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Although a few Seeking Alpha authors have warned about the inefficiency of leveraged ETFs, many continue to recommend them. Almost every day there’s another article advising people to pile into an ultra-short S&P ETF (NYSEARCA:SDS) or an ultra-short Treasury ETF (NYSEARCA:TBT). So it's worth reviewing the shortcomings of these deeply flawed instruments and taking a look at a much better trade—a trade that can net 30% more after taxes.

Most leveraged ETFs seek to double (or triple) the movement of an underlying index on a daily basis. This requires these funds to "reload" every day. If the underlying index goes down, they decrease leverage; if it goes up, they increase leverage. This works fine if the market moves the direction you want in a perfectly monotonic fashion. But in the real world, markets don’t move monotonically, they fluctuate. So the leveraged ETFs increase leverage on up days, and de-leverage on down days--which amounts to “buying high” and” selling low.” As they repeat this process over time, they suffer "leveraged ETF decay." The chart below illustrates this decay with the S&P 500 ETF (NYSEARCA:SPY) and its 3X leveraged counterparts (SPXU and UPRO).

During this period, SPY fluctuated, but ended up exactly flat (leaving out dividends). It didn’t matter which leveraged ETF you placed your bet on --you could have bought either SPXU or UPRO. Both these leveraged ETFs lost a bundle of money: UPRO lost 20% and SPXU lost a staggering 35%. That’s why I used the term “bet.” It makes the 5-6% vigorish taken by Vegas casinos look charitable.

Who's getting rolled?

But it gets worse than that. For leveraged ETFs that use futures, leveraged ETF decay is compounded by what's known as the "roll yield." Every month, these ETFs have to roll over their futures position from the current front month to the next front month. But the price for the new front month can be less favorable because of backwardation or contango. Even more importantly, savvy traders learn the rollover dates and front-run these ETFs, so the ETFs get particularly bad prices. You can see the results of this in unleveraged commodity ETFs like UNG and USO, which consistently underperform the underlying commodities. In recent years, this underperformance has been as much as 20%.

But it’s just a short term trade…

The leveraged ETF advocates I’ve challenged invariably plead: “but it’s just a short-term trade, so the decay doesn’t matter.” The reality is, unless you’re holding the ETF for less than a day, you’ll still suffer decay. But more significantly, any gains you do make will get taxed as ordinary income. By contrast, if you make the trade with futures, 60% of your gain is taxed at favorable long-term capital gains rates. There are some limitations to this. The futures must be based on a broad index such as the S&P500; gains on single-stock futures, such as Intel Futures, are taxed as regular income. Also, if you are a professional trader who elects to use mark-to-market accounting, all your futures trades will get taxed as ordinary income. This is one reason I didn't do the mark-to-market election myself. (Please note disclaimer about tax advice below).

Another reason to avoid using leveraged ETFs for short-term trades is that they are only traded during regular hours (with some thin trading pre- and post-market). If I’m making a real short-term trade on a broad index, I want to be able to adjust my position any time of day--particularly right now, since events in the rest of the world have a huge influence on U.S. markets. In contrast to ETFs, futures on the big indices feature a very liquid market around the clock, even at 2am.

The right way to make the trade

So let’s compare the actual numbers of a leveraged ETF trade with an equivalent futures trade. Suppose you buy $100,000 worth of SDS and hold it for 2 months. If the S&P index declines 10%, you should make $20,000. The sad reality is you'll probably only make about $18,000, because you'll lose as much as 1% per month to leveraged ETF decay. Your $18,000 gain is taxed as regular income, so you only get to keep 65% of it after taxes. So your total gain on the leveraged ETF trade is a paltry $11,700.

Now suppose that instead of buying $100,000 worth of SDS, you short $200,000 of S&P 500 futures. Since there's no decay, your pre-tax return will be $20,000. Since 60% of that return is taxed as long-term gains, you'll take home a lot more of it too. After taxes, you net $15,400.

Here's where the futures-savvy reader says: "Wait a minute. Index futures are in typically in backwardation, so your short position will lose a little by expiration." But the backwardation for two months is only 5 basis points and the compensation is that you only have to set aside $20,000 (vs. $100,000 for SDS) to cover margin. You can do what you like with the other $80,000.

Futures trading has gotten easier

The other plea I get from leveraged ETF advocates (who should know better) is: “readers aren’t that sophisticated; they don’t want to trade futures.” So is it better to steer them toward an instrument with such bad odds that they’re practically guaranteed to lose money? My take is that if someone is not sophisticated enough for futures, they have no business placing bets on leveraged ETFs either.

In any case, futures trading is not as daunting as it once was. There is now a wide variety of “e-micro” and “e-mini” contracts that represent notional values as low as $10,000. A few years ago, you needed a separate account to trade futures. Either you had to set up the account directly with a firm specializing in futures, or your regular brokerage acted as the introducing firm for the futures specialist. In either case, transferring money between your futures and regular investment accounts was a nuisance, and you had to keep extra cash in the futures account to meet margin requirements. There are now several online brokers that allow integrated stock and futures accounts. There are even some that allow futures trading in IRAs.

Summary

The bottom line is: even if you guess the market's direction correctly, your leveraged ETF trade is still likely to lose money. If you hold the ETF for very long, you are almost guaranteed to lose money. If you actually manage to make some money with leveraged ETFs, rest assured, you've made a lot less than you could have with equivalent futures trades. What's more, your ETF trade is taxed at regular income rates (e.g. 35%); it doesn't get the 60% long-term gains treatment that futures do.

Disclaimer: I am not an investment or tax advisor. The ideas in this article are not advice. They are merely ideas to discuss with your investment or tax advisor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Fear Leveraged ETFs, Not Futures