Some Thoughts on Leveraged ETFs

I’ve gotten a bit of criticism from some know-it-all traders who are big fans of the leveraged ETFs. Those who defend the funds say that leveraged ETFs are perfect for those who know how to use them. They derisively state that anyone holding these funds for the long term is an uneducated lame-brain. They claim that the leverage stated is clearly meant for the funds’ daily performance, not for the long term. Well, it is true that the funds state that the multiplier is calculated off of the daily returns.

But here’s where their supportive claims fall flat. These users of the ETFs also state that the funds adequately and clearly disclose that leveraged performance is isolated only to the daily performance. Further, leveraged ETF supporters say that anyone who uses these funds for a long-term bet is idiotic for not knowing that leverage claim made by the ETF fund companies only applies to the daily tracking.

For instance, when talking about how the leveraged funds failed to perform up to expectations for the long-term, one commenter at Seeking Alpha (Marc) stated that the funds “…failed to deliver on a promise that they never made.” Another (ursmax) told me, “Had you taken just a few minutes to at least skim the prospectus plus (especially the) supplemental material you couldn’t have helped but notice the foolishness of your trade: trying to make a profit by holding any leveraged ETF for an extended period of time, especially during times of very high volatility. But here you are, crying “foul” and blaming the fund company. It’s never your fault, isn’t it! I hope you learn from this lesson, and educate yourself next time BEFORE clicking the buy button instead of whining afterwards.”

First, I never said I was in one of these products. At the time, I was speaking primarily to the fact that they were a potential source of late-day bursts in volume and volatility, and that they never lived up to their “implied claim”

But what’s most important is the supporters’ claim that the ETF companies never said these products were suitable for long-term holdings. Really? Perhaps these folks are the ones who never read ProShares’ prospectus.

It’s been my contention for a long time now that something needs to be done about the leveraged ETFs because there are numerous investors who simply don’t realize that the leverage-tracking performance is isolated only to the daily change. And, they have good reason to think that way. Take a look at the charts below (click to enlarge). They’re in an image-capture from the prospectus that I downloaded today. It’s the same prospectus they’ve used since October 2008. It shows the performance of a leveraged bull fund over a one-year period, not one day.

So what does this mean? Well, take a look at the text in the next image-capture, where it says, “The graphs demonstrate that, for periods greater than one day, a leveraged Fund is likely to under-perform or over-perform (but not match) the index performance (or the inverse of the index performance) times the stated multiple in the Fund objective).” So far, so good.

But here’s where an unfamiliar investor can get in trouble. The charts show a hypothetical performance of a fund with 200% leverage over a one-year period. That is double the index gain or loss. The impression you get from the charts are: if the index gains +15.0%, the fund will gain +29.3%, if the index loses -15.0%, the fund will lose -29.4%.

So what’s the under-performance/over-performance in these examples in the prospectus? In the bull market scenario, the +200% fund underperforms the multiplied index by a mere 0.07 percentage points. In the bear market scenario, the -200% fund over-performs the multiplied index by 0.06 percentage points. Got that? According to the prospectus, the difference between the index times the multiple and the ETF is a miniscule few basis points!

Click images to enlarge

But in the real world, that’s not what happened. The S&P 500 Depository Receipt is down about -21%. The 200% leveraged bull ETF is down about -50% — worse by 900 basis points. Meanwhile, the leveraged bear fund, which would have made a bucket load of money had the ETFs behaved as the charts implied, is down about -28%. Reality doesn’t even come close to what’s described in the prospectus, as the bear fund, which should have made money when the market fell, is in deeply negative territory! It is not off by just a few basis points as the prospectus seems to suggest!

Click image to enlarge

But here’s where it gets even worse. ProShares’ current prospectus has numerous additions to it, the latest being about two months ago, May 26, 2009. There was another supplement on April 7, 2009 that contained performance information. That supplement is on page 2 and 3 of a 169 page document. You’d think that the performance info available on April 7 of this year would have near-current information, right? WRONG!

The latest performance data in the April 2009 prospectus supplement was for 2007! 2007!!

Click image to enlarge

2007 data is the most recent data ProShares could come up with in April 2009? All I know is that the data in 2007 sure looks a lot better than the data in 2008, especially for the leveraged bear ETFs.

So that’s why I have a problem. Not because these funds are bad. The ETFs are fine, as long as you know what you’re doing. But that’s not how they’re marketed. And the 169-page prospectus doesn’t help. It begins with a performance table showing outdated information during a favorable time period. That’s quickly followed by hypothetical long-term performance charts that indicate these ETFs will behave close to the index times the multiple. But real-world experience shows these charts don’t come close to real-world behavior.

Listen, I am truly sympathetic to the traders who use these funds properly. And I don’t want them banned. I’ve known about the tracking flaw for years (it’s a logarithm issue). I just want everyone who uses them to know that they are far riskier than a lot of people thought. The prospectus does not give an accurate, current or sufficient portrayal of how these things really work. And to those who say that beginners shouldn’t use them, I agree. Make users of these funds sign a risk disclosure statement similar to what you have to do when you trade any other leveraged derivative like options or futures. And don’t let anyone trade them until they’ve gotten a chart like the Bloomberg chart above showing how they’ve truly performed the past year.

P.S. – Checking ProShares annual report, you’ll find the banks with whom the ETFs have swap agreements. And yes, UBS, who has banned their customers from trading these products, does supply swaps to the funds, as does Goldman (GS), Deutche Bank (DB), Credit Suisse (CS) and Societe Generale (SCGLY.PK). Now that’s ironic!

Comments

[Marc Gerstein]

This article is breathtaking in its bias and distortions. Read the prospectus folks and let the words speak for themselves. What we have here is a classic example of what Don quotes me as saying: that Pro Shares is being convicted of failure to deliver on promises they never made.

After staring at the article for a while trying to figure out what would cause anyone to write such things, I notice the author's background: Options!

Here we go yet again . . . another option guy tearing into a competitor. Now I get it.

Again folks, just read the prospectus. Use Don's screen-shots, they're accurate. Just bear in mind his commentary is being offered by a competitor, not an unbiased commentator. If you want more of my views, do a Seeking Alpha search on my name. I covered lots of ground with lots of objective data; no need to reproduce it all in a comment. Like the words of the prospectus, real-world data speaks for itself too.

And as for my point-of-view, I have no business stake in whether these things fly or die. I approach them as just another investor, one who used to use options but switched to the leveraged ETFs because I find them easier to use. That's my opinion. And my other articles amplify the reasons.

2009 Aug 09 08:53 PM

[JPDD]

I find it noteworthy that the list of "Principle Risks" has changed in the prospectus over time. Note the addition of "Inverse correlation risk" (for example:

From today's prospectus:
<i>ProShares UltraShort Financials is subject to the
following principal risks:
• Aggressive Investment Technique Risk, Concentration
Risk, Correlation Risk, Counterparty Risk,
Credit Risk, Early Close/Trading Halt Risk, Equity
Risk, Inverse Correlation Risk, Investment Company
and Exchange Traded Fund Risk, Liquidity
Risk, Market Price Variance Risk, Market Risk,
Non-Diversification Risk, Portfolio Turnover Risk
and Short Sale Risk.</i>

From Oct 07:

<i>The UltraShort Financials ProShares is subject to
the following principal risks:
• Aggressive Investment Technique Risk, Correlation
Risk, Counterparty Risk, Concentration Risk,
Credit Risk, Early Close/Trading Halt Risk, Equity
Risk, Liquidity Risk, Market Price Variance Risk,
Market Risk, and Non-diversification Risk.</i>

There are diffs in other paragraphs as well.

2009 Aug 09 10:45 PM

[AndrewBaker]

I use leveraged ETF: some I win and some I lose, but my eyes are open, and errors made my responsibility. The marketing people are there to sell the produce, and wise people will always - or should if they don't - take with a pinch of salt some of the inference taken from marketing material. However, one can go too far: if selling investments becomes too prescriptive, then many people will simply not buy because they'll be presented with a list of risks that suggests whatever happens, there's agood chance they won't make money and could lose it all.

Let common sense prevail: most things have their uses for the right user, and most salesmen see everybody as a prospect and right user. If you're not interested say so firmly, and if you are, check it out properly before buying.

2009 Aug 10 09:05 AM

[Leftfield]

I don't see a rebuttal of the main point here: That leveraged ETF's are being touted as perfectly for and track well, long-term. Yet, the user is supposed to figure out on their own that the claims are false.
Good example of Wall St. today. Be ridiculed by experts for not asking questions on your own to discover the falsehoods in a prospectus, then, don't ask questions when it's time to pony up a couple of $trillions for their mistakes.

2009 Aug 10 11:48 AM

[Marc Gerstein]

The companies are not touting them as long-term. They are making true claims, so there's nothing to rebut.

The ones who are advocating them as long-term are the critics like the author here, and those who can't or won't read the documentation on what these things are all about.

On Aug 10 11:48 AM Leftfield wrote:

> I don't see a rebuttal of the main point here: That leveraged ETF's
> are being touted as perfectly for and track well, long-term. Yet,
> the user is supposed to figure out on their own that the claims are
> false.

2009 Aug 10 07:34 PM

[kfisherprotege]

Every time I see someone using a one-year chart comparing levered ETF pairs with their underlying index, I just want to reach through the monitor and shake 'em! These instruments were not designed to perform over any random month, 6-month, one-year period without any regard to start and end points. If you use them as they were designed, that is, to support correct bottom and top calls (i.e.. buy at the top and sell at the bottom - or vice versa), then the chart you see will be quite a bit different. For example, try the same chart with a Jan 6 09 start point and a March 20 09 end point and the picture will look quite a bit different. You'll see that the ETF pairs (SDS and SSO, as an example) will come a lot closer to their advertised +2X/-2X performance. I know. I've done the back testing for the 3 years SDS-SSO were in existence and the results are quite remarkable!

I'm not even denying there's volatility decay. There is. Even in a single day's performance. You'll optimally want to use these as day trading vehicles. All I'm saying here is you must pick valid start and end points - as close to peaks and troughs as humanly possible. If an investor randomly jumps in and out of such ETFs, as this chart suggests, then he has what's coming to him.

2009 Aug 11 04:17 PM

[Ames Tiedeman]

I think it is time to seriously look at SDS, DXD, QID, SRS, FXP, and FAZ. I think the prospects for a very difficult market and a relatively large scale pull back from now until November are very strong. In good times the market does not perform very well from mid-August to November. After this huge bear market rally would one be prudent to think we can go up another 1,000 points? I think not. The direction seems to be down from here.

2009 Aug 11 06:35 PM

[Don Fishback]

Hey kfisher ...,

I couldn't agree more with the improper use of the one-year chart. Just don't reach out and shake me. The *only* reason I show a current, real world chart is to point out the contrast with the *hypothetical* one-year chart that's in the prospectus. Look at their chart and you'll see that it implies near perfect tracking over the course of ... ONE YEAR!

And to your point that these things *do* work as advertised "if your timing is perfect*. I agree. But if you're timing is not perfect, then you cannot expect the fund to perform as the charts in the prospectus indicate. Instead, they'll perform as the Bloomberg chart indicates.

So don't get mad at me for having a one-year chart. ProShares is the one with the one-year simulation chart in the prospectus. I'm just showing people how these things operated in the real world, as opposed to the pretend world.

2009 Aug 12 08:17 AM

[MadScientist]

This discussion will never end, will it? If you don't like the tracking performance of leveraged ETFs over an extended period of time, then don't hold them that long.

I would challenge the assertion that these suffer from unacceptable decay - anyone who has been in SSO, QLD, or DDM since 7/15 would argue that these ETFs perform quite nicely thank you.

Decay is a real phenomenon, but it is irrelevant when you are on the right side of the trade with these guys. Like any other investment, use good money management practices, include stops to protect yourself, and trade them, not invest in them.

2009 Aug 18 07:58 AM

[mh0144]

1/2/09, $NDX=1264 and QLD=29.26
8/21/09, $NDX=1638 and QLD=46.34

Over the period $NDX in +29.6% and QLD is +58.4%

What am I missing?

2009 Aug 21 11:37 PM