Beware Leveraged ETFs

 |  Includes: DUG, EUM, SRS
by: Toro

First, the empirical evidence.

In this paper, we study leveraged ETFs, in particular, Ultra ETFs and UltraShort ETFs from the ProShares family. These Ultra (UltraShort) ETFs are designed to provide twice (twice the opposite) of the performance of the benchmark on a daily basis. We focus on the relation between long term performance of leveraged ETFs and benchmarks. Our results show that over holding periods no greater than one month, an investor can safely assume that the Ultra (UltraShort) ETF would provide twice the return (twice the negative return) of the underlying benchmark. Over the holding period of one quarter, the UltraShort ETFs can deviate from twice the negative returns of the benchmark. For Ultra ETFs, this deviation occurs when the holding period is one year. Overall our results show that leveraged ETFs are not long term substitutes for long or short positions of the benchmark indices.

Forbes picked up the theme.

According to Maister, ETFs fail to mirror their underlying index because of fees and expenses, intentional "optimization" by fund managers and changes in the index itself. In some cases, compliance is a problem.

"The SEC diversification rule mandates that certain funds can have no more than 25% of their assets in one security," says Maister.

For the purposes of his study, Maister excluded certain gold and silver tracking ETFs as well as inverse and leveraged ETFs that have gained widespread popularity in the declining market. These funds come loaded with surprises all their own. Inverse and leveraged ETFs are designed to replicate the daily performance or opposite daily performance of their underlying index. This means these funds effectively reset every trading day, potentially causing wildly unexpected returns for buy and hold investors who thought they were merely making an opposite bet on an underlying index.

For example, anyone buying and holding ProShares Ultrashort Financials would have gained 4.3% in 2008, versus a decline of 50% for the Dow Jones U.S. Financials Index. Since the fund seeks to double the opposite of the Dow Jones Financials Index, many buy and hold investors presumed they would instead have gained 100%. Sorry, Charlie, the devil is in the details.

I have been watching this for a while. Most leveraged ETFs track their respective benchmarks reasonably well over time. However, if you are a long-term investor in a few these ETFs, you will be shocked at the performance.

For example, for the year ending March, the ProShares UltraShort Real Estate ETF (NYSEARCA:SRS) has returned -41.7% in total even though the underlying index fallen 60.4%. The ProShares Short MSCI Emerging Markets ETF (NYSEARCA:EUM) has risen 11% while the index is down 52.9%. The ProShares UltraShort Oil and Gas ETF (NYSEARCA:DUG) is down 10.1% compared to a decline of 40% for the index.

These instruments are not suitable for long-term investing. I have heard of one broker banning the sale of leveraged ETFs to the firm's clients. Given the performance, it would not be a surprise.