Some Thoughts on Leveraged ETFs

Includes: CS, DB, GS, QLD, SCGLY, SDS, UBS
by: Don Fishback

I’ve gotten a bit of criticism from some know-it-all traders who are big fans of the leveraged ETFs. Those who defend the funds say that leveraged ETFs are perfect for those who know how to use them. They derisively state that anyone holding these funds for the long term is an uneducated lame-brain. They claim that the leverage stated is clearly meant for the funds’ daily performance, not for the long term. Well, it is true that the funds state that the multiplier is calculated off of the daily returns.

But here’s where their supportive claims fall flat. These users of the ETFs also state that the funds adequately and clearly disclose that leveraged performance is isolated only to the daily performance. Further, leveraged ETF supporters say that anyone who uses these funds for a long-term bet is idiotic for not knowing that leverage claim made by the ETF fund companies only applies to the daily tracking.

For instance, when talking about how the leveraged funds failed to perform up to expectations for the long-term, one commenter at Seeking Alpha (Marc) stated that the funds “…failed to deliver on a promise that they never made.” Another (ursmax) told me, “Had you taken just a few minutes to at least skim the prospectus plus (especially the) supplemental material you couldn’t have helped but notice the foolishness of your trade: trying to make a profit by holding any leveraged ETF for an extended period of time, especially during times of very high volatility. But here you are, crying “foul” and blaming the fund company. It’s never your fault, isn’t it! I hope you learn from this lesson, and educate yourself next time BEFORE clicking the buy button instead of whining afterwards.”

First, I never said I was in one of these products. At the time, I was speaking primarily to the fact that they were a potential source of late-day bursts in volume and volatility, and that they never lived up to their “implied claim”

But what’s most important is the supporters’ claim that the ETF companies never said these products were suitable for long-term holdings. Really? Perhaps these folks are the ones who never read ProShares’ prospectus.

It’s been my contention for a long time now that something needs to be done about the leveraged ETFs because there are numerous investors who simply don’t realize that the leverage-tracking performance is isolated only to the daily change. And, they have good reason to think that way. Take a look at the charts below (). They’re in an image-capture from the prospectus that I downloaded today. It’s the same prospectus they’ve used since October 2008. It shows the performance of a leveraged bull fund over a one-year period, not one day.

IMAGE Prospectus1 Why Do People Think That Leveraged Funds and ETFs Should Closely Track the Index Times the Multiplier Over the Long Term?

So what does this mean? Well, take a look at the text in the next image-capture, where it says, “The graphs demonstrate that, for periods greater than one day, a leveraged Fund is likely to under-perform or over-perform (but not match) the index performance (or the inverse of the index performance) times the stated multiple in the Fund objective).” So far, so good.

But here’s where an unfamiliar investor can get in trouble. The charts show a hypothetical performance of a fund with 200% leverage over a one-year period. That is double the index gain or loss. The impression you get from the charts are: if the index gains +15.0%, the fund will gain +29.3%, if the index loses -15.0%, the fund will lose -29.4%.

So what’s the under-performance/over-performance in these examples in the prospectus? In the bull market scenario, the +200% fund underperforms the multiplied index by a mere 0.07 percentage points. In the bear market scenario, the -200% fund over-performs the multiplied index by 0.06 percentage points. Got that? According to the prospectus, the difference between the index times the multiple and the ETF is a miniscule few basis points!

IMAGE Prospectus2 Small Why Do People Think That Leveraged Funds and ETFs Should Closely Track the Index Times the Multiplier Over the Long Term?

Click images to enlarge

But in the real world, that’s not what happened. The S&P 500 Depository Receipt is down about -21%. The 200% leveraged bull ETF is down about -50% — worse by 900 basis points. Meanwhile, the leveraged bear fund, which would have made a bucket load of money had the ETFs behaved as the charts implied, is down about -28%. Reality doesn’t even come close to what’s described in the prospectus, as the bear fund, which should have made money when the market fell, is in deeply negative territory! It is not off by just a few basis points as the prospectus seems to suggest!

IMAGE ETF1 Small Why Do People Think That Leveraged Funds and ETFs Should Closely Track the Index Times the Multiplier Over the Long Term?

Click image to enlarge

But here’s where it gets even worse. ProShares’ current prospectus has numerous additions to it, the latest being about two months ago, May 26, 2009. There was another supplement on April 7, 2009 that contained performance information. That supplement is on page 2 and 3 of a 169 page document. You’d think that the performance info available on April 7 of this year would have near-current information, right? WRONG!

The latest performance data in the April 2009 prospectus supplement was for 2007! 2007!!

IMAGE Prospectus3 Small Why Do People Think That Leveraged Funds and ETFs Should Closely Track the Index Times the Multiplier Over the Long Term?

Click image to enlarge

2007 data is the most recent data ProShares could come up with in April 2009? All I know is that the data in 2007 sure looks a lot better than the data in 2008, especially for the leveraged bear ETFs.

So that’s why I have a problem. Not because these funds are bad. The ETFs are fine, as long as you know what you’re doing. But that’s not how they’re marketed. And the 169-page prospectus doesn’t help. It begins with a performance table showing outdated information during a favorable time period. That’s quickly followed by hypothetical long-term performance charts that indicate these ETFs will behave close to the index times the multiple. But real-world experience shows these charts don’t come close to real-world behavior.

Listen, I am truly sympathetic to the traders who use these funds properly. And I don’t want them banned. I’ve known about the tracking flaw for years (it’s a logarithm issue). I just want everyone who uses them to know that they are far riskier than a lot of people thought. The prospectus does not give an accurate, current or sufficient portrayal of how these things really work. And to those who say that beginners shouldn’t use them, I agree. Make users of these funds sign a risk disclosure statement similar to what you have to do when you trade any other leveraged derivative like options or futures. And don’t let anyone trade them until they’ve gotten a chart like the Bloomberg chart above showing how they’ve truly performed the past year.

P.S. – Checking ProShares annual report, you’ll find the banks with whom the ETFs have swap agreements. And yes, UBS, who has banned their customers from trading these products, does supply swaps to the funds, as does Goldman (NYSE:GS), Deutche Bank (NYSE:DB), Credit Suisse (NYSE:CS) and Societe Generale (OTCPK:SCGLY). Now that’s ironic!

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