Seeking Alpha
Long/short equity, special situations, momentum, event-driven
Profile| Send Message| ()  

It wasn’t long after ProShares launched the first inverse and leveraged exchange-traded funds back in 2006 that other fund sponsors followed suit. ProShares initially staked its claim to the familiar large-, mid-, and small- cap U.S. stock indexes, as well as a host of domestic industry sectors. Next came Rydex, which offered competing versions of inverse and leveraged funds built on the S&P 500, the S&P MidCap 400, and the Russell 2000 Index of U.S. small caps.

More recently, Deutsche Bank (DB) became the first firm to bring the inverse and leveraged exchange-traded note structure to the realm of gold trading. In late February, the DB Gold Double Short ETN (DZZ), Gold Double Long ETN (DGP), and Gold Short ETN (DGZ) debuted on the New York Stock Exchange’s automated Arca platform. These new products, which track an underlying index of gold futures, allow investors “to take a leveraged or short view on the price of gold,” Kevin Rich, a Deutsche Bank spokesman, explains.

But is that such a good thing? Ever since these innovative products debuted, investors—both professionals and do-it-yourselfers—have debated what role inverse and leveraged funds should play in an overall portfolio strategy. Some commentators think leveraged ETFs don’t belong in a retail investor’s account at all.

There is no doubt that they have been popular, and for good reason. Before the advent of inverse ETFs and ETNs, the only way an investor could profit from a decline in the price of a security was by opening a margin account with a broker and borrowing the shares—an often cumbersome process that carried enormous risks. “Shorting” a stock with a margin account can result in losses that far exceed the initial cost of borrowing the shares. By contrast, the maximum amount an investor can lose with an inverse ETF is the initial purchase price.

Leverage, of course, allows investors to obtain more exposure to an index with the same amount of capital, a double-edged sword that can leave a well-constructed portfolio in shreds, particularly during periods of excessive market volatility. As many investors know, 2008 has so far been one of the most volatile years on record for the benchmark S&P 500, with more than half of the trading days seeing market swings of more than 1 percent.

One of the problems is that retail investors often don’t understand what they’re buying. For instance, the leveraged ETFs and ETNs on the market are primarily designed to return double the daily performance of their underlying indexes. Many investors mistakenly believe that their leveraged funds will produce double the annual return of the underlying index. The difference can yield some surprising—and disappointing—results. For instance, if the Nasdaq Composite Index goes up 10 percent on Monday and then falls 10 percent on Tuesday, the total loss over those two days is 1 percent. The ProShares Ultra QQQ (QLD), however, will rack up a total two-day loss of 4 percent, not 2 percent, as many investors might suppose without a careful reading of the prospectus.

The other problem appears to be that leveraged ETFs tend to perform poorly when purchased at market peaks. Tristan Yates, a researcher and consultant who has studied them, constructed a model leveraged ETF portfolio and discovered that an investor who bought a leveraged ETF at the peak of the last bull market in 1999 still wouldn’t have fully recovered his losses by the end of 2006, more than three years after the beginning of the next bull run for stocks.

Because inverse and leveraged ETFs are so new, it can be hard to get a bead on how they will perform over the long term. ProShares and Rydex have for years offered traditional actively managed inverse and leveraged mutual funds; their ETF products were outgrowths of that business. Yates suggests looking at the long-term performance of those funds to get an idea of how the corresponding ETF will behave.

The old investing chestnut that says never buy what you don’t understand is excellent advice when it comes to inverse and leveraged ETFs and ETNs. While it can be tedious, reading and understanding the prospectus—and precisely how the fund achieves its returns—is essential before committing investment dollars. For most retail investors, inverse and leveraged ETFs will be most effective in supporting a more broad-based strategy that uses traditional index, sector, and international funds.

Source: Ultra and Inverse ETFs: The Downside of Doubling Up