Clear Proof Against Leveraged ETFs

An article in Saturday's WSJ entitled "New ETFs Don't Please Everyone" seems to have totally missed the obvious. Folks, we have undisputed proof that a leveraged S&P 500 ETF might do no better than a plain, vanilla Spyder.

What led me to this conclusion was my simple hypothesis that if leveraged ETFs and leveraged funds doubled the performance of the index -- or almost doubled the performance due to the much higher fees -- then why should I not invest for 40 years in a leveraged ETF and end up with almost twice as much as what I would have had if I simply invested in the S&P 500 index? After all, I was willing to bet that historical averages held true.

So I did some research. Unfortunately, there are no leveraged S&P 500 index ETFs out there with 40 years of experience. In fact, there are none with even five years. But there is a five year leveraged mutual fund. It is Rydex Dynamic S&P 500 [RYTNX], formerly Rydex Titan. It is a 2:1 fund offered by the Rydex Funds family. So I compared five year performance using a 4/30 close date for each investment. The five year performance as of 4/30 for Spyders (SPY), the Vanguard S&P 500 Index Fund [VFINX] and Rydex Dynamic S&P 500 [RYTNX] were: 8.42%, 8.41% and 8.84%, respectively.

Interesting! It sure killed my get-rich investment strategy. But why did our leveraged fund do such a miserable job toward achieving its stated 2:1 investment objective? So I called the Rydex Funds family. They conveniently failed to mention the obvious, that part of the difference can be explained by the 1.69% expense ratio for the fund compared with under 20 basis points for Spyders. Instead they noted that the difference was a result of negative compounding. I think this has to do with the fact that a 2% drop in a $100 stock requires a 2.04% rise to get back to $100, not 2%.

Anyway, I do not care. My question was answered. Leveraged ETFs and funds are terrible long-term investment plays unless the trend is a very long-term one. Leveraged ETFs are best for short-term trading plays on a pronounced trend.

See also: The Case Against Leveraged ETFs

Comments

[weichangyang]

Let's assume trading cost is zero and management fee is zero too. And let's assume we have two trading days, first day market is -20%, the second day market is +30%. We start with $100. In the plain fund, the return would be 100 * (1-0.2) * (1+0.3) = $104, so we make $4. In the leveraged fund, the return would be 100 * (1-0.4) * (1+0.6)= $96, so we lose $4. This should make it very clear that it is the negative compounding (you first hear it here, from me!) that kills the performance of leveraged fund. To exaggerate a bit, they cannot afford a single down day ;)

This also proves that high volatility kills one's portfolio.
This also explains why growth stock in the long run underperforms value stock.

[Javaharv]

There is nothing like a simple argument to make ones case. So how do you rationalize, "the greater the risk (risk=volatility) the greater the retrun"?

[Kunst]

Let's go back to basic algebra:

(1 + x) (1 - x) = 1 - x^2
So 20% up and 20% down (either order) = 4% down.

(1 + 2x) (1 - 2x) = 1 - 4x^2
Up 20%, down 20% (either order) = 16% down.

What these articles miss, though, is that no one invests in these funds for an overall flat market. If the market goes up, these funds will go up more. If the market goes down, they will go down more. If the market is relatively flat, double-index funds are not a good deal. Don't go into one unless you believe and are willing to take the risk of betting that its index will go up.