day 1, then goes back to $10,000 at the end of day 2. Your 2x leveraged ETF tracking the index falls to $5,000 (2x the drop) at the end of day 1, then goes back to $8,333 (2x the rise) at the end of day 2. So, your index is even, but you are $1,667 down. This seemingly extreme example is what does happen over time with only small daily falls inbetween the up days. If you use these leveraged ETF, check them daily, or accept you may lose out big time.

Mar 09 02:05 PM

[kernels:]

Leveraged ETF's are good when you go into a rally. For example The financials have been gettin the living snot kicked out of them. Suppose you expect a short rally this week due to the M2M hearings. FAS is an excellent place to wager your beats. The trick is to sell off into the rally. Take a look at FAZ, that pps has gone up almost 50% over the last month or so.

Mar 09 04:38 PM

[Douglas S:]

Thanks to all of you! FAS is what I was looking at for the possible upshot, but was considering UYM as kind of a longer term gamble and averaging in. Do you all think dollar averaging over a period would make it any better for UYM or should I just hope my FAS makes me a million and then I won't have to worry about UYM, lol. Thanks again!


On Mar 09 04:38 PM kernels wrote:

> Leveraged ETF's are good when you go into a rally. For example The
> financials have been gettin the living snot kicked out of them. Suppose
> you expect a short rally this week due to the M2M hearings. FAS is
> an excellent place to wager your beats. The trick is to sell off
> into the rally. Take a look at FAZ, that pps has gone up almost 50%
> over the last month or so.

Mar 09 05:16 PM

[Henri DeToi:]

One question: does going short have the exact same effect as going long? It seems to me that if these ITF's are tied to futures or option contracts, as they expire or move into new ones, the bears should gain from the passage of time as opposed to the bulls losing with the passage of time. Anyone?

Jun 18 07:31 AM

[Henri DeToi:]

I mean if the market does not move at all. As an example, if tied to oil and the oil price remains the same.

Jun 18 10:52 AM