Beware Leveraged ETFs

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 (SRS) has returned -41.7% in total even though the underlying index fallen 60.4%. The ProShares Short MSCI Emerging Markets ETF (EUM) has risen 11% while the index is down 52.9%. The ProShares UltraShort Oil and Gas ETF (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.

Comments

[squark62:]

i'd really like to know which broker banned the sale of leveraged ETFs to their firm's clients.

Apr 03 09:37 AM

[Delojozafado:]

Well we shall have to see if (TBT), (AGQ),(DGP), and BDD end in not being very good LT buy and hold ETF ideas. As for the SRS it is a screaming buy after being slaughtered on Friday. Given the Remarks at the closing of the last Fed meeting and Treasury's recent commitment to additional "Q" easing one would have thought.... And indeed AGQ and DGP spiked and TBT was knocked to below $43. The TBT has not been able to break through the lower resistance though, and one would think if the markets believed the Gov't's actions could be effective in manipulating LT Treasury rates TBT may have broke below it's 6 month lows of below $40. We saw the precious metals being knocked down pretty nicely just before the Fed meeting adjourned. Some thing they said as they ended their meeting sent these two leveraged ETFs soaring. Nothing has changed fundamentally. Now the AGQ and DGP are approaching those lows again and it will again be time to add some partial positions and beef up the un-levered (PTM). There is certainly some prudence in taking some partials off from time to time on HUGE spikes like we saw in AGQ as the FEd meeting adjourned. $33.40 to +$44 in two days. Nothing wrong with pairing these long leveraged etfs as LT mega trends with some good unleveraged etfs and Cefs. BDD/BGR&BCF, DAG/MOO, DIG/IGE&IRR.

The fundamental flaw in the US economy has still not been addressed. Decent paying jobs with decent levels of benefits to support the cost of home ownership and the Retail commercial properties, are still disappearing. Meanwhile it is not just the Banking and Autos that are bankrupt it is also the individual states. Property and other taxes associated with home ownership are rising dramatically as States realize that not only are their budgets broken, the state pension systems are not in much better shape than those of the Auto companies and the former examples of the Airlines and Steel companies in the last big recession.

Meanwhile back at the ranch, GE is putting the finishing touches on their new $400 million dollar engineering R&D center in Bangalore, to provide the high technology jobs of the future we are told we must train our next generations to work in.

Apr 04 10:06 AM

[zevach:]

These guys that comment on ETFs and compare them to buy and hold strategies have a hidden agenda.

ETFs are used to capture the trend of the underlying securities. There are few who think that they are long term holds as everyone knows that trends change overtime. Buy and hold investing lost everyone a lot of money over the last 10 years. I would rather play the trends. Get on and get off.

It is true you can loose your shirt faster in these ETFs (double and triple) faster than buying the underlying security but I like the advantage of the quick gain when volatility is high. Therefore, I only buy ETFs at the extremes. When the financial hit bottom in early march FAS was under 4 dollars I loaded up. I got off at 6.50 but so what. I made >50% return in a very short time frame. That is all I was looking for. Currently SRS is at an extreme and I am buying and holding until the CRE market bottoms again.

I really wonder what the real agenda of these authors and commentators (like Cramer) who don't like these ETFs.

Apr 07 12:22 PM