Leveraged ETFs: Handle with Care 30 comments
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Friends and acquaintances have been mentioning how they have been using levered exchange traded funds (ETFs) in the stock market. Some use these ETFs for the overall general market, financials, or commodities. Regardless of the actual ETFs, they all behave in similar manner. Whenever someone mentions using a leveraged ETF, I always ask, "Are you using this ETF for intraday movements or holding this ETF for several days, possibly months?" Invariably, the person responds that he has an outlook and wants to capture an outsized return by holding for many days, possibly months. For example, an acquaintance at the gym mentioned that he is bullish on oil longer term and was using an ETF with double leverage. I advised him to sell. Why did I do that?
While I share his positive longer term outlook for oil, I advised him to get out of his levered oil ETF because of his exposure to volatility over a longer term. A good way to understand this material is to look at a hypothetical example.
| Day | Actual | Positive 2X | Negative 2X | Positive 3X | Negative 3X |
|---|---|---|---|---|---|
| 0 | 100.00 | 100.00 | 100.00 | 100.00 | 100.00 |
| 1 | 125.00 | 150.00 | 50.00 | 175.00 | 25.00 |
| 2 | 100.00 | 90.00 | 70.00 | 70.00 | 40.00 |
| 3 | 125.00 | 135.00 | 35.00 | 122.50 | 10.00 |
| 4 | 100.00 | 81.00 | 49.00 | 49.00 | 16.00 |
| 5 | 125.00 | 121.50 | 24.50 | 85.75 | 4.00 |
| 6 | 100.00 | 72.90 | 34.30 | 34.30 | 6.40 |
| 7 | 125.00 | 109.35 | 17.15 | 60.03 | 1.60 |
| 8 | 100.00 | 65.61 | 24.01 | 24.01 | 2.56 |
| 9 | 125.00 | 98.42 | 12.01 | 42.02 | 0.64 |
| 10 | 100.00 | 59.05 | 16.81 | 16.81 | 1.02 |
| Source: | My Fictitious Sample Data |
|---|
In looking at the table above, what do you find surprising? I find two things: first, Positive 2X's values equals Negative 3X's values on even numbered days; and second, Positive 2X's values plus Negative 2X's values don't equal 100 and Positive 3X's values plus Negative 3X's values don't equal 100. Let's investigate how these numbers were determined to understand these seemingly odd results.
On Day 0, we start with a stock or commodity at a base value of 100.00. The next day, it appreciated 25% to 125.00. The following day, it depreciated 20% to fall back to 100.00. The daily absolute change in the underlying stock or commodity is a positive or negative 25, the percentage change is positive 25% and negative 20% respectively. It is this difference between appreciation and depreciation rates that eats away at the levered ETF's results. As we'll see, the greater the volatility and the longer the time held, the greater the erosion of the expected result.
For the Positive 2X ETF, Day 1 yielded a result of 150.00, which is a 50% appreciation from 100.00. Day 2, it fell 40% to 90.00. Day 3, it rose 50% to 135.00. As we see, these base values are drifting further and further away from the true base values of 100 and 125. Finally, on Day 10, the Positive 2X ETF value is only 59.05, even though the base value remains at 100.00.
In a similar manner for the Positive 2X ETF, Day 1 yielded a result of 50.00, which is a 50% depreciation from 100.00. Day 2, it rose 40% to 70.00. Day 3, it fell 50% to 35.00. As we see these base values are drifting further and further away from the true base values of 100 and 125. Finally, on Day 10, the Negative 2X ETF value is only 16.81, even though the base value remains at 100.00.
Intuitively, many expect that a Positive 2X ETF plus a Negative 2X ETF should balance out to zero change from the base value. As we see from our example, that doesn't hold true.
Let's look at Day 2 for the Negative 2X and Positive 3X results. Negative 2X is 40% rise (-2X times -20%) from 50.00 to equal 70.00. Positive 3X is a 60% fall (+3X times -20%) from 175.00 to equal 70.00. So we see that math for Negative 2X and Positive 3X yields the same results for even numbered days.
Okay, so you're thinking, that's fine for this hypothetical example, where I have massive daily changes of either 25% or 20%. In real life, the results should look much more reasonable. Shouldn't they?
Let's use Yahoo! Finance to examine two ProShares ETFs: Ultra S&P500 (SSO), a Positive 2X ETF; and UltraShort S&P500 (SDS), a Negative 2X ETF.
Please note that you can click through the above graph to see a full sized version.
The green line in the middle represents the S&P 500, and over the past year it is down by about 40%. As an aside, please note that I am eyeballing the percentages, so these figures are not exact. Intuitively we should expect SDS to yield about positive 80%. Yet, we see that SDS only yielded a positive 40%. The remaining 40% is lost. Similarly, intuitively we should expect SSO to yield about negative 80%. Yet, it is only down by 70%. Again, we should expect that the cumulative return of SSO (+2X) and SDS (-2X) should yield zero. However, in this example, negative 70 plus positive 40 yields negative 30. This negative 30, once again, demonstrates the erosion in value.
The reasons for these ETFs to differ from our intuitive expectations are primarily the volatility of the S&P 500 itself and the duration of one year, a time arbitrarily chosen. There are two other lesser reasons: tracking error and ETF fees.
As a complete aside, notice the huge increase in volume after the October meltdown. With the increased volatility in the markets, speculators and investors are using these ETFs to gain even larger swings.
I want to be very clear in that I am not picking on ProShares. I am using their ETFs as convenient examples. In fact, ProShares states the following information on its homepage:
ProShares ETFs Target Daily Returns – Each ETF targets a return that is either 200%, -100%, or -200% of the return of an index or other benchmark for a single day ("daily target"). Due to the compounding of daily returns, ProShares' returns over periods other than one day may be more or less than the daily target. For more on correlation, leverage and other risks, please read the prospectus.
The link under the word compounding in the above quote provides a somewhat similar example to my hypothetical example above. Its examples and explanation are worth reviewing. And in ProShares's FAQs on Performance and Pricing, it states the following:
Assess on daily performance, not long-term performance. ProShares ETFs seek to achieve their objectives on a daily basis (before fees and expenses).
If you look every day, you can see the daily performance of the NAV (before fees and expenses) and the daily performance of the benchmark.
Investors considering ProShares and other leveraged or short funds with daily objectives should not expect them to achieve their objectives over periods longer than one day, however. There are several reasons for this, but the most significant one is index volatility and its effect on fund compounding. In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted effect. For more details, see Understanding Long-Term Performance of Leveraged and Short Funds.
I agree with the ProShares message. Given that ProShares highlights to its customers that its leveraged ETFs are best used for meeting daily, not longer term objectives, I believe ProShares is acting in a fair and reasonable manner.
The numerical examples, SSO and SDS charts, and ProShares' quotations should provide you with sufficient knowledge to understand what happens when you buy and hold a leveraged ETF.
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Strickly for day traders!
"What Are They?
Like many traditional index ETFs, leveraged market cap ETFs offer a simple way to get exposure to broad US market indexes, in this case defined by market cap (small cap, midcap or large cap stocks).
But unlike traditional index ETFs, these ETFs provide double the performance of a traditional index. So if the S&P 500 rises by 1%, for example, the ProShares Ultra S&P500 ETF (SSO) would rise by 2%.
Leveraged ETFs are able to do this by using by options and futures contracts. Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders."
No mention that after one day ProShares and the others say all bets are off on 2x and 3x ETF's and that the deviation from the 2x and 3x can be as much 40% to 50% within several months. This charade shouldn't be allowed to go on with the public unknowingly getting into something that will be very costly for them after a short period of time.
Kevin you should be going after ProShares and others and not be giving them a free pass. If they can actually put out a product that is 2x and 3x these indices I love it but as this is it is not and is dangerous because it is not what people think it is.
Of course if this is allowed I propose you and I start a 10x ETF that tucks away in a disclaimer somewhere this is only valid on Tuesday's and Thursdays between 12:00 and 12:15 if there is a full moon.
On Mar 23 01:22 PM dtrader wrote:
> Kevin...the ultra 2x and 3x ETFs are at least misleading and at worst
> fraudulent. You are doing a disservice to the public if you allow
> yourself to just buy into their explanation and accept that as being
> ok. As such you are just condoning how Proshares and others mislead
> the public can produce products that are so disingenuous. It you
> or I did did something like this we would be immediately arrested
> . Even your website seeking alpha doesn't get it and as such is
> helping to perpetrate this misrepresentation in the marketplace.
> Here's how Seeking Alpha describes the objective of these ETF's.
>
>
> "What Are They?
>
> Like many traditional index ETFs, leveraged market cap ETFs offer
> a simple way to get exposure to broad US market indexes, in this
> case defined by market cap (small cap, midcap or large cap stocks).
>
> But unlike traditional index ETFs, these ETFs provide double the
> performance of a traditional index. So if the S&P 500 rises by
> 1%, for example, the ProShares Ultra S&P500 ETF (seekingalpha.com/symbo...)
> would rise by 2%.
> Leveraged ETFs are able to do this by using by options and futures
> contracts. Because futures provide leverage (more exposure than the
> actual cash invested), ETFs that use futures contracts have uninvested
> cash, which they usually park in interest-bearing bonds. The interest
> on the bonds is used to cover the expenses of the ETF and to pay
> dividends to the holders."
>
>
> No mention that after one day ProShares and the others say all bets
> are off on 2x and 3x ETF's and that the deviation from the 2x and
> 3x can be as much 40% to 50% within several months. This charade
> shouldn't be allowed to go on with the public unknowingly getting
> into something that will be very costly for them after a short period
> of time.
>
> Kevin you should be going after ProShares and others and not be giving
> them a free pass. If they can actually put out a product that is
> 2x and 3x these indices I love it but as this is it is not and is
> dangerous because it is not what people think it is.
>
> Of course if this is allowed I propose you and I start a 10x ETF
> that tucks away in a disclaimer somewhere this is only valid on Tuesday's
> and Thursdays between 12:00 and 12:15 if there is a full moon.
...IF you hold them long-term, across a volatile period with many up and down days. Caveat, caveat, caveat!
However, if you follow trend & buy the rallies and declines, you add alpha on both sides, plus downside protection with these investments. In the Bear Mkt, longer term and with a number of smaller up periods, SOME Ultra value was eroded from my Bear Model (total 8-10% allocation) in the 9 months these investments were IN. But those 2x Inverse ETF reduced losses considerably, and then the 2x Bull EFTs provided great upside after Nov 20th. How many managers with a 50/50 > 65/35 > 50/50 allocation suffered a max loss of -10%, before gaining back and ending +15% for 2008?
Since anticipating & reallocating for a Bear Rally on 3/9/09, the weighted US equity return in my model is UP +36% with four 2xleveraged Bull ETFs; the SPY is UP +17.7%. When the Rally fades, Bull ETFs go bub-bye. What's so complicated about that?
In small measure these are a market timing godsend - or PITA, if you time poorly. The triple 3x leveraged ETFs are probably far too risky for the vast majority of investors, but for diversified allocators a10-20% Bullish or Bearish stake can significantly improve performance in period rallies & declines. You're only as good as your calls, same as it ever was!
The mutual fund industry HATES the attention these leveraged ETFs are getting, as little financial advisors learn how to outperform $$$ fund managers. Also wonder if State Street Global Advisors resents the billions now flowing to ProShare Advisors LLC.
Shilly blogs are a good way to attack the competition, obv.
> with leveraged etfs? there's been an overabundance of these warnings
> posted here already. -cheers
I agree, there's a lot of articles already highlighting this information. So my article is NOT breaking new ground. But, as mentioned in my article, friends and acquaintances are still under the wrong impression. It was for them that I wrote this article. Now, when I meet those people, I can provide a verbal explanation and point them to an article on my blog.
> up and down days. Caveat, caveat, caveat!
Good, we agree with the caveats.
> However, if you follow trend & buy the rallies and declines,
> you add alpha on both sides, plus downside protection with these
> investments. In the Bear Mkt, longer term and with a number of smaller
> up periods, SOME Ultra value was eroded from my Bear Model (total
> 8-10% allocation) in the 9 months these investments were IN. But
> those 2x Inverse ETF reduced losses considerably, and then the 2x
> Bull EFTs provided great upside after Nov 20th. How many managers
> with a 50/50 > 65/35 > 50/50 allocation suffered a max loss of -10%,
> before gaining back and ending +15% for 2008?
I am not going to attempt to follow all you precise timings of the market. If you are an exceptional market timer, then to really juice your returns, you could use options and futures. That'll give you some alpha.
Speaking of which, Google Daily Options Report, a blog written by my friend Adam Warner. In his blog articles, he discusses these ETFs and options gamma.
To save you the search, you can find his blog here:
adamsoptions.blogspot.com/
The point of my article--and many similar articles--is that investors/speculators should *NOT* think they can *buy-and-hold* these leveraged ETFs and expect to maintain their 2X or 3X leveraged results. As we agreed on the caveats, that won't happen.
> Since anticipating & reallocating for a Bear Rally on 3/9/09,
> the weighted US equity return in my model is UP +36% with four 2xleveraged
> Bull ETFs; the SPY is UP +17.7%. When the Rally fades, Bull ETFs
> go bub-bye. What's so complicated about that?
Yes, if you are using these leveraged ETFs for short-terms directional moves, then great--you're using them as you should. Again, the point of my article was aimed at long term buy-and-holds.
> In small measure these are a market timing godsend - or PITA, if
> you time poorly. The triple 3x leveraged ETFs are probably far too
> risky for the vast majority of investors, but for diversified allocators
> a10-20% Bullish or Bearish stake can significantly improve performance
> in period rallies & declines. You're only as good as your calls,
> same as it ever was!
>
> The mutual fund industry HATES the attention these leveraged ETFs
> are getting, as little financial advisors learn how to outperform
> $$$ fund managers. Also wonder if State Street Global Advisors resents
> the billions now flowing to ProShare Advisors LLC.
>
> Shilly blogs are a good way to attack the competition, obv.
Not sure what you're referring to with regard to "the competition." I don't compete in any fashion with ProShares. In fact, I even gave it kudos for its disclosure that its leveraged ETFs should NOT be used for longer term buy-and-hold investors. Instead, leveraged ETFs are meant for daily or very short-term holding periods.
Even though you seemed to have taken exception to parts or all of my article, I am glad you took the time and effort to post your response. All comments help to clarify this topic for others.
On Mar 23 07:00 PM Kevin Stecyk wrote:
> > ...IF you hold them long-term, across a volatile period with many
finance.yahoo.com/q/bc...
What am I missing?
> I have charted the SPY vs. SSO over a 3 month period and don't see
> the effect you are saying will happen. During this past 3 month period
> the SPY has gone down but recovered to the starting value on two
> occasions. On those occasions the SSO has also recovered to its starting
> value. So, I don't see the behavior you are predicting.
David, by looking at SPY and SSO for the three month period, we note that the effect is not pronounced.
See here:preview.tinyurl.com/4d... (spy, sso, sds)
Let's look at six months: preview.tinyurl.com/4d... (spy, sso, sds)
Again, SPY and SSO actually look as though they are performing reasonably well. That is, SSO has fallen roughly 2x as much as SPY. Looking at SPY, though, shows that it is reasonably straight. It has gone down consistently.
However, look at SDS and SSO. Both added together should equal 0. 2X + -2X = 0. On my screen ~+10 + ~-60 doesn't equal 0.
The key to understanding how much these levered ETFs will deviate away from 2X (or -2X or 3X or -3X or whatever) is look at the volatility of the underlying asset and length of time. And, as an additional spot check, add the mirror (if you using +2X, look at -2X) ETF to see if you get 0.
Look at FAS and FAZ. When added together, even over a three month period, you'll note that the two ETFs don't come close to 0. The financials have been much more volatile.
Again, the two main keys are volatility of underlying asset and length of time held.
> This implies that even 1X ETFs that simply move based on daily performance
> of the underlying will be off by about 51% on the 10th day (+1X)
> and by about 75% (-1X) when the underlying would be exactly at the
> same price as on Day 0. Does this suggest we only invest in stocks
> and forget about ETFs?
Sorry Shaun, but I don't follow your 1X ETF will be off statement. A 1X ETF should be very close. That is SPY should be very close the S&P 500. SPY is an ETF.
Day Price +1X -1X
0 100 100 100
1 125 125 75
2 100 100 90
3 125 125 67.50
4 100 100 81
5 125 125 60.75
6 100 100 72.90
7 125 125 54.68
8 100 100 65.61
9 125 125 49.21
10 100 100 59.05
On Mar 24 04:14 PM Kevin Stecyk wrote:
> Shaun wrote:
> My bad... I plugged in wrong numbers for +1X. But what about -1X
> ETF. It seems -1X will be same as +2X on even days.
> Day Price +1X -1X
Yes, your math works. Again, my example is quirky in that we have +25%, -20% alternating back and forth.
The key takeaway from this entire exercise is that using a levered ETF, your actual return will differ from an "intuitive expected return," where the intuitive expected return is the ETF multiplier times the actual realized return of the underlying asset. This difference is magnified by both volatility and time.
I understand performance drift, I trade the BGU and it is down 50% since inception on 11/5 and the Russell 1000 is down 12.9%. At 3X that should be a 38.7% decline in the BGU. In order to combat the negative volatility effects, do you think coupling the levered ETF with a long VIX ETF or option would be a good idea?
What I do not understand is what effect do they have on your holdings if you stay in them overnight. Do they open up the next morning compensating for any plus or minus action that occurred since closing the previous day?
Can they be used at all to protect you from overnight swings in the market?
If not, how do you trade in these if you have a long term perspective on where the market is headed? (In them in the AM and close out in the PM? Everyday until your market expectations change?) How do you capitalize on their potential to out perform?
Anyone got the answer?
Simply an expansion of a classic fallacy that investing n00bs forget. If your portfolio goes down 50% it needs to rise 100% to breakeven assuming no reinvestment through dollar cost averaging and the like of or dividends. Clearly, leverage aggrandizes the matter.
> Kevin,
>
> I understand performance drift, I trade the BGU and it is down 50%
> since inception on 11/5 and the Russell 1000 is down 12.9%. At 3X
> that should be a 38.7% decline in the BGU. In order to combat the
> negative volatility effects, do you think coupling the levered ETF
> with a long VIX ETF or option would be a good idea?
To be honest, I don't know. One person who knows these ETFs, VIX products and options well is my friend Adam Warner. I encourage you to follow his blog Daily Options Report at:
adamsoptions.blogspot.com/
He might be able to provide a better and more informative answer.