The Danger of Leveraged ETFs

There is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments. On the surface they make a lot of sense. You want to hedge your stock portfolio, for instance, so you buy a double short ETF of the market like SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%. It does sound like a great deal.

Leveraged ETFs have been sold as panacea to this market volatility, but a panacea they are not. If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use. They should not be used as a long term investment, but only for short-term trading (i.e. days not months).

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index. The math is too complex and too boring (here is an article by Morningstar that explains this well), but instead let me demonstrate by this very real example (click here to see the chart ). Let suppose that six months ago you had a great insight that financial stocks will decline. You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF). The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%. However, if you look at the chart below you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index.

Note that over the short term (days) these ETFs seem to work. This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are screwed.

Comments

[Jason Z:]

Well, in the long run, all the 2X, 3X ETF will go to near zero, because the underlying instrument is options, not stocks, there is time decay.

May 01 08:57 AM

[alajac:]

I beg to differ. the problem is mainly on the short side: because the same dollar move up is a bigger percentage ($8 to $10 = +25%) than the same dollar move down ($10 to $8 = -20%), over time the up moves (even if much less than the down moves) will overtake the down moves and make the short ETF go to $0.

May 01 09:33 AM

[Graham and ...:]

To me, the gist of this article is about the dangers of leveraged ANYTHING; hedge funds ETFs, real estate, you name it.

May 01 09:33 AM

[David Holli...:]

I don't agree with that. I have been using SSO and UYG for nearly a year and so I can speak from experience. They have performed very well for me recently. The first quarter was bad but I made over $20k in April alone. I don't buy and hold. I am an active trader so that is part of the secret to success because if you don't cut your losses the fact that a 5% loss followed by a 5% gain will result in a slight loss. However, I tend to limp in and if the ETF drops I will buy more so I can benefit from the eventual rise in the ETF. In this current environment I have found these leveraged ETFs to be very good. However, you do have to take profits quite often and cut losses.


On May 01 08:57 AM Jason Z wrote:

> Well, in the long run, all the 2X, 3X ETF will go to near zero, because
> the underlying instrument is options, not stocks, there is time decay.

May 01 04:25 PM

[Alan Young:]

Okay, I have a new insight now from this comment stream.
Actually, it appears that the most common misconception is that long and short leverage have the same risks.

Mr. Hollinbeck (above) looks at successful double-long investing and think it will work for double-shorts. Other people look at disastrous double-short boomerangs and make blanket statements about all leveraged funds.

Both wrong, or at least likely to be wrong. Study the charts. Apply with caution.

May 01 09:16 PM

[JAY BOSLIN:]

How many times is somebody going to warn us of the dangers of leveraged ETF's saying the same thing? We get it--at least what you are saying--not that we necessarily agree. Try writing calls on the longs--fat premiums.

May 02 09:01 AM

[Old Trader:]

As much as I respect and like this author (his "Active Value Investing" is an excellent book), I beg to differ, based on my personal experience using SDS as a hedge during late 2207/2008. During that time, I made several "round trips" with holding periods as short as 2 months, and as long as 6 months (in one instance). All of these were profitable, and are the reason (I believe) that I ended up only losing 9% in 08.

I agree that there may be some "slippage". As pointed out, while it may be true that if the S&P drops by 20%, SDS may well NOT go up by 40%. Still, if the market is down by 20%, I'm quite content to "settle" for a positive gain of "only" 5 or 10%. Perhaps I was merely lucky, but I've spoken with others who shared similar experiences with SDS.

May 02 10:12 AM

[Kunst:]

Jay-
If you sell calls, you have to own the security, right? How about buying puts instead?


On May 02 09:01 AM JAY BOSLIN wrote:

> How many times is somebody going to warn us of the dangers of leveraged
> ETF's saying the same thing? We get it--at least what you are saying--not
> that we necessarily agree. Try writing calls on the longs--fat premiums.

May 02 08:11 PM

[David Holli...:]

Actually, I didn't mention short ETFs because I don't use them. I just sell the longs using stops and wait for a lower entry point. Obviously that's not going to work in a long bear market. I do plan to use a short ETF like SDS but cautiously.


On May 01 09:16 PM Alan Young wrote:

> Okay, I have a new insight now from this comment stream.
> Actually, it appears that the most common misconception is that long
> and short leverage have the same risks.
>
> Mr. Hollinbeck (above) looks at successful double-long investing
> and think it will work for double-shorts. Other people look at disastrous
> double-short boomerangs and make blanket statements about all leveraged
> funds.
>
> Both wrong, or at least likely to be wrong. Study the charts. Apply
> with caution.

May 22 01:28 PM