Leveraged ETFs: Beware the Performance Conundrum

When leveraged and inverse ETFs were first released they were touted as wonderful new innovations. Individuals and institutions can double their exposure to a sector or index quickly and easily, the complicated models created by the providers are readily available in a neat little package. As they have developed more and more investors have caught on to the fact that they don't perform as expected.

The fund provider clearly states in the prospectus that the ETFs are designed to match double the daily percentage change, and that as a result total return over a period of time will not be double the index. The real travesty is that the total return for any number of these funds since inception is either negative or grossly different from the index. Below we examined a small selection of 2x and the new 3x funds.

• Since June 21, 2006 SSO (2x S&P 500) is down 66% while SDS (-2x S&P 500) up on 12%.
• Since February 1, 2007 DIG (2x S&P 500 Energy) is down 63% while DUG (-2x S&P 500 Energy) is down 56%.
• Since November 6, 2008 FAS (3x Russell 1000 Financials) is down 84% while FAZ (-3x Russell 1000 Financials) is down 87%!! The inverse ETF has underperformed the long fund in a period where the underlying index is down 18%!

click to enlarge

Comments

[Rocknbob:]

In the short term , though , these vehicles do track and provide the exposure the investor wants. Long term , whether long or inverse ETF, the holder should be very cautious. These are not long term financial instruments.

Apr 22 11:15 AM

[cvhaus:]

Comparing performance of a short leveraged fund with a long leveraged fund is like comparing apples with rhododendrons, or using a Monty Pythonesque "she's a witch, because she weighs the same as a duck". The compounding of percentage gains and losses operate quite differently. Compare to the underlying index it tracks and we have something useful, IMHO.

Apr 22 11:22 AM

[Analyste de...:]

The author's observation has been made here many, many times before - but thanks for the numbers proving it.

Investors need to know what ANY product is, how to use it and how NOT to use it. Leveraged ETFs are great for daily trades (if you know how to do that) and suitable opportunistic vehicles for predictable medium-term trends.

Alot of investors saw this (Bear) rally coming, and the triple-leveraged bullish funds were excellent vehicles to maximize gains in the past 5-6 weeks. As volatility returns, these 2x-, 3x-leveraged funds are less useful for those trend investors who aren't day traders.

Apr 22 11:45 AM

[ClifCham:]

Any comparison would be more accurate if it included dividends in some manner. PowerShares dividends are significant.

Apr 22 12:51 PM

[aarc:]

Compounding works better to the long side than to the short side. Simply make that calculation assuming 10 consecutive days of rally and 10 consecutive days of selloff with 5% rally/selloff per day and you will realize how compounding works on the upside and the upside.

That aside; it is true that some xETF perfoms quite horribly against underlying index they track.

And then look at 3x ETF such as FAS and FAZ. If the BKX went down a lot further than 17.75 in March 2009 while FAS was printing $2.32 at that time. If BKX went down to 15.00, Fas might as well has gone below zero which is an impossibility. BKX did not go down to 15.00. But the question remains the same, what would have happened to FAS at that time with $2.32 value if BKX goes down more than 1.01 from 17.75. FAZ should be zero by then being a 3x.

Likewise, FAZ went down from $115 to $9+ with BKX retracing less than 20% of it's total selloff from 121 top to 17.75 March 2007 bottom - BKX made a rally to 33+ from 17.75. FAZ lost $105 when BKX almost doubled from March bottom.

What if BKX retraces even 50% of the total selloff from 121 to 17.75?. Meaning BKX making a rally from current 33+ to 69. BKX would more than double from current price . Would FAZ lose more than $105 by then? That would be an impossibility since FAZ right now is only worth less than $10.

What happens if those 2x and 3x ETFs go down to zero and the underlying index kept going against them. Will they be considered bankcrupt?

This is a problem xETF managers will have to address and correct immediately.

Apr 22 01:23 PM

[squark62:]

i trade leveraged ETFs in pairs. the only pair of the 3 the author charted, SDS & SSO are the only pair over the long-term you could arbitrage. from this perspective, the others charted are broken pairs trades. 2 other good pairs trades are DXD & DDM and QID & QLD. there may be some others but the 3 that work give you a good sense of overall market performance.

Apr 22 02:58 PM

[Michael Comeau:]

I get the feeling that quants and hedge funds love these ETFs - I'm sure they have figured out relationships between expected & actual performance to crank out the $$$.

Apr 22 03:20 PM

[squark62:]

proshares is probably the best xETF managers of the bunch. they've been around for several years and billions are invested in the best ETFs. no all of their xETFs work, but on the whole they perform better than the others.


On Apr 22 01:23 PM aarc wrote:

> This is a problem xETF managers will have to address and correct
> immediately.

Apr 22 03:36 PM

[Gary Gallo:]

FAS is also up 300% March 09 to current. When the sell off ended and the market rallied. I still say buy the 3X in the $5-$10 range or lower for a excellent risk reward. The day I decided to buy FAS the market had closed. FAS closed at 2.71. It went to 3.71 the next day when I bought. My stop, 3.71 of course. Same with UYG, buy 2.18, stop, you guessed it, 2.18. Maybe they go to $25.00 or $50.00 some day. 5% in each 90% cash. I don't care what the market does.

Apr 22 08:41 PM

[medcenter12:]

My logic is, buying these leveraged ETFs is good for long term investment. For example MDY has done 12 % compounding growth in the past 15 to 20 years almost matching to Berkshire growth. Investing in this ETF MWJ ( 3 X MDY ) for long term of 15-20 years and if possible buying in dips may be the surest way of beating the market handily. It may grow 30 % compounding in long run just as MSFT grew in the pre 2000 era.

May 11 05:53 AM