Leveraged ETFs: Buy and Holders Beware, These Are for Active Traders

Warren Buffett, John Bogle and Jeremy Siegel all recommend it. That is, many superheroes of the investing universe advise the "little guy" to buy-n-hold index funds. And for these heroes... you should hold through thick, thin, down, up and sideways.

Regular readers and money management clients know that I have a different "take." I believe that you buy good stuff with an intention of holding your investment. And when, for whatever reason, your good stuff is no longer maintaining its "goodness", you sell. You make sure that every investment choice that you've ever made is either a big gain, small gain or small loss... but never a big loss. (Check here for more on the wisdom of avoiding a big loss.)

Yet, let's say that you've bought into the buy-n-hold mentality. You accept the notion that you simply keep buying in good markets and in bad markets because... eventually... stocks go up over the long run.

With that belief in tow, then there "seems to be" little reason to avoid leveraged ETFs. You have those that seek to deliver twice (2x) a broad market benchmark like the ProShares Ultra S&P 500 (SSO). Others may drill down into style, such as the "double-the-midcap-growth index fund," the ProShares Ultra Mid Cap Growth Fund (UKW). Still others seek to leverage economic segments where the ProShares Ultra Materials Fund (UYM) seeks 200% of the Dow Jones U.S. Basic Materials Index.

Again, if you are buying stock indexes for the long haul, wouldn't you double your returns by selecting an investment that gives you 2x that index? No-brainer... right?

Well... not exactly. An understanding of compounding and "bear market math" makes buying-n-holding a leveraged investment downright dumb.

Let's first illustrate with actual returns. Nearly 2 years ago, on June 21, 2006, the ProShares Ultra S&P 500 began to trade. The S&P 500 has gone from 1290 to 1425 through May 16, 2008 and the S&P 500 SP DR Trust (SPY) that tracks its progress is up 18.5% (adjusted for dividends).

A semi-logical assumption might be to assume that the Ultra S&P 500 would have gained 36% in this period... double the index. However, this investment is actually up a bit less than the unleveraged fund, at approximately 18%, also adjusted for dividends. (See the chart below.)

The easiest way to understand discrepancies between leveraged and unleveraged investment results is by doing a little "bear market math." For instance, let's say that an unleveraged energy fund and a leveraged energy fund are both trading for $50. You purchase the leveraged ETF. The energy index soars out of the gate like Big Brown at the Preakness, 10% higher to $55 in a matter of weeks. Even better, your leveraged investment has rocketed 20% straight to $60.

Ahhhhhhh... but the world energy markets hit a major oil slick. The unleveraged energy index slips 25% from its $60 highs, and now trades at roughly $41. Yet the leveraged investment falls 50% from its peak, and now trades at $30. You are now down 40%!

Now let's say that energy recovers its winning ways... and it gains a handsome 25% off of its unleveraged $41 bottom. The unleveraged index investor has recovered losses, and sits a bit above his/her purchase price at approx $52 for a 4% gain.

What about the leveraged index investor? He/she gets a phenomenal 50% gain off the $30 price, and winds up at $45. He is still down with a -10% return!!!

Matt Hougan for IndexUniverse has done extensive research on leveraged ETFs. His findings suggest that twice leveraged investments will deliver no more than 130-150 per cent of an index return over the long run. Worse yet, if you run into a bear, the effects of volatility, negative compounding and "bear market math" could destroy your portfolio.

Does this suggest that investors should avoid leveraged ETFs altogether? No... but buy-n-holders should definitely stay away.

We could easily see a 15-year cycle where the Dow trades as high as 20,000 and as low as 7,500, ending up at Dow 10,000 in 2015. The buy-n-holder of unleveraged ETFs will at least break even, whereas the buy-n-holder of leveraged vehicles may suffer negative returns that he/she would be unable to recover from. (It'd be like trying to rebound from Nasdaq-like 80% losses.)

On the flip side, investors who have a plan to sell will recognize profits in 3 or 4 bull markets during the hypothesized 15-year cycle. And when the bearish downturns come, he/she can avoid the bulk of it by realizing small losses. Nobody needs to hold through a bear.

You can profit in leveraged ETFs. I made a suggestion near the March bottom to bet against the doom-n-gloomers. I suggested that that aggressive traders look into the unloved Ultra Financials (UYG) and the unfairly crucified tech sector with Ultra QQQ ProShares (QLD). (And I also made a point of telling ultra-aggressive traders to plan on selling!)

Similarly, I talked about shorting the consumer services sector in September 07 with great success. Once again, I made the suggestion ONLY in the context of having a plan to sell.

Leveraged ETFs can work well as a trader's tool. They can also work well for protecting positions (long or short) without having to sell. But they are more likely to hurt buy-n-holders than help them.

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[kavier]

I own UYG. Is it still a good play?

[DaveW]

kavier,
It seems, to me anyway, that the financial sector is much more negative than positive. I"m in the inverse fund SKF for that very reason. My bet is on both the poor outlook of financials and a likely short term down-turn. I'll be out quick if I smell a hint of optimism in the next day or two. But think of this, if the markets don't correct soon and go on further into positive territory do you really think financials warrent real enthusiasm? I believe their golden age is gone, investors are finally realizing that these stocks just won't bring the long-term profits they once did. Your money may better be spent where enthusiasm does currently reside: mid-cap growth stocks outperformed other equity styles in April with no reason for that to change anytime soon. For example, today:

seekingalpha.com/artic...

If you are feeling optimistic and are looking for leveraged growth you might consider the leveraged Mid-Cap Growth ETF (UKW) mentioned above.

[DaveW]

Regarding these leveraged tools and the individual investor. Like me, everyone has and will make mistakes betting on short-term futures from time to time. Here is one of my mistakes and how I corrected it, I think it's working out pretty well so far. Back in mid-April I made a bet on commodities dropping by going short using the ProShares UltraShort Basic Materials ETF (SMN). I know, idiotic move. Commodities were in fact not done going skyward. When my position in SMN reached -7.0% I made a move to hedge my mistake from becoming a double-digit mistake. I purchased an equal weighting of the Ultra Basic Materials UYM as insurance from deeper losses. Since that move my SMN position is now about -15% and my UYM is about +10%. Thus, my overall loss is actually stabilized now at around -5%. My plan is to wait for true signs of a commodity correction, sell UYM to capture that gain and ride SMN upward.

I would postulate that this technique could be used with these leveraged tools anytime there exists opposite pairings ( e.g. UYG vs. SKF, UKW vs. SDK, SMN vs. UYM, etc.), thus providing the individual investor a way to hedge/insure a smaller mistake from becoming an overwhelming mistake.

[Paulo]

Gary is right in pointing out that leveraged ETFs can work well for protecting positions without having to sell.
The size of a leveraged ETF position bought initially to short can be reduced as the market changes, to the changed objective of protecting positions. And for the rigorous, a stop loss at would prevent any significant loss on the remainder of the holding.
Buy and hold is definitely not the way to go.

[themicrokid]

I am not so sure, financials are dead. They seem to have a way to keep making money, probably because everybody has to use them. I am less certain, if a bottom is in. There seems to be a water torture way to try to find a new set of problems.

One of the most interesting investment methodologies I know of is the statistical work Robert Drach has done. He has data back to 1977 validating his timing model to beat the averages. He is heavy in financial's. At this web site, with data back to 1995, you can see his model portfolio changes every day. www.pbs.org/nbr/site/r.../

He has much better results on his subscription timing model.

And every time he goes long, everybody says, it's different this time.

********** Switching Gears********

Leveraged funds have a couple of other characteristics. 1) They are
not an investment in equities, but in futures and other derivatives. Therefore, they do not always meet their 2x objective, even while in a trend and occasionally beat it. 2) On some of them the spreads and the intraday hysteria may make them significantly off their tracking index.

I did a quick study on QQQQ, QLD, and QID to see some real cases.

I picked 5/19/2008 as the closing date and assumed purchases on three dates of an equal dollar amount. The first two dates were picked without paying attention to the market. The third was picked to assure the QQQQ's were high, to see, the effect of the QID's.

One issue with this study is leveraged ETF's are a new phenomena. I could have performed this with Rydex mutual funds and went back much farther.

Purchase 8/1/2006 a few weeks after the launch of QLD.
Gain 5/19/2008 QQQQ 37%, QLD 59%, QID -46%

If you were long QLD, you are much happier than long QQQQ. If you were long QID, you were out to lunch.

Purchase 7/31/2007 a year later.
Gain 5/19/2008 QQQQ 5%, QLD 1%, QID -16%

Spinning wheels, unless you were in the bearish QID.

Purchase 10/26/2007 chosen to have a fairly high QQQQ
Gain 5/19/2008 QQQQ -8%, QLD -20%, QID 9%

Only QID would have you happy and you would be much happier, if you had bailed from it on March 10, 2008. Gain 5/19/2008 QQQQ -23%, QLD -44%, QID 65%

This suggests, if you can play horseshoes with tops and bottoms, you can make yourself very happy with leveraged ETF's.

All these percentages are adjusted for dividend payouts. Yes, even leveraged ETF's may pay out dividends at times.

I write about topics such as this and other things at themicrokid.blogspot.c.../

[Paulo]

So if you are not sure financials are dead (and I am not either) you can use leveraged ETFs to protect your position(s). Even though leveraged ETFs are far from perfect you can still arrange things so as not to take a significant loss.
This is one of the things the above article may be trying to get across.