Exchange Traded Funds (ETFs) have gained enormous popularity. The combined assets of the nation's ETFs were $1.817 trillion in July 2014, according to the Investment Company Institute (ICI) and in the last year alone, more than 120 ETFs have been added. Leveraged ETFs are becoming a fast growing category. The number of leverage ETFs is close to 250.
The leveraged ETFs offer 2X or 3X daily compounding over the returns of the underlying index. The Proshares 2X ETF ticker "SSO" provides daily compounding of twice the returns on S&P 500 index. The Direxion's 3X ETF ticker "FAS" provides the daily compounding of three times the returns on Russell 1000 financial services index. Very few investors understand their behavior. The daily eye popping returns of these ETFs invoke the animal spirits and let investors make dumb decisions.
I'm going to run some hypothetical scenarios to explain the returns of these 2X and 3X funds. The scenarios provides a framework for properly understanding these funds.
Scenario 1: Volatile market. Here the stock goes up and down on a daily basis. In this scenario, both the 2X and 3X underperform the returns on the base index.
Scenario 2: The market goes up first 6 days, followed by negative returns for another 6 days. In this scenario, both the 2X and 3X underperform the returns on the base index.
Scenario 3: The market goes down the first 6 days, followed by 6 up days. In this scenario, both the 2X and 3X underperform the returns on the base index.
Now comes the fun part. In a bull market, 3X performs the best, followed by 2X and Base index. There is no surprise here.
Scenario 5: A bear market. As expected, the 3X performs the worst, followed by 2X and base index. Again, there is no surprise.
What is obvious from these scenarios is that, you need to get both the direction and timing right to make money. You lose money if you are wrong on either direction or timing.
Real life examples:
- The recent bull market started on Mar 2009. If you jumped in 2 months early, an investment in the Financial Select Sector SPDR ETF (NYSEARCA:XLF) would have returned 28% over next two years and the Direxion Russell 1000 Financials Bullish 3X ETF (FAS) would have returned -35%. It is a fools errand to try to predict the timing.
- How did the leveraged S&P 500 ETFs perform since the start of the recent bull market run? The returns have been phenomenal. The Direxion Daily S&P 500 Bull 3X Shares ETF (NYSEARCA:SPXL) returned a whopping 1,500%, the ProShares Ultra S&P 500 ETF (NYSEARCA:SSO) returned 700% and underlying index returned 200%. In the depths of the recession when unemployment rate hovered in double digits, it would have been hard to predict which of the those scenarios 1-5 would play out. We know with the benefit of hindsight, that the bull market scenario 4 played out.
The leveraged funds also have the following issues:
- The implicit cost of managing the built-in leverage may cost several percentages. These costs are borne by the investors indirectly.
- The funds charge an arm and a leg compared to plain ETFs.
- ETF providers get poor pricing when they try to write the contracts.
The prudent investors are better off using it only for hedging their market exposure over very short durations.
Alternatives to leveraged ETFs.
There are several alternatives that minimize the impact due to volatility and daily compounding.
- Deep in the money leaps: Leaps are long dated options that provide leverage. An example of a leap is the call option expiring December 16, 2016 for the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) with strike price of $150. It trades for around $53. If SPY closes at $250 on the day of expiry, SPY would have returned 25% and the leap would have returned 88%. You lose 100% of amount invested in leaps if SPY closes at $150.
- Portfolio margin: A portfolio margin allows you to borrow funds using the equity as collateral. The funds can then be invested.
- Futures: The S&P, Dow and Nasdaq futures contracts allow leveraged exposure to the market indices.
All these three options allow you to avoid losses due to volatility and daily compounding.
- Stock Encyclopedia.com
- Screen shots for scenarios 1-5 are hypothetical examples created using MS excel.
- Leap quotes from Yahoo Finance.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.