Take A Pass On Leveraged ETFs

Includes: FAS, FAZ, SKF, UYG, XLF
by: Lucas Krupinski

Unfortunately, it's pretty common that I talk to someone with a position in leveraged ETFs, not as the trading vehicles, for which they are designed, but as long-term holdings. Most buy into them on the belief that the leveraged ETF will provide 2 or 3 times the performance of the underlying index over whatever time period they hold them for, as opposed to the 24-hour period for which they're designed.

Proshares and Direxion, the leading leverated ETF providers, have created many products catering to traders needs.

You can have two or three times daily leverage (long or short) on Financials (using (NYSEARCA:UYG) or (NYSEARCA:SKF) for 2x leverage, or (NYSEARCA:FAS) and (NYSEARCA:FAZ) for 3x leverage), the S&P 500, the energy sector, and many sectors as well.

Direxion plainly states on their homepage:

Direxion Shares Leveraged ETFs seek daily investment goals.
Not Monthly. Not Annual. Direxion Shares are not for everyone.

However, many people who become buyers of these products are buying for the allure of 3x leverage, not realizing that daily products aren't able to perform according to their hopes. Instead, many people buy these products using mental math that looks like this:

"Index X is worth 100 today - if it reaches 133, then the 3x leveraged ETF will have doubled in value"

100 + (33 * 3)

Yes, if that move occurs in a single day, their outcome would likely be very close to that, but unfortunately, volatility makes that outcome extremely unlikely. The math just doesn't work, and history demonstrates that point exactly:

If you compare the performance results of the Financial Select Sector SPDR (NYSEARCA:XLF) compared to Direxion's 3x levered financial ETF's, both long (FAS) and short (FAZ) over the last year, the results clearly demonstrate that, while the performance of leveraged ETFs does come very close to what their prospectus' outline on a daily basis, that does not at all translate into the long-term.

Compare the results of $1,000 invested in each product and held over the course of the last twelve months (June 1, 2011 through May 31, 2012). For simplicity sake, shares bought will be rounded to two decimal places, and distributions will not be reinvested. Historic prices and distributions are taken from Yahoo! Finance's history pages for each product.




Opening Value

$ 1,000.00

$ 1,000.00

$ 1,000.00

Opening Price

$ 15.78

$ 27.91

$ 42.47

Closing Price

$ 14.01

$ 76.68

$ 27.01

Shares Bought





$ 14.77

$ -

$ -

Closing Multiplier




Closing Value

$ 902.58

$ 549.49

$ 636.09





Going through the returns by investment, XLF, the non-leveraged investment lost 9.74% over the time period. People investing in these products would assume that FAS would have lost 3 times as much as XLF, but in fact, the FAS' losses were much greater than that. Even still, we'll hear from people who will argue that's the effect of magnified leverage, and will trumpet out the bear ETF as the solution to these loses. But over the same time period, when XLF went down, the FAZ, the 3x bear (short) ETF went down as well. Its losses surpassed XLF's, but didn't quite approach FAS'.

How can that be?

Volatility is the answer. Open up an excel spreadsheet create a $100.00 investment that returns 5% on Day 1, loses 8% on Day 2, and gains 5% again on Day 3. At the end of the period, your $100.00 will have turned into $101.43.

Now add leverage. On day one, your investment returns 15% (3 times as much), day two it loses 24%, and day 3 it gains 15% back. Your 3x long "investment" will now be worth $100.51. Meaning that, with 3x leverage and operating exactly as the leverage is advertised, after 3 days it gained less than the non-leveraged investment.

You can do the same with reverse leverage (a la Bear shares) and see the results: 15% down one day, 24% up the next and 15% down the last day, creates a loss of much greater than 3 times the non-leverage gain.

For readers who didn't want to follow along, the screen shot below illustrates it.


Leveraged ETFs are advertised to provide daily returns of 2 or 3 times as much as the indexes they track, and they generally work as advertised. However, even though they work exactly as advertised, day in and day out, the demonstration above shows that holding them for over 1 day results in returns that aren't at all correlated with the index they track.

These are products made for traders. Investors, or in this case, anyone expecting to hold their investment for longer than a single day, would be well advised to steer clear of leveraged Daily ETFs.

Disclosure: I own no leveraged bull or bear ETFs and have no intention on purchasing any in the next 72 hours.

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