Understanding Triple Leveraged ETFs

Much has been written about the math behind leveraged ETFs and mutual funds, yet most investors fail to realize the true impact. As a result, many of these products have been ridiculed for failing to meet user expectations.

Contrary to popular belief, leveraged and inverse products that reset their exposure level every day are not new. Rydex introduced the concept with the launch of Rydex Nova (RYNVX) in 1993 and Rydex Ursa (RYURX) in 1994 (note: Ursa has since been renamed Rydex Inverse S&P 500 Strategy).

However, as more and more leverage is applied in these products, the adverse impacts appear to grow exponentially. Direxion introduced 3x ETFs in late 2008, and now we have five months of data to look at.

For this example, I have chosen two inversely related leveraged funds: Direxion Financial Bull 3x Shares (FAS) and Direxion Financial Bear 3x Shares (FAZ). The chart below illustrates the returns for the five-month period from 11/6/2008 through 4/6/2009 for the following four scenarios:

1. Green Line: Buy and hold FAS = -86.3%
2. Red Line: Buy and hold FAZ = -76.9%
3. Yellow Line: Buy and hold equal amounts of FAS and FAZ with no rebalancing (what some might consider a perfect hedge) = -81.6%
4. Cyan Line: Buy equal amounts of FAS and FAZ and rebalance every day (a lot of work) = -25.0% (not counting transaction fees and slippage)

click to enlarge

Chart and data by www.FastTrack.net

Even if you go to the trouble of rebalancing every single day the market is open, you are still fighting a headwind of 25% for a five-month period. Most people would consider that impossible to overcome on any kind of continuing basis.

I’ve said it before and I’ll say it again: Leveraged ETFs can be great short-term trading instruments, but make sure you understand the longer-term impact before holding any of them for more than a few days.

All the ETF sponsors of leveraged and inverse products provide warnings and educational material. Here are links to such information for DirexionShares, ProShares, and RydexShares.

Disclosure: no positions

Comments

[nutty buddy]

Thanks for the explantation.

I concur with your reasoning, because I went long BGZ triple short and watched a quick 3% the first day evaporate into red for the next 2 months due to sideways action - not even a significant upswing. It took the March plunge to bring me into the green, but by then I was so relieved that I pulled my position and missed the really big move. You would have thought I learned my lesson, but I'm long BGZ again on the expectation of resistance at the 8200 level. I was happy the first day - now I'm steeped into the red el quicko. Hopefully, there's another bottom forming to save me again. (I learned my lesson - honest!)

2009 Apr 08 09:08 AM

[Ryan Freund]

It all depends on the long-term trend. If the long-term trend is upwards, FAS is terrific. If the long-term trend is down, FAZ is terrific. Sideways markets are what kill these two.

2009 Apr 08 10:56 AM

[mrmcook]

How about if one sells near term calls on your long position on either FAS or FAZ. That seems to protect some downward move somewhat?

2009 Apr 08 11:11 AM

[mutual]

what is reason for it to be a loser to hold long term?
what are the costs?
where do they come from?
is the same true re tbt?

2009 Apr 08 11:43 AM

[Mental Block]

Match the upward spikes on the charts of the leveraged short funds with each new low made by the index that it shorts (or even just on a chart of SPY). If one has reason to believe (as anyone with his eyes open would, IMHO) that those indices are likely to be making new lows, then it seems to me that the big headwind *can* be beaten.

*Why* these "spikes" come back down so quickly eludes me. I had *thought* it was because each time they spiked up, the government changed the rules. However, I it may actually be something else that is intrinsic to the these vehicles. I'm not smart enough to figure it out. However, when the S&P takes out 666, I'm betting that holders of the leveraged shorts - even starting at today's price levels - with some agile profit taking, can still do extremely well. I'm all ears for ideas on improving my agility. :-) However, I do have my eye on a specific price target for my holdings so that I can get out before you do. :-)

2009 Apr 08 12:47 PM

[Ron Rowland]

The reason these things work this way is because the daily reset of the leverage results in higher "effective" leverage every day the trend continues to move in your direction.

For example, say you buy a 3x fund that moves in your direction for a few weeks and you are now sitting on a 100% gain. At that time your leverage is about 6x from where you started. And most importantly, it is at 6x at the worst possible time - when the trend reverses. So now you have 6x leverage working against you.

2009 Apr 08 01:22 PM

[Mental Block]

Thanks. And what happens after it has run against you for a few weeks - but then runs back your way for a couple? TIA


On Apr 08 01:22 PM Ron Rowland wrote:

> The reason these things work this way is because the daily reset
> of the leverage results in higher "effective" leverage every day
> the trend continues to move in your direction.
>
> For example, say you buy a 3x fund that moves in your direction for
> a few weeks and you are now sitting on a 100% gain. At that time
> your leverage is about 6x from where you started. And most importantly,
> it is at 6x at the worst possible time - when the trend reverses.
> So now you have 6x leverage working against you.

2009 Apr 08 01:37 PM

[Drew Arnold]

If they both lose money, why not short both of them and collect some arbitrage profits?

2009 Apr 08 01:51 PM

[squark62]

FAZ & FAS are extremely broken levered ETFs relative to ProShares index trackers such as SDS & SSO. arbitrage is attainable with these instruments & w/o shorting or trading options. the good thing about these ETFs is they can be traded in retirement accounts. the concept of re-balancing on a daily basis is hideous, too expensive. there are methods to attain delta neutral performance, high beta performance and in between using a concept from the engineering world that requires much less re-balancing and offers greater returns. pairing a long & short position that track the same index is a prime case for using methods in classical mechanics to optimize weights and when to re-balance. i maintain a service for individual investors doing just this.


On Apr 08 01:51 PM Drew Arnold wrote:

> If they both lose money, why not short both of them and collect some
> arbitrage profits?

2009 Apr 08 03:08 PM

[Ron Rowland]

"...pairing a long & short position that track the same index is a prime case..."

Wouldn't it be easier and cheaper to sit in cash than do what you are suggesting? Or take a smaller position of just one if you are equally weighting the two?

2009 Apr 08 03:48 PM

[Barbarous Relic]

How about shorting a leveraged short etf as a bullish position? If your holding period is long enough, seems like you may give up some upside during a bull run, but may still make money if the underlying index goes down (in a volatile period).

2009 Apr 08 04:12 PM

[Ron Rowland]

Shorting these are a great idea but borrowing the shares is nearly impossible.

2009 Apr 08 05:15 PM

[Gary Gallo]

Why over analyze yourself out of profits. I bought FAS at 3.71. Market rallied 20% FAS up 80%. Over a two month period. Im sure if the rally continues FAS will continue to outpace the market overall. My stop? Well its 3.71 a share. Where can it go? Well it was in 40`s. Not so bad after all.

2009 Apr 08 08:34 PM

[squark62]

neutral (nearly so anyway) performance is one strategy i use with my model, going 50%-50% in both is not neutral with these ETFs. the real neutral point is constantly moving. the model finds the optimum pair weighting balance and from there i keep track of where and how fast neutral is moving. using this set of information i implement another strategy and amplify the weight of the ETF that is gaining and attenuate the other weighting. when conditions in the model change, i re-balance the other way. i would not be able to do this if i didn't know where neutral was, which way it's moving and how fast. when i'm not sure, i re-weight to neutral for a while. typical re-balancing is done by adding shares, not selling. if you look at a chart of the performance, the contributions of SDS (short) and SSO (long) looks like a motor commutator signal or a superimposed sine-cosine wave pattern. sounds very complicated but implementation of the technique is very easy and effective. that's what counts.

-cheers


On Apr 08 03:48 PM Ron Rowland wrote:

> "...pairing a long & short position that track the same index
> is a prime case..."
>
> Wouldn't it be easier and cheaper to sit in cash than do what you
> are suggesting? Or take a smaller position of just one if you are
> equally weighting the two?

2009 Apr 08 10:09 PM

[Whippet]

Barbarous Relic- since these shares are nearly unborrowable, volatility is ridiculous, and the constant leverage trap erodes their returns, they are pristine candidates for various option write strategies. Bear call spreads in lieu of shorts, bull put spreads in lieu of longs. Short straddles and strangles or iron condors are also good in sideways markets. The only issue with these particular characters is slippage and low volume/open positions on certain strikes. This is bound to improve with time.

2009 Apr 09 09:30 AM

[Luck-o-the-Irish]

Shares are difficult to borrow, but not impossible. We do it on a daily basis. Furthermore, you can use synthetic shorts. Also, just shorting both sides can be done, but in a sharp trend...hmmm...let's see, like late Feb or Mid March, you better have a heck of a lot of capital, because for how the compounding can help you over the long run, it can crush you over the short run. Just look at the latest run by FAS versus the drop in FAZ. Being short both, just during the downtrend or uptrend, would have resulted in HUGE losses, so unless you had the capital and/or margin room, a person may not have been able to wait for a reversal. If you had gone short both right around SPY 670, you'd still be waiting for that reversal and well underwater. Squark62 has a solid concept. Our firm's concept is a bit different, and done in more of an arbitrage format, and yes, we short these things and hold, but it is a concept more formulated, and protected, than just flat out shorting both sides. If you are wishing for the inventory to short both sides, and that is all you are doing...be careful what ou wish for and have a LOT of capital for your position.

2009 Apr 10 10:33 AM

[arthatek]

short them both and make 81% in 5 months. what could go wrong ?

2009 Apr 10 12:10 PM

[E Thomas St.]

Some of this performance stuff isn't even as complicated as one has to make it. The performance of two ETFs tracking the same index in opposite directions is not scaled linearly. You can do simple multiplication to figure this out (A large downside move needs an even large upside move to offset it. A 10% drop needs more than 10% upside to get back to the initial value the next day. A 10% gain can be lost by 10% loss the next day. Now do this again and again and again.) It doesn't matter much if there is leverage involved, but it does exacerbate the propensity to lose money. I've also noticed that for a traded pair to stop losing money there needs to be a 3 day trend one way or another. Even so, a 4 day trend of equal gain every day one way can be wiped out by a 2 day trend the other way.

The only ways you ever come out ahead on traded pairs is when one part of the pair goes above 100% (offsetting the possible zero value of the down side wholly. Look at DTO/DXO for this) , when you time the purchase correctly (which is kind of defeating the purpose of the supposed strategy of being market neutral), or when there is a strong trending period (which brings into question why you didn't put all of it on the ETF that was trending).

2009 Apr 10 12:56 PM

[E Thomas St.]

One final way to come out ahead is you trade the pair on the thesis of mean reversion where you have purchase the pair at the mean (if you can really determine that for some of these products) and you sell the one that goes up at some point in the future, then wait for the value to return to mean. I don't buy this hypothesis working in reality but it is still a possible way to use them.

2009 Apr 10 01:06 PM

[moneyneversleeps]

Great products that tend to get a lot of bad press. I really wish Cramer would lay off on his criticism of these products as they are great tools when used correctly.

moneyneversleepsblog.b...

2009 Apr 10 03:19 PM