Save Your Capital: Avoid Touching Leveraged ETFs

Summary

• The desire to short equities is high in today's market.
• Using inverse bear ETFs seems like a simple way to express a bearish view.
• Avoid the trap of using leveraged ETFs.

Over the past couple of months, we have had no less than ten investor inquiries about using leveraged/inverse ETFs to either profit in this bear market or to hedge portfolios. Since most questions deal with shorting the S&P 500 or taking aggressive positions in the gold miners, we will illustrate our advice using these two asset classes. Leveraged and inverse ETFs are complex financial products that rely on the use of derivative contracts to replicate or amplify the underlying index returns. Importantly, leveraged ETFs do not amplify the annual returns of an index but instead track the daily changes. The NAV (net asset value) is calculated based on the daily percent changes in the underlying index. Herein lies the major pitfall for those hoping to "invest" in a leveraged ETF.

To illustrate how the NAV of a leveraged ETF is calculated, we created a simple numerical example. We note months in the time column (in order to make the large periodic percent changes larger and quickly show the impact of volatility on the ETF's NAV), but again, the NAVs are really calculated based on daily percent changes in the underlying index.

Price Divergence Example: 2x Bear ETF
Time	Index level	Index % Change	ETF Price	ETF % Change
Month 1	100		100
Month 2	90	-10.00%	80	-20.00%
Month 3	75	-16.67%	53.33	-33.33%
Month 4	83	10.67%	64.71	21.33%
Month 5	89	7.23%	74.07	14.46%
Month 6	70	-21.35%	42.44	-42.70%
Month 7	92	31.43%	69.12	62.86%
Month 8	96	4.35%	75.13	8.70%
Month 9	88	-8.33%	62.61	-16.67%
Month 10	97	10.23%	75.42	20.45%
Month 11	100	3.09%	80.08	6.19%
Profit/Loss		0%		-19.92%

Click to enlarge

The above table assumes a generic 2 times reverse ETF. The first month (day) down shows a -10% loss for the index. The ETF falls -20%, as expected. So far

Analyst’s Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.