Why You Shouldn't Hold Leveraged ETFs Long-Term

Last week I tweeted from the FMA conference about the luncheon speaker who pointed out the fact that levered ETFs that regularly relever are good at mirroring the market on a daily basis, but in the long term are bad bets since they are short an embedded option on Gamma which makes it very likely that the levered fund will be a money loser.

To show this, let's look at two levered funds that are designed to be bets on the Russell 1000 financial index.

I pulled the following two charts from for the Direxion Daily Financial Bull 3x (FAS) and Bear 3X shares FAZ). Both of these levered ETFs track the same index but the Bull fund is designed to move with the with the index (albeit 3X faster) while the Bear fund is designed to go in the opposite direction of the index at the same warp speed.

MSN describes the two funds as follows: The Bull Fund (FAS) as

"The investment seeks to replicate, net of expenses, 300% of the daily performance of the Russell 1000 Financial Services Index The fund will invest at least 80% of assets in securities that comprise the index. It will also utilize financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. The fund is nondiversified."

and the same for the Bear fund (FAZ) as :

"The investment seeks to replicate, net of expenses, 300% of the inverse daily performance of the Russell 1000 Financial Services Index The fund will invest at least 80% of assets in securities that comprise the index. It will also utilize financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. The fund is nondiversified."

So "common sense" would suggest that if you bought each the overall returns (ignoring transaction costs) would be zero. BUT that is not the case, in fact, you would lose money long term not only in the combined position, but on both the Bear and the Bull funds individually as well!

Let's take it to the charts:

Here is the Five day chart of the underlying Russell 1000 Financial Services Index, the FAS and FAZ. Note how they move in almost exactly as we would expect. That is the bull fund moves, albeit more sharply, the index and the bear fund moves opposite direction.

Now the One year chart: of FAS and FAZ. Note how they both decline. That is why you do not want to be long levered funds in the long run.

Comments

[GoochyPuppy:]

Duh!

Oct 30 02:47 PM

[Marc Gerstein:]

I believe the point of the prior comment is that your insight, so to speak, is not at all new. This has been a hotly and vigorously debated topic for quite some time, on major web sites including Seeking Alpha, among regulators, among investors, etc. Readers today expect that if someone states this conclusion, they ought to be offering some novel insight. Here, on the other hand, you didn't even address the minimum basics.

Oct 30 07:35 PM

[Bruce Vande...:]

Yes, the dangers of holding levered ETFs long term has been well discussed on Seeking Alpha and elsewhere. However, newcomers to Seeking Alpha and investing arrive regularly so we do need, on occasion, to call attention to these risks.

Oct 31 10:13 AM

[Luck-o-the-...:]

I have to agree with Marc here. This topic has been beaten over and over again. To me it feels that this is more a thread to start getting a resume of "being published." I would wager that there are at least 25, nay, 50, articles saying this exact thing. Some do bring new ideas or new strategies. Unfortunately, you are just stating the known. The effort is good, but next time I would recommend doing some research into that which has already been published, and only write an article as such if you have new information or a new twist to add.

Oct 31 12:16 PM

[squark62:]

jim, type "levered ETF", "leveraged ETF" or "inverse ETF" in the search field. i don't believe there's been serious discourse about this topic here for 6 or 7 mons or more.

Oct 31 07:08 PM

[Kunst:]

Duh! I'm up 45% since April trading FAS and FAZ. I never hold them overnight.

Nov 01 12:42 AM

[Brian O'Fla...:]

Actually, I think somebody should post one of these articles every day until the masses finally get it. It is shocking to me how many people still defend these funds and think it is appropriate to own them long-term. It's almost like smoking, some people refuse to believe or care about the health risks. And it's time for warning labels on these toxic ETFs lest the ill informed make the mistake of owning them. For those that own them anyway, as for smokers, you'll get what you deserve.

Nov 01 03:40 PM

[Kunst:]

There are warnings all over them, starting with the prospectus. You actually have to sign (online, at Fidelity) a statement saying you know how dangerous they are in order to trade them, and a warning is displayed every time you buy one of them.

How many smokers don't know that cigarettes are dangerous?


On Nov 01 03:40 PM Brian O'Flanagan wrote:

> Actually, I think somebody should post one of these articles every
> day until the masses finally get it. It is shocking to me how many
> people still defend these funds and think it is appropriate to own
> them long-term. It's almost like smoking, some people refuse to
> believe or care about the health risks. And it's time for warning
> labels on these toxic ETFs lest the ill informed make the mistake
> of owning them. For those that own them anyway, as for smokers,
> you'll get what you deserve.

Nov 01 06:28 PM

[WDavid:]

Does anyone know if there are similiar risks to holding UNLEVERAGED inverse ETFs (such as DOG or SH) longer term??


On Oct 30 02:47 PM GoochyPuppy wrote:

> Duh!

Nov 02 10:05 AM

[Heythere:]

This has been discussed frequently the last 6 months, if you don't get it, you shouldn't be investing in non-stock/bonds ETFs.

WDavid, there are similar risks w/ -1x ETFs; however, they are relatively small compared to the +/- 2/3x funds.

Kunst, it depends on when you are holding them. Had you been holding FAS (3x long) the last 11 months, you would be down 56%, whereas the index is up 17%. If you started your position in the end of June and sold in the end of September, you would have been up 78%, whereas the index was up 24%. Do you notice the wide disparity in its performance? Anyone can get great performance and claim that these funds are great over the long-term, but the truth is, you need to be able to accurately predict both the market trend and the volatility. Congrats for doing well, but this will not be consistent.

Nov 02 12:53 PM

[Heythere:]

squark62, there are other media outlets and blogs in the world besides Seeking Alpha. This is a great site, but please don't use it as your only research source. There have been multiple articles on Ignites, Wall Street Journal, IndexUniverse, Morningstar, etc. The companies have already publicly announced their rewriting of the funds' prospectuses, which is evidence enough of the massive media presence of this issue.

Nov 02 12:59 PM

[Kunst:]

You're missing the point. I don't hold them. Buy (maybe) and sell the same day. The challenge is which one to buy.


On Nov 02 12:53 PM Heythere wrote:

> This has been discussed frequently the last 6 months, if you don't
> get it, you shouldn't be investing in non-stock/bonds ETFs.
>
> WDavid, there are similar risks w/ -1x ETFs; however, they are relatively
> small compared to the +/- 2/3x funds.
>
> Kunst, it depends on when you are holding them. Had you been holding
> FAS (3x long) the last 11 months, you would be down 56%, whereas
> the index is up 17%. If you started your position in the end of
> June and sold in the end of September, you would have been up 78%,
> whereas the index was up 24%. Do you notice the wide disparity in
> its performance? Anyone can get great performance and claim that
> these funds are great over the long-term, but the truth is, you need
> to be able to accurately predict both the market trend and the volatility.
> Congrats for doing well, but this will not be consistent.

Nov 12 11:36 PM