The Case Against Leveraged ETFs

Tristan Yates and Lye Kok (IndexRoll) submit: The Leveraged ETF offensive is under way. A year ago, there were no leveraged ETFs in existence. Today, there are at least fifty leveraged ETF products in the marketplace and another fifty in the SEC/AMEX pipeline. By this time next year, perhaps every traded ETF will have a 2x leveraged counterpart. Are these leveraged ETFs suitable for retail investors? No, they are not.

In this article, we lay out the case against these products, based upon popular misconceptions of what exactly these ETFs provide, a hidden trap related to leverage, and the poor performance of related funds and of the ETFs themselves.

Note that this article updates a SeekingAlpha article posted about six weeks ago, and we’d like to thank the many readers who were kind enough to provide us with additional research and commentary.

The Daily Double

Leveraged ETFs are exchange-traded funds that are based upon well-known indexes, but that provide investors with additional leverage by using borrowed money. Their goal is to increase the return of the underlying index and provide a better return for the fund’s investors. Typically they provide $1 of debt for every $1 of investor equity, and are marketed as 2X funds.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Two companies, Rydex and ProShares, dominate the leveraged ETF marketplace. They have offered leveraged investment funds for many years, and have recently repackaged these products into ETFs.

A listing of some of the more popular ProShares leveraged funds:

A widely held misconception about these funds is that they will offer twice the return of the underlying index, which means that if the S&P 500 returns about 10% a year, then the SSO should return 20%. But that’s not true, because these funds only double the daily return, and there’s a big difference between doubling the daily return and doubling the annual return.

What’s the difference? Let’s say that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

Historical Returns

How much do daily doubled returns diverge from doubled annual returns? To find out, we created an imaginary fund called X2. X2 simply provides double the daily return of the S&P 500 index. We invested $1 in the fund and compared it to a $1 investment in the SPY over the fourteen-year period.

Note that this fund is imaginary by definition – there are no management fees, transaction costs, or capital costs. It is simply used to provide an illustration of the potential of a 2x leveraged fund.

The annual returns are close to double the SPY for the most part, but some years are off. In 1994, the X2 fund only provided 1.35x the return of the SPY, rather than 2X as expected. In 2001, the X2 fund provided 4.17x the loss of the SPY.

As a long-term investment, the X2 fund provides very good returns. Most years have positive double-digit returns. $1 invested in the X2 fund in 1993 would return $11.08 by the end of 2006, as compared to only $4.07 for the SPY.

However, if the investor had the misfortune to invest at the peak of the market, at the end of 1999, the investor would have lost 61% of the investment in the next three years, and would still have a loss by the end of 2006. Our X2 fund is a solid performer in the good years, but suffers disproportionately during the downturn and can’t recover its losses in the next rally.

Constant Leverage Trap

Let’s take a moment to see how a leveraged ETF works. In order to deliver the 2x results that the fund’s investors expect, fund management has to hold equal proportions of debt and equity at all times.

In other words, if there’s $100m invested in the fund, it has to borrow an additional $100m and make a $200m investment in the underlying index. That’s the only way that the fund can provide 2x the underlying daily return of the index.

Of course the fund doesn’t go to the local bank and borrow money every day and then invest it. It uses financial derivatives, such as swaps, options, and futures. But the overall effect is the same.

However, every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. By the end of the market day, the fund’s leverage is either too high, or too low, and some kind of corrective action is required to bring it back to 2x.

In order to maintain the target leverage ratio, our fund has to buy or sell millions of dollars worth of shares every day. Not only does this increase expenses, transaction costs, and short-term capital gains taxes, but it’s also just a bad investment strategy.

Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the afund’s sset base, making it much harder to recover gains in the next market upturn.

Note that this situation is called the Constant Leverage Trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets. It’s similar to a margin maintenance call.

X2 Implementations

Our X2 fund is imaginary for one important reason – nobody will loan us $100m to invest without charging interest.

In the real world, trading costs money, administration costs money, and money costs money. Funds like the ProShares ETFs have transaction costs, expenses, and costs of capital. Put all these costs together, and a lag is created between an investor’s expected and actual results.

We’ll look at two ETFs: SSO and QLD by ProShares. Neither has been around that long, just about nine months. We compared the funds' nine-month performance to a doubled daily return of the underlying index. Note that the prices used are adjusted for dividends.

Both ETFs have a big lag over the expected doubled daily performance. It’s not clear why the lag is so large, but it’s likely due to high transaction costs and management fees. Maintaining the required portfolio of financial derivatives may be more costly than expected.

Because the QLD lost about 0.7% every month due to lag, the fund’s investors had a hidden expense in their investment. This expense lowers short-term gains, long-term gains, and most importantly, future gains from investment compounding.

Note that some lag will always be unavoidable because the fund will be charged short-term interest on its leveraged investments. The current interest rate used in options calculation is approximately 5.25%, and it is reasonable to expect that a fund would pay that rate. Because this rate would only apply to the half of the portfolio that is debt, we would expect a 2.63% annual lag, minimum, on our fund, based upon just the interest cost alone.

Leveraged Funds

In order to learn more about leveraged ETFs, we have to look at original set of funds that they’re derived from. ProShares, Rydex, and Direxion all have offered leveraged funds based upon the indexes for several years. We reviewed the long-term performance records of some of these funds from their websites.

Note that there are at least fifty different leveraged funds for an investor to choose from, but these funds listed below seem representative of the larger population of leveraged funds.

The leveraged fund returns are shocking. The two Rydex leveraged funds are still in negative territory after almost seven years. Two other funds have returns that look like Japanese bonds. Only the ProFunds Ultra Midcap fund has an acceptable long-term return.

What happened? All of these funds were started just before the stock market downturn in 2000. Due to the use of constant leverage, they sold shares in the down market, and didn’t have enough of an asset base to recover. That’s why even with their leverage, they’re still poor performers.

What if we were able to avoid the downturn? Would we have sidestepped the losses and racked up huge gains in the next bull market?

For almost five years, we have been in a bull market, and the leveraged funds have performed well, but not exceptionally. They certainly haven’t provided double the performance. Three unleveraged low-cost Vanguard funds are provided below for comparison.

The fact is that the track record of leveraged index funds is poor. During the bull markets, they perform a little better than low-cost unleveraged funds, but during the downturns, they really suffer. We should expect the current crop of ETFs to perform the same way.

Conclusions

1. Many investors are misled by these leveraged ETFs and believe that they’ll get twice the daily return of the underlying index over the long term. In other words, if the index returns 10% next year, they’ll get 20%. But doubling a string of daily returns is not the same thing as doubling the annual returns, so investors should not expect that level of performance, unless they somehow rebalance their portfolios every single day.

2. Even just looking at X2 funds as a theoretical concept, the idea has some problems. The only way for a fund to maintain a constant leverage ratio is to buy shares whenever prices go up and then sell them when prices go down. This buying and selling activity increases the underlying volatility, and can lead to huge sell-offs in down markets that are impossible to recover from in the next bull market. This effect can be seen in every leveraged fund that went through the 2000 to 2002 downturn.

3. The current ETFs do not even deliver twice the daily performance of the underlying index. In just the nine months that the products have available, a lag has emerged between theoretical and actual performance. This lag is 3.3% for the SSO and 6.4% for the QLD. Given this lag, we could extrapolate that over several years, these funds would greatly underperform their theoretical X2 counterparts and at some points, even the underlying indexes. Note that a lag is unavoidable because of interest costs.

4. Investors should compare these new ETFs to the leveraged funds that were offered by these same companies seven years ago, because the long-term performance will most likely be similar. These funds were hit hard during the downturn and never really recovered during the next bull market.

I want to make it clear that I am not saying that leveraged indexing is a bad idea. I’ve written many articles on the subject and find that it has tremendous potential. The underlying concept, borrowing cheaply to make long-term investments in a total stock market index, is based upon both solid historical data and Nobel-prize winning academics.

But until new products are available, based upon the short-term results of SSO and QLD, the long-term results of the leveraged funds, and the mathematical pitfalls of constant leverage, I would suggest that investors avoid holding these leveraged ETFs as investments. If a leveraged indexed investment is desired, the best solution is still call options, index futures, or conventional index ETFs held in a margin account.

Comments

[Roger Nusbaum:]

The mis-conception that these funds capture twice the index over the long term is huge huge huge, I agree that a lot people miss that.

I use the double short SPX, ticker SDS, in a small amount as an insurance policy and I concede the long term flaws you cite that may leave investors disappointed with results.

There are a couple of things in your article that I don't quite follow. The 2x funds are mostly cash invested in T-bills earning around 5%, they don't borrow anything, as I understand it they are something like 90% cash. Yes there is perpetual tweaking to maintain the right mix.

I have used SDS for quite a while and last December clients got a fairly healthy dividend on the t-bills.

I do not disagree with you on the flaws but as a small insurance policy is was a big help on 2/27.

2007 May 17 10:55 AM

[jbs:]

Although they may not be "borrowing" funds from the bank, the derivatives serve the same purpose and they have a cost also - the premium. The premium can be equated to the cost of borrowing because it is the cost of gaining the leveraged exposure.

2007 May 17 11:26 AM

[Roger Nusbaum:]

which equates to the number days left until maturity of the current 91 day t-bill I believe? So are we talking about a small drag on a small slice of the fund?

The mis conception about long-term versus daily would seem to be much more important. Just my take.

2007 May 17 11:55 AM

[David Jackson:]

Roger, have you compared the interest on the bonds these funds pay out compared to the lost dividends from owning futures instead of the actual stocks? I wonder how the overall yield compares. V interested to hear your views on this and any numbers you have.

2007 May 19 07:10 PM

[Josh Stern:]

This is a well written article which I enjoyed even though I was already familiar with most of the concepts and material. I'm also a software guy at heart and appreciate an analytical approach to these topics.

2007 May 17 10:58 AM

[jbs:]

Very good article that brings many of the lesser-known issues to the forefront.

The issues you address are becoming more significant as ETFs are marketed to retail investors. I fear that uninformed retail investors are buying these ETFs that are marketed to boost returns. They'll eventually get burned and the only people coming out ahead will be the traders who used the ETFs intelligently and the firms that market them.

2007 May 17 11:24 AM

[Josh Stern:]

Re: Relation to interest rates -
In order to profit from opening an options contract, a trader has to either exercise the option or close the contract. In the former case they need a lot of capital to do that. In the latter case they are paying the bid/ask spread. So current borrowing costs are factored into the bid/ask spread.

Re: Portfolio insurance -
Long term maintenance of synthetic option positions is clearly too complicated and not cost effective for retail investors. But I wonder why brokerages, especially electronic ones, don't offer user-friendly portfolio insurance to their clients based on synthetic option positions. They could charge X$ to open plus Y%/month to maintain. I bet it would be a money maker for them both in terms of direct fees and encouraging higher levels of investment participation from nervous investors and ones with shorter time horizons until they made need the money.

2007 May 17 01:04 PM

[Tristan Yates:]

Exactly - the financial derivatives they use has a built in cost of capital and the investment gains are reduced by exactly that amount.

For example, today the closing futures price for the S&P 500 for June is 1518.80. But today's S&P price is 1512.75. The difference represents a cost of interest, and if you calculate that cost on an annual basis, you'll get something close to 5%. Or the fund might just buy a swap - at settlement date they exchange the gains in the S&P 500 for the accumulated interest on a short-term bond that pays 5%. It all amounts to the same thing.

I agree that's its confusing, and I did struggle with that section for a while, trying to do a better job of explaining it.

2007 May 17 06:55 PM

[Roger Nusbaum:]

amounts to 5% of the small portion not in t-bills?

2007 May 17 07:14 PM

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

I've talked with some folks from Rydex, and I think Roger is close on the amount of cash they actually use to get the leverage, and it appears to fall between 5 and 10%, but I need to revisit the prospectus to see if it is spelled out. I think another huge concern is the tax bite. SSO distributed over $3 per share cap gains last year and MVV distributed almost $5 per share. I don't want 3 to 6% of my client's money coming out as short term cap gains each year, and what happens in a volatile year that goes up and down, and winds up down. You could still wind up with huge short term cap gains on a down position, so it is tough to use these in a taxable account unless you diligently tax harvest. One strategy I did use with these was to follow up with bi-weekly target rebalance. Therefore, if one rose too far (ie. became either 10%, 13%, 16.4%, or 20%) overweighted, I would sell to bring the asset allocation back into alignment. Furthermore, when an asset class fell a certain percentage below it's targeted asset allocation amount, I would then add to the position. It is actually inverse to what the fund itself is doing. I found that this helped to smooth returns a bit. Yes, it is somewhat labor intensive, but using a low cost firm like Interactive Brokers, which allows global client trades, costs were kept to 20 cents to $2 per trade (yes, you read that correctly).
Enjoy the discussion. Keep it up.

2007 May 17 10:53 PM

[Josh Stern:]

Re Rydex:
So far SSO is underperforming Rydex Dynamic S&P. It seems like both the redemption factor with mutual funds and the creation factor with ETFs complicate things, making me wonder whether a traditional closed end fund 2X fund wouldn't make more sense.

Re: percentage of NAV in options/futures. Even if it was only 5% at a time, since the cost of borrowing is embedded in the bid/ask spread, we need to know the annual turnover percentage of the derivative position to figure out how it effects the annual cost percentage of the ETF. Consulting Morningstar for the Rydex Dynamic S&P 500, they list the cash percentage for RYTNX as 9.4 %, the annual asset turnover as 19%, and the expense ratio as 1.69%, but it's not clear exactly what those first two stats mean.

2007 May 18 12:28 AM

[Tristan Yates:]

I'll expand on the example. Today the closing futures price for the S&P 500 for June is 1518.80. But today's closing S&P price is 1512.75. The difference is 0.4%. In other words, the S&P 500 has to go up 0.4% by June closing, about 30 days away, just so you can break even. That's "how they get you", or in financial terms, how they build the cost of capital into the investment.

Let's say you have $100k to invest and you want to create a 2X S&P 500 index fund. You buy index futures on $200k worth of the index. Every month, you settle and buy more futures. A year later, the index has gone up 10%. Your gains are 20%, or $20,000 right? Not quite. The futures cost you 0.4% x 2 x $100,000 per month, or 4.8% of $200,000 = $9600 for the year. You end up with only $10,400 in gains.

But, because it only takes 5% margin to own a future, you were able to keep $90,000 worth of cash in your account all year earning interest. Invested at 5%, you get an extra $4,500. So your gains are $14,900, or about 15% of your investment. Which is what we'd expect given basic leverage formulas: $2 x 10% - $1 x 5% = 15%.

This is what I mean when I say money costs money. An interest rate is built into any financial derivative you buy, and any leveraged investor has to exceed that cost of capital before they start making money.

2007 May 18 02:33 AM

[qft25zj:]

From 6/21/06 (when SSO started) till today, I get SSO returned 43% and S&P500 up 22%. Is to short a time span? I'll admit I am having a hard time understanding this so don't kill me.

2007 May 18 07:43 PM

[David Jackson:]

Tristan, how do dividends factor in here? The futures don't pay dividends, but the underlying stocks do, so do you lose out on the equity dividends if you buy these funds, or is that also factored into the price of the futures?

2007 May 19 07:17 PM

[msangelabates:]

Your math is accurate. However, a smart trader never just buys and holds any of these ETFs or index-linked mutual funds. You should note that each vehicle has a corresponding inverse fund: thus, e.g., Rydex offers the RYVYX and RYVNX funds, and similarly ProShares offers the QLD and QID ETFs.
These are mated funds, one going 2X long the QQQQ, the other 2X short the QQQQ. Similar mated funds track DIA and SPY.
I have been trading back and forth using the Rydex funds; switching between long and short involves no commissions, and can be done as often as twice a day if one wishes. When in doubt, or bored, or on holiday, I move to cash, at no cost. I trade online, very simple. When the markets swoon, I profit rather than panic.
Granted, the funds have a stiff fee structure, about 1.7%.
The secret to profiting from this game is to develop and follow a strict technical trading methodology. I use short term moving average crossovers as the indicator of market pivot points, thereby profiting on up as well as down swings in the underlying market.
The first full year I tested my strategy was mid 2005 to mid 2006. Net gain: 55%. Not a bad return on a rather large real-money trading account. I check the end of day market situation, taking a few minutes to examine the status of the moving averages, and then either hold my position, or switch to the other fund, or go to cash.
So simple. I continue to refine my indicators, currently using a 5 day SMA crossing the 15 day SMA. I am testing longer and shorter term swings as well as EMAs.
This method reduces market play to mathematics, and removes the spurious aggravations of trying to predict or time the market or play individual stocks. The key is to find the right rhythm. It's like surfing, or dancing: if you are in sync with the movement, you will do well. If you just stand stubbornly on one foot, you will make a mess of it.
I would appreciate your comments on this trading technique.
Thank you.
Angela Bates

2007 May 21 02:05 AM

[msangelabates:]

One addition to my comment above:
Trading back and forth between mated funds allows one to profit from the greatest secret in finance: the amazing benefits of compounding. If done right, nearly each time one switches long and short positions, the trading account should be a little bigger than before, and a gain will be had whether the market is rising or falling. Without doing the math here, I would guess that the power of compounding will dwarf any quibbles one might have with the costs or inefficiencies of these 2X trading products, especially when conducted over time.
A.B.

2007 May 21 02:21 AM

[Tristan Yates:]

Thanks for the comment and questions. This is exactly why I publish.

msangelbates: It sounds like an interesting trading strategy, though I'm skeptical on the predictive power of SMA lines. The article is aimed more at people who are considering holding these at long term investments, as for example, Bill Donahue from the Street has suggested. Email me and we can talk more in-depth - I'm writing another article on momentum vs mean reversion and have some papers you may be interested in. [e-mail].

But as a trader, you likely have access to better index-linked products anyway, like index and ETF futures and options, which is what I personally use. In a low-volatility market I can leverage the index 5x+ times with a capped 20% downside risk using an in-the-money LEAP call. Why even consider a leveraged ETF then?

david: I used Yahoo adjusted-close prices, which include the effects of dividends. I think SSO keeps the dividends and uses them to pay interest costs, and that adds to the lag.

qftz: You may not be using dividend adjusted prices. On close 6/21, adjusted for dividends, SPY was 123.97 and SSO was 68.32. At yesterday's close, SPY was 152.42 and SSO was 97.67. Gain for SPY is +22.9%, SSO is +43.0%. See the 6.1% lag in the nine month period? (43.0 / (2 x 22.9)). If our fund really doubled the return, we would have expected to make +45.8%.

Note that this math differs from the article because we have some additional days, and I did the straight gain here rather than taking the individual daily SPY prices, doubling them, and comparing them to SSO.

2007 May 23 01:05 PM

[msangelabates:]

re your comments:
Thanks for the comment and questions. This is exactly why I publish.

msangelbates: It sounds like an interesting trading strategy, though I'm skeptical on the predictive power of SMA lines. The article is aimed more at people who are considering holding these at long term investments, as for example, Bill Donahue from the Street has suggested. Email me and we can talk more in-depth - I'm writing another article on momentum vs mean reversion and have some papers you may be interested in. [e-mail].

But as a trader, you likely have access to better index-linked products anyway, like index and ETF futures and options, which is what I personally use. In a low-volatility market I can leverage the index 5x+ times with a capped 20% downside risk using an in-the-money LEAP call. Why even consider a leveraged ETF then?



Hi Tristan:
Thanks for your comments, and yes, I would be interested in whatever opinions or articles you have on optimal ways to place leveraged bets on major market movements.
I think it is very risky to hold any 2X product long term, or for that matter, to hold anything related to the stock market without having some well defined signal to sell or reverse course when the product goes south. Look at the miserable aggregate 5 and ten year performances of any of the indexes. And with your useful analysis of the pitfalls of doubling the aberrations, such a tactic really is suicidal. I don't know what Mr Donahue says on the matter, but I think anyone who buys and blindly holds anything in the stock market is asking for a disaster.
Now, as to the 'predictive' aspects of MA crossovers, I agree with you ...I am skeptical of the predictive power of any indicator. I don't believe in trying to predict any moves in the markets. My effort is simply to get in sync with the market as soon after the actual shift occurs as I possibly can. As a novice fan of technical analysis, I like moving averages because they are the only true indicators of what the market is actually doing, without the "noise" of the actual price line. Much of the time it is like watching the drum major and staying in step with the parade, not guessing where it's headed next.
Trendless, sideways markets are the Achilles heel of my method. But often enough, at least so far, when a MA crossover occurs, it means the parade has turned, it tells me there is a sentiment shift occurring at that moment in the market and then all my account is shifted to that side of the table (i.e., the bull or bear fund) . Sometimes I have to shift back quickly, and lose a little money. This is the big problem I have in a range-bound market, where the MA crossovers are of too short a duration and give off too many signals. So far, though, depending on getting the MA duration just right, there seem to be wide enough trends in the big indexes that can provide on average a 2-4% per month gain on up as well as down moves in the major indexes.
That works out to be about a 25-60% compounded annual gain, no matter what the market is doing. It is reassuring to me to know that I can make money with zero concern about the economy, company fundamentals, stock performance, hedge fund moves, political disorder, fraudulent accounting games, currency chaos, etc. I'm looking for a trading system that is agnostic about any of these issues, so I like dispassionately following the broad indexes with that little 2X boost. And even better, the more dramatically the markets swing up and down, the greater the effects of the compounding. One just has to be nimble and follow the parade.
If there is a better way to play this than my method, I do want to learn it, and I'll bet others would also appreciate your writing an article on using LEAPS or other leveraged techniques to play the indexes. I'm sure there are many readers who distrust the stock market as much as I do, but want reasonably low stress and low risk ways to just play both the ups and downs for some profits.
Thanks...
sincerely,
Angela Bates

2007 May 25 03:30 PM

[Michael Bom...:]

I think I have some additional data that shows the inefficiencies in these inverse funds might be related to vega sensitivity. I summarize the argument in the bottom paragraphs.

Very nicely work compiling this Tristan.

2007 May 25 10:47 AM

[Karl Zachar:]

I was naively just about to buy a 2X leveraged ETF and your article shed a lot of light on the subject. Great article Tristan and great discussion. Thank you.

Here's my "problem". I am looking to invest in my IRA with a 10-20 year time horizon. (This is obviously a non-taxable account and I can't use leverage (no margin borrowing in an IRA)). My theory is that the SP500 will return an average of approx 8% per year for the next 10 years. So I am looking for an instrument that that is better than buying an ETF on the SP500. I want to get some leverage on the SP500. (The risk of doing this is that the first couple of years are key. If the market is down big in year 1 and 2, my leveraged SP500 idea will look pretty stupid.)

Assuming the market in teh next couple of years will not be disasterous, what instruments can I use? How about LEAPS on the SP500? Any better ideas?

2007 Nov 13 05:04 PM

[Benjamin Wa...:]

Tristan:

I am 24 years old. My investment horizon is 40 years. It seems like after 40 years of investing, I will be way ahead with one of these 2x accounts. I understand your point that the 2x strategy may be too risky for short durations, and I understand your point that 2x might really be something like 1.4x (because of transaction costs).

However, given my long-term horizon, shouldn't I be eager to put some money in a 2x ETF, because of the higher expected return? I do not care about the portfolio's standard deviation from year to year, or even from decade to decade.

Thanks for your help.

2007 Dec 25 09:09 PM

[Dean M:]

I have been thinking of trying something like Angela's approach, I'm new to technical analysis and am working on developing models now. I have a couple of questions. Is there a way to compare the funds based approache to options/futures on an individual trade to see how much you would be giving up? With the mutual fund you can't trade in and out intra day, is that correct and what is the implication there. Thanks....

2007 Dec 26 05:18 PM

[bws9322:]

Thank you for this insightful article. The comments are very interesting as well. I do have a question about a premise that is assumed in this article though. Is it truly realistic/helpful to think of ETF price movements entirely in terms of percentages? Or is it more likely that an ETF will fluctuate daily more on a fixed basis instead of a percentage basis. In other words, in the real world, in the short term, is an ETF with a price of 100 more likely to go up 1.00%, then down 1.00% rather than up 1.00 point, then down 1.00 point? Or could there be a complex combination of both processes at work here? Has anyone done a detailed analysis on this and all its ramifications?

2008 Jan 12 11:04 AM

[NoFate:]

Angela - I think your 5/15 SMA tool is good for Bull markets, but may be dangerous in a Bear market. The high volatility is the problem ...if the market suddenly plunges for a day and then does a moonshot the next day you can find yourself on the wrong side of the trade (and it could be expensive).

This is similar to the problems with the MACD ...which is a similar tool. By the time the crossover occurs the market has often moved on (like last week ...both directions).

2008 Jan 29 12:06 AM

[pdsro:]

About the constant leverage trap, I don't get it why you have to buy high and sell low. Don't know how is formed the table. And how if the index increases in 1% the leverage ratio is 1.98. What formulas was used for get that number?
Also, if the ultra have the constant leveraged trap, did the short ETF's have it?

2008 Feb 13 04:07 PM

[Winston:]

Excelent article! By far the best that I've seen on the subject.

I'm in the same position as Benjamin Washington above and have been invested in these type products in my IRAs for about five years on the same theory that he stated. Can anyone come up with a counter argument?

Note that IRAs (1) have tax deferred status, so capital gains distributions don't matter (2) prohibit margin borrowing and most options strategies.

As someone who has a very long time horizon for my money, it seems to me that a beta of 1.0 that I would get from an index fund is simply too conservative, but IRA rules prohibit me from increasing my systemic risk to what I consider to be an appropriate level.

2008 Aug 12 07:20 AM

[axxs:]

Quote the op "However, if the investor had the misfortune to invest at the peak of the market, at the end of 1999, the investor would have lost 61% of the investment in the next three years, and would still have a loss by the end of 2006. Our X2 fund is a solid performer in the good years, but suffers disproportionately during the downturn and can’t recover its losses in the next rally. "

this guy has clearly never read the four pillars of investing or a random walk down wall street.if you bought consistently thru the bear market,not only would ur shares from 1997 to 1999 recover when the market revert to mean,the shares you bought during the bear market from 2000 to 2002 would skyrocket.

you should just use a 4x margin broker and buy Ishares instead of this blood suckers

2008 Oct 31 11:54 PM

[axxs:]

sorry when i said "this guy" i was referring to the fund manager

2008 Nov 01 03:58 AM

[Nick Gogerty:]

just an FYI this is known as Siegel's paradox. mathworld.wolfram.com/...

2008 Nov 03 02:46 PM

[Deepfryer999:]

Why did you show the returns of the leveraged funds starting from 1999, but you compared them to the indices (S&P 500, midcap, smallcap) from a DIFFERENT time period (the past 5 years)? That's pretty misleading if you ask me. I think these leveraged funds have done a pretty good job of managing their expenses and, for the most part, they are doing what they claim to do.

Also I want to point out that yes, if the stock market goes up 10% one day, and goes down 10% the next day, the etf will be down 4%, compared to the market going down only 1%. But that's a good thing, because it works both ways! Example: what about when the market goes up 10% two days in a row? The market will be up 21%, and the etf will be up 44%. More than double. Besides, this factor will not be nearly as dramatic as these examples seem to imply. The market doesn't usually go up or down by 10% in one day. So relax.

I'm impressed by these funds, and I think this is a perfect time to buy some SSO and MVV, and watch your portfolio grow as the market turns around. If you can buy those 2 funds for your 401k and hold them for 30 years, you are going to make millions of dollars, no question about it. Don't let this buzzkill writer stop you from making some extra dough with these funds.

2008 Nov 04 02:26 PM

[lraroar:]

Angela, do you have an update? (November, 2008)


On May 21 02:05 AM msangelabates wrote:

> Your math is accurate. However, a smart trader never just buys and
> holds any of these ETFs or index-linked mutual funds. You should
> note that each vehicle has a corresponding inverse fund: thus, e.g.,
> Rydex offers the RYVYX and RYVNX funds, and similarly ProShares offers
> the QLD and QID ETFs.
> These are mated funds, one going 2X long the QQQQ, the other 2X short
> the QQQQ. Similar mated funds track DIA and SPY.
> I have been trading back and forth using the Rydex funds; switching
> between long and short involves no commissions, and can be done as
> often as twice a day if one wishes. When in doubt, or bored, or on
> holiday, I move to cash, at no cost. I trade online, very simple.
> When the markets swoon, I profit rather than panic.
> Granted, the funds have a stiff fee structure, about 1.7%.
> The secret to profiting from this game is to develop and follow a
> strict technical trading methodology. I use short term moving average
> crossovers as the indicator of market pivot points, thereby profiting
> on up as well as down swings in the underlying market.
> The first full year I tested my strategy was mid 2005 to mid 2006.
> Net gain: 55%. Not a bad return on a rather large real-money trading
> account. I check the end of day market situation, taking a few minutes
> to examine the status of the moving averages, and then either hold
> my position, or switch to the other fund, or go to cash.
> So simple. I continue to refine my indicators, currently using a
> 5 day SMA crossing the 15 day SMA. I am testing longer and shorter
> term swings as well as EMAs.
> This method reduces market play to mathematics, and removes the spurious
> aggravations of trying to predict or time the market or play individual
> stocks. The key is to find the right rhythm. It's like surfing, or
> dancing: if you are in sync with the movement, you will do well.
> If you just stand stubbornly on one foot, you will make a mess of
> it.
> I would appreciate your comments on this trading technique.
> Thank you.
> Angela Bates

2008 Nov 13 10:30 AM

[User 299451:]

can someone answer Tristan... because so far no one has.


On Dec 25 09:09 PM Benjamin Washington wrote:

> Tristan:
>
> I am 24 years old. My investment horizon is 40 years. It seems like
> after 40 years of investing, I will be way ahead with one of these
> 2x accounts. I understand your point that the 2x strategy may be
> too risky for short durations, and I understand your point that 2x
> might really be something like 1.4x (because of transaction costs).
>
>
> However, given my long-term horizon, shouldn't I be eager to put
> some money in a 2x ETF, because of the higher expected return? I
> do not care about the portfolio's standard deviation from year to
> year, or even from decade to decade.
>
> Thanks for your help.

2008 Nov 16 09:48 PM

[User 299451:]

i meant to say Benjamin Washington

2008 Nov 16 09:53 PM

[Cory H:]

Ok...so this might be a stupid question but say the underlying index of a 2X ETF is down 50% in one day, does that mean the ETF will be down 100% in one day?

2008 Nov 18 10:42 PM

[madan:]

I think, if your index is down 50%, your 2X will be down 75%. eg. if index goes from 100 to 50; I would assume 2X end up at 25, making that a 75% drop. Make sense?


On Nov 18 10:42 PM User 301083 wrote:

> Ok...so this might be a stupid question but say the underlying index
> of a 2X ETF is down 50% in one day, does that mean the ETF will be
> down 100% in one day?

2008 Nov 21 04:03 PM

[dchi:]

Given market volatility, all leveraged ETF prices will eventually go to zero. Just do a simple exercise in Excel and you will see this. If the market just bounces around from day to day but does not go up or down in the longer term, bear leveraged ETFs will go to zero faster than bull leveraged ETFs. I will not hold a leveraged ETF for longer than a few days, especially in this volatile market.

2008 Dec 03 09:24 AM

[imagasser:]

I understand the implications of owning 2x long ETF's going from high to low market indices. However, if you look at where the market is now, over the next year, is it more likely to be 25% higher or 10% lower? I would say it is more likely to trend higher than lower. Would that not make the case for buying a long ETF now?

2008 Dec 11 11:55 PM

[Robwynge:]

Although this in an informative article, I find it makes me MORE likely to invest in levereged ETFs, not less. Why? The examples all showed that the levereged products outperformed the unlevereged ones in bull markets. The author keeps saying "it's less than 2x and that is bad." So what? As far I am concered, they do better than 1x, so it's worth it! Of course they will do worse in bear markets, but even a simple technical analysis system (like the moving average crossovers discussed above) can keep you long in bull markets and short in bear markets most of the time. I still see these as a good product for an intelligent investor with an understanding of technical analysis, but they are certainly not for the buy-and-hold fools (if this bear market hasn't killed that strategy, I don't know what will).

2008 Dec 15 10:52 PM

[Hefaistos:]

Robwynge, you have to consider the risk as well. Everything doesn't just trend up (or down). You'd better compare Sharpe quotas to see which one is preferable. (risk premium/ standard dev)

Jan 14 01:19 PM

[bottomfish:]

FAS is 3x. it has gone from roughly $2.60 per share to roughly 10.05 per share in the last month or so. seems like it worked as advertised.

thanks for all the info above, it is very interesting. I got in FAS at $2.80, should I sell now or do yall think it may go up some more?

Apr 18 09:45 AM

[User 401744:]

I have a question why not just short both sides of the etf for example DIG AND DUG one year ago you would be up on both??can someont tell me what I am missing here??

Apr 24 07:51 PM

[User 401744:]

I have a serious question. Why based of the action of the etfs i looked at for example dig dug skf uyg srs ure if you would have shorted them all 1 year ago you would have made money on both of them. So if I short them both now 1 year from now will they not both be lower or atleast one of them substanally so. DIG was at 115 DUG was at 29 today dig is 25 and dug 22 see my point. It is the same story for all the other mentioned. So if they just end up lower why just not short the ultra long and the ultra short and just wait???

Apr 24 07:52 PM

[Gandulu:]

I got carried away by your story and came up with a simple formula for annual rate of return of a leveraged fund over a long period of time:
P = L R - (L-1) C + f^2 (L-L^2)

L= Leverage
R= Annual performance of the underlying index in % (typically 10)
C= Annual cost of borrowing in % (typically 6 say)
f = measure of daily fluctuation in % (about 1)

So, for L=1X, P= 10%
for 2X, P = 12%
for 3X, P =12%
for 4X, P = 10%
for 5X, P = 6%, and downhill after that.

So, 2X leverage sounds OK and any higher than that would be disastrous. As you correctly observed, though, that the 2X fund would perform only marginally better than a good 1X fund. Have you come across any such analysis, perhaps in scholarly publication?

May 09 01:52 AM