Clear Proof Against Leveraged ETFs

 |  Includes: DDM, QLD, SPY, SSO
by: Christopher Baldwin

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 (NYSEARCA: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