Everybody Hates Leveraged ETFs

by: Mauneel Desai

Last week, Edward Jones said that it will stop selling leveraged ETFs. This Monday, UBS (UBS Wealth Management Americas) announced that it has suspended the purchase of leveraged and inverse ETFs for its wealth management clients. Both firms cited the short-term nature of these securities as a reason. The State of Massachusetts has also launched an investigation into the leveraged ETFs.

These ETFs have also received a lot of flack from the regulatory agencies like SEC and FINRA. They all say the same thing - these are for sophisticated investors only and they are not long-term investment vehicles.

My question is, what made anyone think that these ETFs should be used for long term investing?

These companies have detailed brochures which outline the risks associated with leveraged ETFs. If you glance at their website, or even search for these ETFs, you will find ample details about the high risks and the short-term nature of these ETFs. The websites of Proshares, Direxion and Rydex have listed the disclaimers on their website as well. They clearly state that they seek DAILY investment result of 200% or 300% investment of the price performance of the Index they follow (or its inverse in the short ETFs).

I am still not sure if certain allegations regarding these ETF companies trying to mislead investors hold any truth. They are not forcing anyone to invest in their products.

The bottom-line is that long-term and 'buy-and-hold' investors should stay away from these investments or be clear about the risks they carry. They should preferably be used by sophisticated investors and day traders.

It's very important to understand the concept of "daily performance" for these ETFs. Let's take an example of FAS. FAS is a triple leveraged (3x) product from Direxion. FAS seeks daily investment results of 300% of the price performance of the Russell 1000 Financial Services Index.

Now YTD, the Russell 1000 Financial Services Index is up 2.1% thanks to the nice rally in Financials after the March 09 lows. This does not mean that FAS would be up 6.3%. In fact, FAS is down a staggering 63% YTD.

Let's look at an inverse ETF - SDS. SDS is a product from ProShares that seeks daily investment results that correspond to twice the inverse daily performance of the S&P 500 Index. If you see the 52-week performance of S&P 500, it's down 20%.

If that leads you to think that SDS should be up 40% (twice the inverse), you might be in for a bit of a shock. SDS is actually down 32%. That's the reason for the stress on 'Daily Performance'. If you look at the daily performance of these leveraged and inverse ETFs, they are fairly close to the indices they track and that's their intention as well.

During the market crash last year, inverse ETFs like SKF (ProShares UltraShort Finance), SDS (ProShares UltraShort S&P 500), BGZ (Direxion 3X Bear Russell 1000), DXD (ProShares UltraShort Dow 30), FAZ (Direxion 3X Bear Russell 1000 Financial Services), SRS (ProShares UltraShort Real Estate) and others were very popular.

At the same time their leveraged counterparts (UYG, SSO, BGU, DDM, FAS, URE) lost tremendous value because they were performing twice or thrice worse than the indices. The markets picked up after the October lows into January 2009 only to drop to historic lows in early March.

After the March 09 lows, the market has had a steady rise for the most part. It's extremely volatile markets like this one that make it impossible for the leveraged or inverse ETFs to perform over a longer period.

Unless your timing of buying and selling these ETFs was immaculate, if you held these ETFs for the last year or so, they have underperformed the respective indices by a substantial margin. In a more directional market (either bullish or bearish), the performance of these ETFs might be better or at least predictable. But when the market makes historic lows and follows with a 36% rise in a matter of few months, it's impossible for these ETFs to perform consistently.

So why do leveraged ETFs fail to perform over a longer period of time? Leveraged ETFs are traded very actively since they seek the daily performance of the index they follow. Imagine trying to get twice or thrice the return of a particular index (or its inverse) on a daily basis! Leveraged and inverse ETFs use options, futures, swaps and other derivatives to gain the desired performance. The leveraged ETFs 'reset' every day and their goal is to make sure that for any given day they give the stated performance with respect to the particular index.

Let's look at an example of BGU which seeks thrice the performance of Russell 1000 index. Let's say for month 1, Russell 1000 index was up 10% and for month 2, it drops 10%. At the end of these two months the Russell Index is down only 1% [(1.1) * (0.9)].

Now let's examine BGU. For month 1, BGU would be up 30% and for the month 2, it would be down 30%. At the end of the two month period, BGU is down 9% [(1.3) * (0.7)]. Theoretically, it should have performed three times worse as the Russell 1000 index - down 3%. The most important thing to understand here is that compounding works both ways.

There is a good article on leveraged ETF performance and calculation here.

The bottom-line is that in this kind of a market, leveraged ETFs should be used by day-traders or experienced investors. If someone still feels compelled to invest, they should fully understand the purpose of these ETFs and risks associated with them. If you were lucky enough to make a good profit with these ETFs, it might be a good idea to protect your profits rather than riding the wave on the down side - remember compounding works both ways.

Disclosure: Option Spreads in BGU and BGZ.