Leveraged Long ETFs Warn Of Poor Reward-Risk Ratios

by: Peter F. Way, CFA

As markets rise in times of questionable economics, the Market-Maker forecasts for leveraged long ETFs still offer above-average return prospects, but at the cost of encountering even larger interim price drawdowns.

Their upside vs. downside price change prospects are pictured in this tradeoff map:

(used with permission)

A fistful of these high-powered wealth-builders actually are being appraised as having more downside exposure than upside - all those above the diagonal dotted line. Several down in the green area pose upsides 5 times as great as their forecast downsides. That may all be true by some 3 months from now, but in the interim temporary distress may lie in wait.

Our daily review of over 250 ETFs, including those pictured above compares the present-day forecasts with standardized test results of what has happened in each ETF's past 5 year history when prior daily forecasts took on the same up-to-down proportions as they have now. Here is what we see currently:

For those new to this analysis, the sell targets are the top of the range forecasts, worst-case drawdowns are an average experience of implied forecasts during the last five years' having a balance of upside to downside like today's. That balance is expressed in the Range Index, which tells that percentage of the forecast range (from low to high) which lies below the Price Now. The win odds are the proportion of those similar prior forecasts that produced profitable experiences in the 3 months subsequent to the forecast, usually by reaching sell targets.

That R~R ratio is a comparison of the sizes of Sell Target prospect and Worst-Case price drawdown experiences. It is what is giving us pause for many of these ETFs now. A ratio of less than 1.0 indicates worst-case price drawdowns greater than the prize being sought. For many investors, especially those aggressive enough to seek leveraged returns, that condition is a particular caution.

The table ranks its subjects by their past ratio of winning (profitable) experiences from like prior buy opportunities, with all of the top 5 ETFs earning gains in 7 out of every 8 ventures, or better.

Our test discipline limits holdings to a 3 month period, shortened by price reaching the forecast sell target. During those holdings prices may take temporary dives, creating the kinds of emotional stress that sometimes prompts mistakes, or may occur at inopportune times when a need for capital liquidity forces a loss to be taken. One that might later recover to be a gain.

The blue averaging lines aggregate this group's current character. At the table's bottom is the parallel measure for the SPDR S&P500 ETF (NYSEARCA:SPY) for contrast as a passive strategy. While the odds favor those five best past performers repeating, any and all of these are subject to a heightened risk component. The Direxion MidCap (3x) leveraged Bull ETF (NYSEARCA:MIDU) anticipates a near +6% upside, despite a relatively high Range Index of 63. Its prior 111 experiences at this level quickly grabbed profits in one market-month of 21 trade days, to compound an annual rate of gain of 90%. For some investors, that easily justifies encountering and enduring a -9% exposure below cost.

ProShares Ultra Pro (3x) leveraged Mid-Cap ETF (NYSEARCA:UMDD) competitor is only a bit less pricey at a Range Index of 58, but sees only half the upside of MIDU. Because of the small return potential, its risk exposure is double the target, but to the downside.

Small-cap tracker of the Russell 2000 index by ProShares in a (3x) leverage version (NYSEARCA:URTY) expands the upside back above +6%, but entertains a near-double drawdown of -11% that would be difficult for many to endure.

Perhaps the best set of tradeoffs at present is in the Direxion Semiconductor (3x) Bull ETF, (NYSEARCA:SOXL), which slightly betters prior teeth-clenching drawdowns of -13% with a forecast of near-+14% gain, backed up by prior gains of +16%, and triple-digit annual rates of return.

Rounding out the top 5 is the ProShares UltraPro Dow30 (NYSEARCA:UDOW), a tracker of the DJIA. Its 65 Range Index leaves less than 2 ½% upside gain room, which has been easily surpassed previously in one-month holdings for +50% annual rates of gain, three times what the SPY has done.

Thrills and spills. Other leveraged long ETFs with lesser batting averages offer some quite competitive alternatives. It's all out there, but not for the faint of heart, nor for the buy, hold (and forget) crowd. These require active attention.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.