Over the last year, leveraged ETFs have been the subject of intense scrutiny from a number of parties, including regulatory agencies, state governments, broker-dealers, individual investors, and even class action lawyers. While several aspects of leveraged ETFs have been thoroughly analyzed and debated, perhaps no issue has drawn more attention than the effects of compounding returns when held for multiple trading sessions.
Because most leveraged ETFs seek to provide amplified returns on a daily basis, they reset their exposure to the underlying benchmark on a daily basis.
As a result, the performance of leveraged ETFs over multiple trading sessions depends not only on the movement in the benchmark of the funds, but on the direction of the markets during that time period.
In seesawing markets, returns can vary significantly in magnitude and even direction of changes in the fund’s reference index (see our Free Guide to Leveraged ETFs for a more thorough discussion).
The last two years have seen unprecedented levels of volatility in U.S. equity markets. In 2008, the Dow Jones Industrial Average gained or lost at least 100 points in 146 sessions, as many as in the previous three years combined. The VIX Index, which measures the implied volatility of S&P 500 index options, peaked above 80 in November 2008, about four times its 20-year historical average.
The impact of this volatility on leveraged ETFs was astounding. The ProShares UltraShort MSCI Emerging Markets Fund (EEV), which seeks to provide daily returns equal to twice the inverse of the return daily on the MSCI Emerging Markets Index, declined 27% on the year. The iShares MSCI Emerging Markets Index Fund (EEM), which tracks the MSCI Emerging Markets Index, declined by nearly 50%. On a daily basis, EEV’s returns tracked its objective very closely. But over a calendar year, the volatility in the underlying benchmark caused EEV to decline even though EEM was also down.
Earlier this year, ETF Database ran a story highlighting seven misconceptions about leveraged ETFs. One of these myths no doubt grew out of the unique economic environment of 2008 (and the first several months of 2009):
When held for multiple trading sessions, leveraged ETFs will always underperform the return of the target daily multiple of the underlying index.
Some investors who failed to understand the nuances of leveraged ETFs (primarily the daily time frame) were reportedly burned by holding these funds for extended periods of time, believing that because the markets were moving generally as they had expected, their bets on leveraged ETFs would pay off.
As evidenced by EEV’s performance during 2009, volatility can result in severe erosion of returns on leveraged ETFs when held for multiple trading sessions. But there’s another side to this coin as well. Compounding of returns can also work for investors in leveraged funds. Just as seesawing markets erode returns, trending markets can bolster them.
The month of September saw most equity markets post solid gains with relatively low volatility. Generally, winning sessions were followed by more winning sessions. Because a leveraged ETF (a bull ETF for purposes of this example) increases its exposure as the benchmark gains and decreases exposure as the benchmark declines, these funds can deliver returns that exceed the multiple of the gain on the leveraged ETF over multiple trading sessions.
This concept isn’t specific to leveraged ETFs. If a traditional ETF gains 10% for two consecutive sessions, the net increase is not 20%, but 21%. With leveraged ETFs, the effect is the same, just more of it.
Several leveraged ETFs delivered greater returns than the simple multiple of the return on the reference index in September, including the Direxion Daily Developed Markets Bull 3x Shares and Daily Large Cap Bull 3x Shares:
For ProShares 200% leveraged ETFs, the results were similar:
The potential for erosion of returns when holding leveraged ETFs for multiple trading sessions is very real. But it’s not a given. Far from it. Compounding of returns can be devastating in seesawing markets, but the phenomenon can significantly enhance returns in trending markets. Don’t believe everything you hear about leveraged ETFs (see our Seven Misconceptions About Leveraged ETFs for more debunking of myths).
Investors looking to make a play through leveraged ETFs face considerable risks, and should be prepared to monitor and rebalance their holdings on a regular basis. The vast majority of investors in leveraged ETFs continue to be sophisticated traders and institutions with time horizons measured in hours, not days.
But the thought that leveraged ETFs will always erode returns when held beyond a single day (or even a single month) is flat out wrong.
Disclosure: Long IVV.