Everybody Hates Leveraged ETFs

Last week, Edward Jones said that it will stop selling leveraged ETFs. This Monday, UBS (UBS Wealth Management Americas) announced that it has suspended the purchase of leveraged and inverse ETFs for its wealth management clients. Both firms cited the short-term nature of these securities as a reason. The State of Massachusetts has also launched an investigation into the leveraged ETFs.

These ETFs have also received a lot of flack from the regulatory agencies like SEC and FINRA. They all say the same thing - these are for sophisticated investors only and they are not long-term investment vehicles.

My question is, what made anyone think that these ETFs should be used for long term investing?

These companies have detailed brochures which outline the risks associated with leveraged ETFs. If you glance at their website, or even search for these ETFs, you will find ample details about the high risks and the short-term nature of these ETFs. The websites of Proshares, Direxion and Rydex have listed the disclaimers on their website as well. They clearly state that they seek DAILY investment result of 200% or 300% investment of the price performance of the Index they follow (or its inverse in the short ETFs).

I am still not sure if certain allegations regarding these ETF companies trying to mislead investors hold any truth. They are not forcing anyone to invest in their products.

The bottom-line is that long-term and 'buy-and-hold' investors should stay away from these investments or be clear about the risks they carry. They should preferably be used by sophisticated investors and day traders.

It's very important to understand the concept of "daily performance" for these ETFs. Let's take an example of FAS. FAS is a triple leveraged (3x) product from Direxion. FAS seeks daily investment results of 300% of the price performance of the Russell 1000 Financial Services Index.

Now YTD, the Russell 1000 Financial Services Index is up 2.1% thanks to the nice rally in Financials after the March 09 lows. This does not mean that FAS would be up 6.3%. In fact, FAS is down a staggering 63% YTD.

Let's look at an inverse ETF - SDS. SDS is a product from ProShares that seeks daily investment results that correspond to twice the inverse daily performance of the S&P 500 Index. If you see the 52-week performance of S&P 500, it's down 20%.

If that leads you to think that SDS should be up 40% (twice the inverse), you might be in for a bit of a shock. SDS is actually down 32%. That's the reason for the stress on 'Daily Performance'. If you look at the daily performance of these leveraged and inverse ETFs, they are fairly close to the indices they track and that's their intention as well.

During the market crash last year, inverse ETFs like SKF (ProShares UltraShort Finance), SDS (ProShares UltraShort S&P 500), BGZ (Direxion 3X Bear Russell 1000), DXD (ProShares UltraShort Dow 30), FAZ (Direxion 3X Bear Russell 1000 Financial Services), SRS (ProShares UltraShort Real Estate) and others were very popular.

At the same time their leveraged counterparts (UYG, SSO, BGU, DDM, FAS, URE) lost tremendous value because they were performing twice or thrice worse than the indices. The markets picked up after the October lows into January 2009 only to drop to historic lows in early March.

After the March 09 lows, the market has had a steady rise for the most part. It's extremely volatile markets like this one that make it impossible for the leveraged or inverse ETFs to perform over a longer period.

Unless your timing of buying and selling these ETFs was immaculate, if you held these ETFs for the last year or so, they have underperformed the respective indices by a substantial margin. In a more directional market (either bullish or bearish), the performance of these ETFs might be better or at least predictable. But when the market makes historic lows and follows with a 36% rise in a matter of few months, it's impossible for these ETFs to perform consistently.

So why do leveraged ETFs fail to perform over a longer period of time? Leveraged ETFs are traded very actively since they seek the daily performance of the index they follow. Imagine trying to get twice or thrice the return of a particular index (or its inverse) on a daily basis! Leveraged and inverse ETFs use options, futures, swaps and other derivatives to gain the desired performance. The leveraged ETFs 'reset' every day and their goal is to make sure that for any given day they give the stated performance with respect to the particular index.

Let's look at an example of BGU which seeks thrice the performance of Russell 1000 index. Let's say for month 1, Russell 1000 index was up 10% and for month 2, it drops 10%. At the end of these two months the Russell Index is down only 1% [(1.1) * (0.9)].

Now let's examine BGU. For month 1, BGU would be up 30% and for the month 2, it would be down 30%. At the end of the two month period, BGU is down 9% [(1.3) * (0.7)]. Theoretically, it should have performed three times worse as the Russell 1000 index - down 3%. The most important thing to understand here is that compounding works both ways.

There is a good article on leveraged ETF performance and calculation here.

The bottom-line is that in this kind of a market, leveraged ETFs should be used by day-traders or experienced investors. If someone still feels compelled to invest, they should fully understand the purpose of these ETFs and risks associated with them. If you were lucky enough to make a good profit with these ETFs, it might be a good idea to protect your profits rather than riding the wave on the down side - remember compounding works both ways.

Disclosure: Option Spreads in BGU and BGZ.

Comments

[Albert Ling:]

Why do they keep saying that these ETFs are good for "sophisticated" investors? Aren't there better ways to bet on indices with even higher leverage and lower trading costs using futures, margin accounts, etc?

I may be way off here but I had a feeling triple levered ETFs were a retail product to milk suckers out of fees.

Jul 30 10:54 AM

[outtafavr:]

Bob Pisani just explained everything about leveraged ETFs on CNBC. Thanks to his explanation, I now completely understand them and I think the government should make them illegal.

Jul 30 11:35 AM

[kkerr:]

Best quote of the article: "The bottom-line is that long-term and 'buy-and-hold' investors should stay away from these investments or be clear about the risks they carry."

Also, here is another article that explains decay (with charts and graphs):

blog.quantumfading.com.../

Jul 30 11:55 AM

[squark62:]

whiners....whiners...w... a happy medium would be to allow individuals with a certain amount of capital in their accounts to buy leveraged ETFs perhaps even with a required limit down lock on the account. or just require a certain margin ratio between losses & cash in the account. you don't have to be a professional financial planner to know how to use these ETFs. i know many advisers who don't have a clue. many of them don't have a clue about trading options. should options be banned too???

Jul 30 12:01 PM

[AndrewBaker:]

Why do people want to stop leveraged ETF when no-one is forced to buy them, and anyone who does should know what they are buying before they do. I have lost on these but because the market didn't do what I expected, not because anyone sold me a pup.

It seems that it's ok to rig the market if you are in the right position of power and influence and can get away with it, but not ok to trade the market with a sophisticated instrument that can make make you a lot of money if you get it right.

Jul 30 12:03 PM

[johnny inca:]

i have been short both FAS and FAZ since late April and it returns about 7% a month, although you do need to rebalance from time to time. I will never cover these positions.

Jul 30 01:43 PM

[MattZN:]

It's hilarious that anyone can believe these ETFs are good for anything. They can't even be used to hedge. They are day-trading tools and that's it. Hell, they aren't even very good day-trading tools.

I played a simple game. For the last few months I shorted both SKF and UYG and every month I shorted a little more to keep the dollar amounts roughly the same. The overall position went profitable within two weeks and the profits kept growing after that. I see another poster is doing the same thing. This sort of game directly removes the profits the companies controlling the ETFs would otherwise make.

Actually, from looking at their holdings, I think a lot of people are doing this now. It's destroying the assets of the ultra-short funds and is proof enough that the entire concept is flawed even if you don't include the ethics arguments.

-Matt

Jul 31 01:55 AM

[WhoisJohnGalt:]

It's a tool for the gamblers and those confident of their predictions on short-term market directionality. Otherwise for leveraged ETFs, it's as they say: "In the long run, we're all dead".

Jul 31 10:23 AM

[31October:]

"...Edward Jones said that it will stop selling leveraged ETFs. ...UBS (UBS Wealth Management Americas) announced that it has suspended the purchase of leveraged and inverse ETFs for its wealth management clients...."

What is most telling is that these "advisors" were selling leveraged ETFs to wealth management clients. I trade these, but I have little to lose. What kind of idiot would sell this to somebody to retire on?

All these state AGs investigating Direxion need to investigate the incompetent brokers instead.

Jul 31 02:26 PM

[Suzanne H.:]

Yes, thank you. Long only does not work especially in crisis when everything correlates, but it has been a tough road preaching to professionals the need for it, along with some sort of timing strategy (another "taboo" topic on wall street -- but if done properly it works, can visit legacyfunds.wordpress.com ). My guess is everybody that hates market timing would by extension hate leveraged ETFs, because without a timing and risk management strategy, these ETFs can be dangerous. So investors have it upon themselves to educate themselves and either build their own portfolio of ETFs using both long and inverse or wait until active funds really do manage risk and not only protect but possibly generate some return when markets are down vs. measuring performance relative to a benchmark as is traditionally done.


On Jul 30 07:15 AM dla35 wrote:


> investors. On the other I think wealth management companies should
> start to make their “active” funds, actually active rather than the
> long-only buy and hold strategy which does not work. Those managers
> get paid huge amounts of money for not much work.

Jul 31 02:49 PM

[Swashbuckler:]

Yeah, let's ban leveraged ETF's because people sometimes misuse them. Let's ban hunting rifles, shotguns, roach and rat poison, matches and non-prescription drugs too. And while we're at it let's have government mandate the type of toothpaste we use, our exercise routines, our body weight, the type and amount of food we eat, the oxygen we breathe, and what time we go to bed at night. After all, they are so much more qualified to make those decisions for us than we are.

Jul 31 04:33 PM

[Internet Cr...:]

I agree that leveraged ETF's are extremely risky. I have only used TYH and EDC. My strategy has been to buy at the close and sell at the open. It is very volitile. Day trades become positions very quickly.

More so, I have made day trades within channels, resulting in small gains. I only risk 10% of my capital on a given day. The reason I choose EDC/TYH is because of the indexes. I would not take the same level of risk with TAN for example.

Aug 02 11:13 PM

[LanceLink:]

For option sellers, some of the 3Xers have provided excellent premium over the past few months. I've written calls against FAS (both pre- and post-split), EDC, TNA, and ERX.

But I only write if there's enough premium to justify the downside risk, and these are risky indeed.

Aug 03 08:57 AM

[DeeRaz:]

I'm a printer by trade. My 401K was invested in Mutual funds and "managed by professionals".
From November 2007 to March 2009 it went from $108,000 to $50,000. I took responsibility (Key Word) for my Money and began trading in and out of the (FAS) and (FAZ), Never holding either for more than 4 days straight or over the Weekend. My Portfolio is over $250,000 as of 8/1/2009. Do Your HomeWork before you invest! or leave it to the "professional money managers" (Now there's an Oxymoron!) to lose for you at a fee!.....We are NOT Children. Inform us so we can make educated choices. Don't Call for a Ban. Thats for Totalitarian Regimes like (Iran and China). America is about Free Choice! If TD Prevents me from trading the etfs of my choice, I will imediately pull my account and find one that will! Stop Blowing "Kramer's Horn" on leveraged etfs. Let's not Forget he Also "Protected us from Investing" in China in the 2006 -2007 Run!........ OUCH!!!!!!!!!!!!!!!!!!!

Aug 03 10:59 AM

[digger1234:]

You can use these ETF's in retirement accounts if you don't think it is a buy and hold. It doesn't matter what kind of account you use these in, it matters how you watch it. If you manage them correctly, you make money.

The broker/dealers fear the worst of the advisors or money managers will use them improperly.

I have made over 1000 trades with the 3x ETF and haven't had a losing trade. I have client portfolios that are up over 150%.

Fear is what moves the broker/dealers. Fear that someone will screw up and they will be sued. So one person's misuse makes them tell all of us that the ETFs are bad. However, I look at a mutual fund with a 5.75% sales load and see it had 4 double digit losing years. Is that a better investment tool? I don't think so.

Aug 03 05:04 PM

[IRAWinner:]

Edward Jones seemed pretty content to recommend BofA at $40/sh in '08. Of course, I know I'm using hindsight but if I look at things now, the chance/risk of it or any other company specific stock going to $0 always exists. The leveraged index/sector ETFs are volatile but it seems to me have ultimately less downside risk than holding an individual stock.

Aug 07 05:01 PM

[marc9l:]

Leverage ETFs and their false and ignorant critics.


Most articles from “advisers or experts“ show a total lack of basic mathematical understanding.

Well, these supposed experts should take a course in basic mathematics before making uneducated and ignorant statements trying to influence lawmakers in their decisions and understanding.

If an index trades at 100 and its leverage 300% ETF is also at 100, when the index goes down 30%, the result will be that the index is now at 70 and the 300% leverage ETF at 10. (3*30 = 90)

Now if the index goes up by 30% from 70 it will only go up to 91 and not 100, and by the same token the 300% ETF from 10 will only go to 19 (30%*3 = 90% 10 + 90%= 9)

So to be amazed that they have not recovered to their initial price shows a total lack of understanding and basic mathematics skills, therefore these people should not only “not be advisers” but should be sued for spreading “false and misleading information”.

If the lawmakers use this ignorant logic to make new laws, they should be send back to high school to be taught basic mathematics, instead of, passing new laws about financial products they obviously do not have a clue about.

Marc

Aug 11 03:53 AM

[marc9l:]

Leverage ETFs and their false and ignorant critics.


Most articles from “advisers or experts“ show a total lack of basic mathematical understanding.

Well, these supposed experts should take a course in basic mathematics before making uneducated and ignorant statements trying to influence lawmakers in their decisions and understanding.

If an index trades at 100 and its leverage 300% ETF is also at 100, when the index goes down 30%, the result will be that the index is now at 70 and the 300% leverage ETF at 10. (3*30 = 90)

Now if the index goes up by 30% from 70 it will only go up to 91 and not 100, and by the same token the 300% ETF from 10 will only go to 19 (30%*3 = 90% 10 + 90%= 9)

So to be amazed that they have not recovered to their initial price shows a total lack of understanding and basic mathematics skills, therefore these people should not only “not be advisers” but should be sued for spreading “false and misleading information”.

If the lawmakers use this ignorant logic to make new laws, they should be send back to high school to be taught basic mathematics, instead of, passing new laws about financial products they obviously do not have a clue about.

Marc

Aug 11 03:54 AM

[Shockwave:]

When these ETFs were first created and traded they did not have the tracking error they have had over the last 6 months. We ask...What has changed to create this tracking error all of a sudden. The clear answer is market maker theft associated with the funds creators hedges. Even sophisticated investors will be robbed if they hold over night. An investigation is warrented and charges should be brought for this type of corruption.


On Jul 30 07:02 AM PutneyHillYank wrote:

> Not me I find them very effective as ballast

Sep 07 03:49 PM

[Jonathan Swift:]

If we want to keep America's strengths alive we have to recognize that government paternalism is no substitute for expecting personal responsibility overall. Personal responsibility is the basis on which successful societies are dependent. That means accepting, among other things, that "fools and their money are soon parted!" If we don't let the poor decisions of individuals and institutions lead to failure (and the good decisions to lead to success), we do not have a viable, thriving free society.

Sep 21 07:34 PM