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There are many ways you can invest your money. Whether you choose a simple savings account or the most complicated ETF, the main goal is to have some sort of positive return on your investment. One risky way to invest your money is through a leveraged - or inverse leveraged - ETF. This type of ETF is extremely risky, but as the saying goes: "More risk, more reward." As I will show later, this adage applies perfectly to these two categories of ETFs.

ProShares ETFs states that a leveraged ETF is:

Each Short or Ultra ProShares ETF seeks a return that is either 300%, 200%, -100%, -200% or -300% of the return of an index or other benchmark (target) for a single day. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily.

This means that a leveraged ETF is a specialized ETF focused on providing a certain return for a single day, dependent upon a particular Index. While this return is targeted for a one day plan, the return is usually double or triple of what the focused Index returns, since a leveraged ETF carries a multiple of 2x or 3x.

As you can see in the ProShares definition, there are negative percentages. These represent inverse leveraged ETFs. Inverse leveraged funds are perfect for you if you predict a downward turn in the Index that the ETF is following.

Because leveraged ETFs carry a multiple, your return is doubled or tripled - which is terrific since regular stocks or funds do not double your return. This is where the "more risk, more reward" theme comes into play; if the index does the opposite of what the ETF was set to do, then you can lose two or three times as much for that particular day.

Another critical part of leveraged and inverse leveraged ETFs is the fact that they are compounded daily. Compounding these funds daily means that the assets are reset everyday. I will provide an example of how this works later, but for now it is important to know that leaving your money in a short or ultra short ETF may cost you big money, even if the ETF is higher than when you initially bought shares. On the other hand, if the Index grows throughout the time your money is invested, then your investment could exponentially increase.

Inverse Leveraged ETFs

The first example I will use that shows this effect is with ProShares Trust: UltraShort Technology (NYSEARCA:REW). This ETF is a 2x inverse leveraged ETF that tracks the Dow Jones U.S. Technology Index. This means that the ETF is set to return double the opposite of what the Technology Index returns. This means that if the Technology Index returns 10, then, under ideal conditions, the ETF will return -$20 for each share you hold.

Now would be a good time to show a theoretical example of how this works. Please keep in mind that the following scenario would be true under ideal situations with no fees or taxes:

  • If you bought 200 REW shares on Friday during the late trading session you would have paid $10,948 as the price was 54.74 per share. You may also decide that the technology market will tank this week, so you decide to leave your money in the ETF the entire week.
  • If on Monday the index goes down 1.407% then you multiply the index by -2 to get 2.814%, which means your ETF should raise, in an ideal situation, 2.814%. This would leave you with the same 200 shares equaling $11,256.077.
  • On Tuesday, the index closes -0.908%, which means the ETF would close up about 1.816%, which would give you $11,460.467 for your 200 shares. As of now it looks like you have made a good choice to leave your money in as you would have made about 4.68% while the Technology Index has fallen about 2.5%. This is a perfect example as to why an inverse leveraged ETFs is great for you if you are a short term investor with a firm grasp on the market, since double (and sometimes triple) the amount that the market loses can be gained through this style ETF.
  • On Wednesday, the Index closes up 1.683% which means you lost 3.36% of your money. This leaves you with $11,074.708 after three days.
  • On Thursday, the Technology Index surges up 1.36%, which gives you a loss of 2.721%. This drops your 200 shares value to $10,773.30.
  • On Friday, you decide to sell after the market closes, in which the Technology Index falls another .762%; which leads to the ETF gaining 1.523% for that day.
  • You then sell your 200 shares for $10,937.48, which is $10.52 less than you paid. If there were fees involved, this loss would be even greater.

Despite you losing money, the ETF finished about 0.066% above where it began the week. This shows how daily compounding can affect your money substantially. Of course, it works the same if it were the opposite. If the ETF continues to raise then you will make more money since your money is compounded daily.

The chart below compares REW with the Dow Jones U.S. Technology Index over the past 6 months. The point to be made from this chart is that a given index and the ETF following that Index do not follow a set in stone ratio. For instance, as you can see, these two functions are not a perfect double inverse of each other.

click to enlarge images

As you can see, REW dips way lower than it should when the Index is doing well. It is the same vice versa; the ETF surges way higher than it should when the Technology Index falls. If the ETF followed the Index in an ideal way, the ETF would be a perfect double inverse function on the opposite side of the "0%" line.

As you can see, these functions are not even. This is due to the fact that the Index simply follows technology stocks that are being traded - which means the Index cannot be traded. On the other hand, the ETF that tracks the Index can be traded; therefore, as traders buy and sell, the price can fluctuate. However, since the ETF is set to track the Index, the two functions will eventually converge to be double inverses of each other.

In terms of REW, the ETF has returned -12.03% year to date (YTD), while the Index has returned 4.827%. Of course, comparing these two numbers is futile when trying to figure out if the ETF is working properly since this ETF is a double inverse. After taking the double inverse of the Index's return we get -9.65%. This shows that the ETF should have only lost 9.65% YTD; yet it has lost about 12%.

Of course even if REW had only lost 9.65%, it is still well underperforming the objective of the fund. Also, it must be stated again that the Ultra Short Technology ETF is short term, not long term. Therefore this is not an ETF you should leave your money in for more than a day; and if you do then you are making a fundamental mistake. Especially with technology stocks bouncing up and down all year, it has been hard to grasp which direction they will go next.

Leveraged ETFs

For the next example I will use the same technique to show how ProShares Ultra Heath Care (NYSEARCA:RXL) follows the same greater risk greater reward pattern, though this ETF is a little different as it is a 2x leveraged ETF. This ETF holds dozens of companies from all aspects of health care, from its most held company, Johnson & Johnson (NYSE:JNJ), to its smallest holding, Savient Pharmaceuticals (SVNT). Since this is not an inverse fund, it tends to follow the Dow Jones U.S. health care companies very closely. Also, as the Health Care Index goes up, the ETF will return double the amount. Again, please remember that the situation below is under ideal conditions, and like most ideal examples, they do not represent actuality.

  • Next you decide to buy 200 shares of RXL at 66.57, which costs you $13,314.
  • On Monday, the Index goes up 1.938%, which means you make roughly 3.876% on your money. This adds up to $13830.05 for your 200 shares.
  • The next day, the Index falls 0.50%, which means you lost about 1%, which brings your money down to $13691.46. After two days you are up a good amount.
  • On Wednesday, the Health Care Index raises another 2.236%, which means the ETF would return about 4.472%. This would make your 200 shares equal $14,303.84.
  • As expected, after a big bounce in the market, a pull back occurs and the Index falls about 2.782% on Thursday. This turns out to be a 5.563% drop for the ETF, which brings your money back down to $13,508.15.
  • On Friday you decide to pull out after another 0.73% slide in the Index. After this slide you are only left with $13,310.89, which is $3.11 less than you started with. Granted, a $3 loss is quite miniscule when investing in leveraged ETFs, but factor in fees and taxes and you will lose more than $3.

Just as the inverse example, over a 5 day period the ETF returned 0.075%, but you lost just over $3. As mentioned before, this is due to daily compounding of assets. If not for the daily compounding, you would have made 0.075% over the week, while the Index itself only grew about 0.0375%. As you can see in the chart below, the Health Care Index is lagging behind the leveraged ETF that follows it.

This is a good sign for investors, but that does not mean you can expect to receive positive returns from now on, since even if the ETF does continuously move in an upward direction, you can still lose money if the dips are larger than the surges. For instance, if the Index raises 1% each day for 5 days, then drops 5%, you will be down on your initial investment. Similar to the inverse ETF example, the explanation for the difference from the Index to the ETF is due to the ETF being a normally traded fund while the Index is just a compilation of certain securities.

When comparing RXL to the Index, RXL has returned 27.9% YTD, while the Index has only returned 12.95%. To properly compare these numbers and to test the ETF, you must multiply 12.95% by two, which is what the ETF does. Even after doing that you still only get 25.9% return. This shows that the ETF has outperformed the Health Care Index and the overall goal of the ETF has been achieved.

Of course, you must remember that large drops preceded by slow gains do not equal a positive return. Nevertheless, in the case of RXL, it would have been a great long term leveraged ETF. To go along with that, RXL would have been a safe choice for you if you wanted exposure to health care stocks, but did not know which ones were the best choice for your portfolio. I would recommend RXL over the coming weeks as many of the ETF's holdings are having catalytic events in the month of May (as I have written about here). Of note are Johnson & Johnson and Merck (NYSE:MRK) (number one and three, respectively, in the ETF's holdings list as of Friday, May 6th).

It is clear that leveraged ETFs and inverse leveraged ETFs are not easy to manage unless you are a frequent trader. By frequent, I mean you follow the stock market very closely everyday. You can sometimes get away with not putting enough time or research into regular security if you choose a strong company, but with a leveraged ETF you would be in trouble. Despite the negative connotation I give off about leveraged ETFs, they are a great way for you to build a successful portfolio if you have the ability to predict which way the market, or a certain sector, will go the following day. But, as always, the greater the reward, the greater the possibility of a substantial loss.

Source: REW and RXL: The Paradox of Leveraged ETFs