The panelists are three SA contributor portfolio managers who use ETFs in client portfolios and write actively on new developments in the field of exchange traded funds. Here are the panelists, their credentials and a preliminary writeup from each of them with their views on leveraged ETFs:

1) How, if at all, do you use leveraged ETFs in your own portfolios?

At the ETF Digest, we’ve recently launched an all leveraged ETF program for Dave’s Special Portfolio. In it we’ve broken down the current group to a dozen that are currently popular based on performance and liquidity. At the same time, we keep another two dozen or so in reserve to bring out as interest and liquidity build. Our approach is very short-term, with holding periods of a day or so if unsuccessful, to no more than two weeks if successful.

I have used ProShares Ultra Short S&P 500 (SDS) intermittently to hedge client portfolios. The weightings are always small -- initiating positions at 2-3% of the portfolio.

I prefer using funds covering broad indexes. The daily compounding of the sector products can be very difficult to anticipate and can be very ineffective for hedging purposes. Likewise with the 3X products. The variability along these lines with SDS is, to me, acceptable.

The craze of exchange-traded funds (ETFs) which employ leverage (the use of borrowed capital to increase the potential return of an investment) has been on a tear over the past year.* It makes sense that speculative investors would toy around with such vehicles given the extreme market volatility we’ve been experiencing of late. Combine that with the high level of conviction certain day traders have about which direction the markets will move in and when, and you can fully appreciate why the trading volume on these ETFs is so high.

Leveraged ‘inverse’ ETFs are part of this craze as well, allowing investors to take bets against sectors of the market which they expect to decline. Just to be clear, these leveraged ETFs are designed principally for experienced investors who engage in market timing. They wouldn’t generally be suitable for an inexperienced investor or somebody who didn’t fully understand the characteristics, including the risks of the product. The financial advisor channel uses leveraged ETFs as well. In my practice their primary use is as a hedging tool to lock in gains or limit losses on certain positions at certain times. The function which they do not serve, and most advisors will agree on this, is as core portfolio holdings. More on that below:

Most people grow old within a small circle of ideas, which they have not discovered for themselves. There are perhaps less wrong-minded people than thoughtless.

- Marquis De Vauvenargues, 1715-1747, French Moralist

A lot of authors on Seeking Alpha have noted that levered ETFs don’t behave as some investors intended to due to compounding effects. The levered or inverse products do what they say over a period of a single day, but not over a longer time-period. Recent examples are the post by Paul Kedrosky, where both levered bullish and bearish energy ETFs were negative simultaneously and another post by Matthew McCall, where he noted both a financials ETF and a 2x inverse financial ETF lost over the same period.

To understand better, assume the ETF asset follows a Geometric Brownian Motion (the same assumption used to derive Black-Scholes formula for options). The assumption is not perfect, but not far from reality.

Recent market turmoil and volatility has popularized short ETFs to nearly epic proportions. This meteoric rise in visibility provides an occasion for closer examination of five of the earliest of these funds, designed by ProShares in early 2007 to give investors short strategies in single sectors. ProShares launched the 22 sector pairs simultaneously, and Ultra Short Financials (SKF), Ultra Short Real Estate (SRS), Ultra Short Basic Materials (SMN), and Ultra Short Oil & Gas (DUG) currently have the highest three-month average daily trading volume out of the batch, all averaging well over a million shares per day. The ProShares Ultra Short sector funds are unique strategies that require unique consideration before investment. While the recent attention paid to SKF, SRS, SMN, and DUG has increased the perception of their accessibility, investors should examine the funds in relation to their “big picture” strategies and weigh the unique risks and rewards involved, before diving into the short end of the ETF pool.

ProShares sector ETFs were designed as pairs of strategies to track underlying Dow Jones formulated sector indexes. The ultra long ETF of each index would provide investors with a 200% exposure to the index while the ultra short strategy would offer a negative 200% exposure. The most highly traded sector ETF from ProShares, SKF, is based off the Dow Jones U.S. Financials Index (IYF) and has a corresponding ultra long ETF, UYG. The popularity of the ProShares ultra short products can be traced to the inherent riskiness of selling short equities in an open market, thereby exposing oneself to unlimited potential downside if the equity price goes up.

I am a skeptic on leveraged ETFs in one way. My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.

To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index. There is also slippage from rolling futures from month to month.

Utilities tend to outperform when the economy is in a downturn, and with many of stocks now finding long term support levels and attractive valuation, it looks like a sector that some new money could flow into over the next few months, and is an eye-catching investment.

On, 9/16, we issued a bearish note on the utility sector due to valuation, debt concerns amid a credit crisis, and declining margins. We recommended going long the Ultra-Short Utility ETF (SDP) at $73. The SDP traded to $140 as recent as last Friday and we are now flipping our position and becoming bullish the sector. 

Market participants know that the ProShares Short and UltraShort ETFs have become wildly popular.  These ETFs allow investors with long-only accounts to easily bet against the market or hedge their bets.  The ProShares Ultra ETFs provide either double or double the inverse of the daily returns of the asset classes they track.  In the current market environment, the UltraShort ETFs have been huge winners.

For those interested, below we highlight all of the ETFs currently offered by ProShares.  We also include the year-to-date performance of each one, along with its current percentage from its 50-day moving average (to measure overbought/oversold levels).  As shown, the Ultrashort Financial ETF (SKF) is up a whopping 67% year to date, as financial firms have fallen across the board.  SKF is trailed by the Ultrashort Semiconductors (SSG), Ultrashort Russell 1,000 Value (SJF), and Ultrashort Dow30 (DXD) as far as year-to-date performance is concerned.

ProShares has a diversified lineup of ETFs that allows investors to adopt various strategies based on individual sectors, market-cap, desire to be long or short, etc.

Of the 64 ETFs currently offered, it is clear that some are more popular than others. This popularity is translated into trading volume.

ProShares has offered a variety of "Ultra" and "UltraShort" sector ETFs for more than a year now. These funds are designed to track twice the return of the underlying index, and each corresponding long fund is created to match its corresponding short.

There is no doubt that these ProShares offerings have been the subject of a great deal of interest. They promise the rewards of leveraged sector returns without the headache of margin or portfolio construction, allowing profitable bets with less capital and less risk. This might not come for free, however, and many have investigated how closely these funds track their double-return target in terms of price. For more on that topic, I suggest this article directly from ProShares.

Global Utilities ETFs
iShares S&P Global Utilities Sector Index Fund (JXI)
SPDR FTSE/Macquarie Global Infrastructure 100 ETF (GII)

In this article, we lay out the case against these products, based upon popular misconceptions of what exactly these ETFs provide, a hidden trap related to leverage, and the poor performance of related funds and of the ETFs themselves.

ProShares Ultra Sector ETFs
ProShares Ultra Basic Materials ETF (UYM)
ProShares Ultra Consumer Goods ETF (UGE)
ProShares Ultra Consumer Services ETF (UCC)
ProShares Ultra Financials ETF (UYG)
ProShares Ultra Health Care ETF (RXL)
ProShares Ultra Industrials ETF (UXI)
ProShares Ultra Oil & Gas ETF (DIG)
ProShares Ultra Real Estate ETF (URE)
ProShares Ultra Semiconductors ETF (USD)
ProShares Ultra Technology ETF (ROM)
ProShares Ultra Utilities ETF (UPW)

The leveraged ETFs are: ProShares Ultra QQQ ETF (QLD), ProShares Ultra S&P500 ETF (SSO), ProShares Ultra MidCap400 ETF (MVV), ProShares Ultra Dow30 ETF (DDM), ProShares Ultra Russell2000 ETF (UWM), ProShares Ultra SmallCap600 ETF (SAA), ProShares Ultra Russell1000 Value ETF (UVG), ProShares Ultra Russell1000 Growth ETF (UKF), ProShares Ultra Russell MidCap Value ETF (UVU), ProShares Ultra Russell MidCap Growth ETF (UKW), ProShares Ultra Russell2000 Value ETF (UVT), ProShares Ultra Russell2000 Growth ETF (UKK), ProShares Ultra Basic Materials ETF (UYM), ProShares Ultra Consumer Goods ETF (UGE), ProShares Ultra Consumer Services ETF (UCC), ProShares Ultra Financials ETF (UYG), ProShares Ultra Health Care ETF (RXL), ProShares Ultra Industrials ETF (UXI), ProShares Ultra Oil & Gas ETF (DIG), ProShares Ultra Real Estate ETF (URE), ProShares Ultra Semiconductors ETF (USD), ProShares Ultra Technology ETF (ROM), and the ProShares Ultra Utilities ETF (UPW).

Roger Nusbaum submits: ProShares finally listed its ultra sector ETFs. They go double long or double short eleven sectors or sub-sectors.

I wrote about a possible market neutral trade involving these a while back, and I had an article run on TSCM over the weekend that captures the idea with more detail.

It’s not immediately clear if ProShares will launch the straight short funds later; the group has already filed for these funds . Those have always been the least interesting products in the ProShares line-up, as investors can short traditional ETFs and earn the same exposure. The short funds seemed to be a legacy of ProShares’ days selling traditional mutual funds, where being able to go short was a big innovation.