The Case Against Leveraged ETFs

Tristan Yates and Lye Kok (IndexRoll) submit: The Leveraged ETF offensive is under way. A year ago, there were no leveraged ETFs in existence. Today, there are at least fifty leveraged ETF products in the marketplace and another fifty in the SEC/AMEX pipeline. By this time next year, perhaps every traded ETF will have a 2x leveraged counterpart. Are these leveraged ETFs suitable for retail investors? No, they are not.

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.

Note that this article updates a SeekingAlpha article posted about six weeks ago, and we’d like to thank the many readers who were kind enough to provide us with additional research and commentary.

The Daily Double

Leveraged ETFs are exchange-traded funds that are based upon well-known indexes, but that provide investors with additional leverage by using borrowed money. Their goal is to increase the return of the underlying index and provide a better return for the fund’s investors. Typically they provide $1 of debt for every $1 of investor equity, and are marketed as 2X funds.

Leveraged ETFs are implemented using financial derivatives, such as options, swaps, and index futures. All of these tools are available to individual investors, but are much more complex than traditional share buying and selling and require larger amounts of capital. Thus, the advantage of the leveraged ETFs for many investors is a reduction of complexity and lower capital requirements.

Two companies, Rydex and ProShares, dominate the leveraged ETF marketplace. They have offered leveraged investment funds for many years, and have recently repackaged these products into ETFs.

A listing of some of the more popular ProShares leveraged funds:

A widely held misconception about these funds is that they will offer twice the return of the underlying index, which means that if the S&P 500 returns about 10% a year, then the SSO should return 20%. But that’s not true, because these funds only double the daily return, and there’s a big difference between doubling the daily return and doubling the annual return.

What’s the difference? Let’s say that one day the market goes up 10%, and the next day it falls 10%. The two-day loss for the index is 1%, but the loss for the leveraged fund is 4%. Here’s why:

Index: (1 + 10% ) x (1 – 10%) = 1.1 x 0.9 = 0.99, 1% loss
X2 Fund: (1 + 20%) x (1 – 20%) = 1.2 x 0.8 = 0.96, 4% loss

Thus over a two day period, this fund’s losses are 4x the amount of the index, not 2x. This example comes from the ProShares prospectus, and is a clear indication that investors in 2X funds should not expect their investment to provide double the return of the S&P 500 for any period longer than one day.

Historical Returns

How much do daily doubled returns diverge from doubled annual returns? To find out, we created an imaginary fund called X2. X2 simply provides double the daily return of the S&P 500 index. We invested $1 in the fund and compared it to a $1 investment in the SPY over the fourteen-year period.

Note that this fund is imaginary by definition – there are no management fees, transaction costs, or capital costs. It is simply used to provide an illustration of the potential of a 2x leveraged fund.

The annual returns are close to double the SPY for the most part, but some years are off. In 1994, the X2 fund only provided 1.35x the return of the SPY, rather than 2X as expected. In 2001, the X2 fund provided 4.17x the loss of the SPY.

As a long-term investment, the X2 fund provides very good returns. Most years have positive double-digit returns. $1 invested in the X2 fund in 1993 would return $11.08 by the end of 2006, as compared to only $4.07 for the SPY.

However, if the investor had the misfortune to invest at the peak of the market, at the end of 1999, the investor would have lost 61% of the investment in the next three years, and would still have a loss by the end of 2006. Our X2 fund is a solid performer in the good years, but suffers disproportionately during the downturn and can’t recover its losses in the next rally.

Constant Leverage Trap

Let’s take a moment to see how a leveraged ETF works. In order to deliver the 2x results that the fund’s investors expect, fund management has to hold equal proportions of debt and equity at all times.

In other words, if there’s $100m invested in the fund, it has to borrow an additional $100m and make a $200m investment in the underlying index. That’s the only way that the fund can provide 2x the underlying daily return of the index.

Of course the fund doesn’t go to the local bank and borrow money every day and then invest it. It uses financial derivatives, such as swaps, options, and futures. But the overall effect is the same.

However, every day the market moves and the assets in the fund either increase or decrease in value, throwing off the leverage ratio because total assets are no longer equal to total debt. By the end of the market day, the fund’s leverage is either too high, or too low, and some kind of corrective action is required to bring it back to 2x.

In order to maintain the target leverage ratio, our fund has to buy or sell millions of dollars worth of shares every day. Not only does this increase expenses, transaction costs, and short-term capital gains taxes, but it’s also just a bad investment strategy.

Whenever the market makes a big move downward, the fund sells shares and reduces its debt level in order to maintain its target leverage ratio. This locks in losses and reduces the afund’s sset base, making it much harder to recover gains in the next market upturn.

Note that this situation is called the Constant Leverage Trap and is a well-known problem in financial modeling. Investment portfolios that try to maintain constant levels of leverage over time perform very poorly in bad market conditions because they sell off large percentages of their assets. It’s similar to a margin maintenance call.

X2 Implementations

Our X2 fund is imaginary for one important reason – nobody will loan us $100m to invest without charging interest.

In the real world, trading costs money, administration costs money, and money costs money. Funds like the ProShares ETFs have transaction costs, expenses, and costs of capital. Put all these costs together, and a lag is created between an investor’s expected and actual results.

We’ll look at two ETFs: SSO and QLD by ProShares. Neither has been around that long, just about nine months. We compared the funds' nine-month performance to a doubled daily return of the underlying index. Note that the prices used are adjusted for dividends.

Both ETFs have a big lag over the expected doubled daily performance. It’s not clear why the lag is so large, but it’s likely due to high transaction costs and management fees. Maintaining the required portfolio of financial derivatives may be more costly than expected.

Because the QLD lost about 0.7% every month due to lag, the fund’s investors had a hidden expense in their investment. This expense lowers short-term gains, long-term gains, and most importantly, future gains from investment compounding.

Note that some lag will always be unavoidable because the fund will be charged short-term interest on its leveraged investments. The current interest rate used in options calculation is approximately 5.25%, and it is reasonable to expect that a fund would pay that rate. Because this rate would only apply to the half of the portfolio that is debt, we would expect a 2.63% annual lag, minimum, on our fund, based upon just the interest cost alone.

Leveraged Funds

In order to learn more about leveraged ETFs, we have to look at original set of funds that they’re derived from. ProShares, Rydex, and Direxion all have offered leveraged funds based upon the indexes for several years. We reviewed the long-term performance records of some of these funds from their websites.

Note that there are at least fifty different leveraged funds for an investor to choose from, but these funds listed below seem representative of the larger population of leveraged funds.

The leveraged fund returns are shocking. The two Rydex leveraged funds are still in negative territory after almost seven years. Two other funds have returns that look like Japanese bonds. Only the ProFunds Ultra Midcap fund has an acceptable long-term return.

What happened? All of these funds were started just before the stock market downturn in 2000. Due to the use of constant leverage, they sold shares in the down market, and didn’t have enough of an asset base to recover. That’s why even with their leverage, they’re still poor performers.

What if we were able to avoid the downturn? Would we have sidestepped the losses and racked up huge gains in the next bull market?

For almost five years, we have been in a bull market, and the leveraged funds have performed well, but not exceptionally. They certainly haven’t provided double the performance. Three unleveraged low-cost Vanguard funds are provided below for comparison.

The fact is that the track record of leveraged index funds is poor. During the bull markets, they perform a little better than low-cost unleveraged funds, but during the downturns, they really suffer. We should expect the current crop of ETFs to perform the same way.

Conclusions

1. Many investors are misled by these leveraged ETFs and believe that they’ll get twice the daily return of the underlying index over the long term. In other words, if the index returns 10% next year, they’ll get 20%. But doubling a string of daily returns is not the same thing as doubling the annual returns, so investors should not expect that level of performance, unless they somehow rebalance their portfolios every single day.

2. Even just looking at X2 funds as a theoretical concept, the idea has some problems. The only way for a fund to maintain a constant leverage ratio is to buy shares whenever prices go up and then sell them when prices go down. This buying and selling activity increases the underlying volatility, and can lead to huge sell-offs in down markets that are impossible to recover from in the next bull market. This effect can be seen in every leveraged fund that went through the 2000 to 2002 downturn.

3. The current ETFs do not even deliver twice the daily performance of the underlying index. In just the nine months that the products have available, a lag has emerged between theoretical and actual performance. This lag is 3.3% for the SSO and 6.4% for the QLD. Given this lag, we could extrapolate that over several years, these funds would greatly underperform their theoretical X2 counterparts and at some points, even the underlying indexes. Note that a lag is unavoidable because of interest costs.

4. Investors should compare these new ETFs to the leveraged funds that were offered by these same companies seven years ago, because the long-term performance will most likely be similar. These funds were hit hard during the downturn and never really recovered during the next bull market.

I want to make it clear that I am not saying that leveraged indexing is a bad idea. I’ve written many articles on the subject and find that it has tremendous potential. The underlying concept, borrowing cheaply to make long-term investments in a total stock market index, is based upon both solid historical data and Nobel-prize winning academics.

But until new products are available, based upon the short-term results of SSO and QLD, the long-term results of the leveraged funds, and the mathematical pitfalls of constant leverage, I would suggest that investors avoid holding these leveraged ETFs as investments. If a leveraged indexed investment is desired, the best solution is still call options, index futures, or conventional index ETFs held in a margin account.

Comments

[smcanuck47]

good article...

one thing i don't think is stressed enough is that there is a capital/interest cost.... no bank counterparty will give you leverage for free.

so if you pay 3.5% interest and the underlying does 8% your return is 12.5% for double leveraged vs. 8% for underlying.

leverage is not "free" anywhere but that's by the far the biggest element of difference between double leverage etf vs. double the underlying.

as you said yourself, in the long term the difference between your theoretical double etf and double the underlying tracked very nicely. (there are certainly other areas where there is slippage - management fee, excecution etc.)

but the big difference is the leverage cost IMO... i could be wrong but i don't think i am

[smcanuck47]

sorry, i apologize you do mention the interest cost in your article...

and you are the only commentator i've seen so far that does.

too many people look at the somewhat non-intuitive mathematics of daily leverage (implementing daily vs. then measuring performance annually for example) and then say that is mostly why the double leverage etf did 10% when the underlying did 7.5%.

management fees, interest cost and other slippage simply dwarfs the mathematics of double leverage etf's

double leveraged short etf's i think the arcane math makes a much bigger difference. some people lost 70% of their money on something that on the surface looks like they should have made 100%+. there were a few examples (double short china and double short r/estate from vague memory)

thanks for bringing up the interest cost because i've never seen it mentioned before.

[3xetf]

simple way to beat this short the inverse fund you want to buy
IE you want to go long QQQ and be leverage 3x (TQQQ)
Short the SQQQ then you can profit on the maintance and other cost.
Just look at the difference for 1 day

TQQQ 47.25 +1.35 +2.94% Jun 8, 4:00PM EDT
SQQQ 51.20 1.56 -2.96% Jun 8, 4:00PM EDT
.02 % not much but it will add up
but look at gold much better return shorting vs buying
NUGT 12.37 +0.20 +1.65% Jun 8, 4:00PM EDT
Dust 43.69 0.91-2.04% Jun 8, 4:00PM EDT
.39% more for a single day that could make a big difference
Natural gas has much higher expense and shorting the inverse would be much smarter then buying
UGAZ 17.89 +0.40 2.29% Jun 8, 4:00PM EDT
DGAZ 74.53 -2.29 -2.98% Jun 8, 4:00PM EDT
.69 % more for a single day shorting inverse vs buying ;)
Profit off the maintance short ETF'S

[Dirk Burhans]

Great article, very informative... will file for reference use. Thank you!

[glenb]

Very informative article which is well laid out. I was going to buy some leveraged funds and noticed that their performance was living up to expectations even with the market upturn in the last 6mo, but didn't understand why. If I want leverage I will borrow the money and invest it myself.

[dr.mcmc]

@aspiring_beginner and angleabates... that's great that you're presently making money going in/out of the market using moving averages, just know that the market often moves in ways that quickly violate such "rules". The market tends to periodically kick such strategies squarely in the ass. The success patterns of such "rules" are usually temporary and most participants don't discover that fact until their 85% return has dwindled to -15% (or some such) when the so-called "rules" have changed.

My main struggle with the article is that it appears to conflate two things. It describes how 1) the daily settlement in these leveraged ETFs prevents them from matching the annual return of the underlying index, and 2) that this in turn prevents one from making money if one invests at the wrong time--such as when the market is at a high point. To me, these are two very true but unrelated facts. If one invests at a market high, one will lose money, at least temporarily--with or without leverage.

One ought to find success with leveraged ETFs provided one's average daily returns over the life of holding the ETF are positive (assuming 0% interest) or above the underlying interest rate/cost of leverage (e.g., 5.25% in Yates & Kok's article).

Given that one's actual daily returns are going to be random and unknown--but with an assumed mean and standard deviation, the ideal leverage amount can be found using the Kelly fractional betting formula. (I'm curious as to the origins of Gandulu's comment/formula above.) Using the Kelly formula and Gandulu's assumptions for return (10%), interest rate (6%), and daily fluctuation (1%), I find the optimum leverage amount to be around 1.6. This is below the 2x leverage in, say, SSO, which suggests you not invest your entire portfolio in an S&P-based 2x ETF. This 1.6 value is more conservative than Gandulu's result.

My question is: why invest in a leveraged ETF vs. simply buying the underlying index on margin? (Recall, as Tristan said above, that there's indeed an interest cost embedded in the leveraged ETF). I suppose the advantage of the ETF is that it is settled daily and so you're never going to get a margin call (and certainly not in the direct sense). It's also a way to juice the returns (and risk) of an RIA to which you couldn't otherwise apply margin.

[aspiring_beginner]

Robwynge:

EXCELLENT COMMENT!!!!!!!!!!!!!!

You and angelabates are the only two who seem to "get it".

-aspiring_beginner

[aspiring_beginner]

Cory:
A CORRECTION: I was thinking in terms of a "bear" 2X fund. For that type of instrument, then yes, if the index goes down 50%, the ETF share price goes down a THEORETICAL 100%.

I'm not sure what the math is for a Bull 2X fund. I think that maden might have the math right on that one.

-aspiring_beginner

[aspiring_beginner]

Corey:

Yep. But why are you thinking about an index going down 50% in one day? 1987 was 25%.

[aspiring_beginner]

deepfryer:

Right On.

[aspiring_beginner]

bws9322:

The only thing that matters, really, are percentages. And most of the major INDEX BASED ETF'S do an excellent job at tracking the indexes almost perfectly, at least within a short term, say less than a month.

I use TZA and TNA, both are 3X. If the Russell 2000 (the underlying) moves up 1%, the TNA moves up 3%, almost exactly. There is sometimes a tiny "bleed", what some people call "decay", but it is trivial over short time periods.

I recommend doing a spreadsheet using REAL WORLD ( NOT simulated) levels of the Russell and the TZA and TNA products. Do your spreadsheet for 1, 2, 3, and 4 weeks. You'll find that the total cumulative percentage moves of the ETF and the Russell are virtually identical (or triple if using TNA and TZA).

-aspiring_beginner

[aspiring_beginner]

msangelabates:

"The secret to profiting from this game is to develop and follow a strict technical trading methodology. I use short term moving average crossovers as the indicator of market pivot points, thereby profiting on up as well as down swings in the underlying market. "

Finally, an intelligent comment on the subject. You are so right on, it is amazing. This is exactly what I do, and it works fantastically. Congratulations. You're the first person (and I've read hundreds) who have gotten this very simple concept right.

I agree with absolutely every word you wrote. My techniques are virtually identical. I use a 5 Simple DMA with 3.5% Moving Average Envelopes. I've made 84 % in ten months.

-aspiring_beginner

[aspiring_beginner]

Tristan:

" Are these leveraged ETFs suitable for retail investors? No, they are not."

BULL.

Your whole article is full of so many errors I can't begin to address them all.

Please search for and read all my many posts on the Leveraged ETF's.

Thanks,

-aspiring_beginner

[Trader33]

I get the fact that holding Leveraged ETF's for > 1 day is risky however, there is a scenario in which it is beneficial for one to hold these investments beyond one day. The scenario I am talking about is if your are relatively certain their will be a "run" in either direction, however banking on the run and its excess return needs to be compared with the downside. The downside is extreme so squeezing this for the little extra return is not worth it. Just wanted to put this scenario out there though.

[tonythefreak]

Goal of almost every leveraged fund is to return a multiple of an underlying index/sector/group on a DAILY basis. Holding beyond that time period has more risk-- MUCH more risk...

One of the risks of ANY fund is that it may not achieve it's Goal. Market efficiency does not hold the Leveraged ETF (LETF) to the same standard as exchange traded stocks, or even ETFs in a derivative fashion.

Using these LETFs in a different way than what is intended (and published in disclosures) - will likely lead to losses if the position is not VERY closely tracked.

There have been recent law suits initiated by people who have purchased these types of instruments and have been surprised that their goals (appreciation over periods longer than a day) have not been met. An interesting link that discusses this in more detail.

etfdb.com/2009/breakin.../

I Use LETFs and love them but rarly if ever hold overnight.

[Trader33]

I was wondering if someone can help me with this:
Today I was following UYG ProShares Ultra Financials & the index it tracks ^DJUSFN. According to all the posts I have read, the daily return of UYG should mirror 2x the ^DJUSFN. However, at the close today UYG was -.03% and ^DJUSFN was +.07%. UGY should have reached +.14% at the close because the trade duration was only one day, but this didn't happen. Was this because there was more leverage on under performing stocks in the UYG ETF? Or is there something else at play here? Thanks.

[dirtyharry]

Here's an idea: Since the bias is DOWN for both long and short leveraged ETFs, why not go with the flow? When the market hits interim highs, sell short the leveraged LONG version of the ETF and never go long (buy) on either the leveraged long OR short version of th ETF. By only trading these at perceived market tops and only shorting the levereaged longs, the long term bias down is always working in your favor when you execute this trade.

[widestrides]

Soon, there will be MONTHLY leveraged ETFs and they will be designed to track the indexes x2 or x3 but on a monthly basis. This will help ease the concern about the compounding and volatility issues.

[widestrides]

To those who think these are a good long term investment for your IRAs, etc., I would say that if it trends your way consistently, you will do well, but if there is choppiness and volatility along the way, you would actually do better in the 1x ETF! It's just a matter of math and compounding.

FAZ and FAS are the perfect example or the perfect storm AGAINST 3x ETFs. First FAZ skyrocketed as the financials plummeted. But then it plummeted as the financials recovered. The result of that huge up and down wrecked both FAS and FAZ.

If the market goes up and down, BOTH leveraged ETFs will lose.

[widestrides]

Shorting both sides works if you expect up and down market for your time frame. But if the market trends one way, you will lose more on the uptrending one than you will gain on the downtrending one. If you've got deep pockets and can hold on until the uptrending gone comes back down, you will do well.