Apr

30

V KThere is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments. On the surface they make a lot of sense. You want to hedge your stock portfolio, for instance, you buy a double short ETF of the market SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%. It does sound like a great deal. Leveraged ETFs have been sold as panacea to this market volatility, but panacea they are not. If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use. They should not be used as a long term investment, but only for short-term trading (i.e. days not months).

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index. The math is too complex and too boring (an article by Morningstar explains it well), but instead let me demonstrate by this very real example (chart here).

Let's suppose that six months ago you had a great insight that financial stocks would decline. You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF). The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%. However, if you look at the chart  you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index.

Note that over the short term (days) these ETFs seem to work. This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are in trouble.

Marlowe Cassetti comments:

I have been both an ETF junkie as well as a mechanical trading system developer. Why not combine the two? I have found trading systems that operate on a basket of ETFs tend to suffer from the inclusion of the leveraged ETFs into the basket. This leads me to infer that the leveraged act more randomly then their cohorts. With that knowledge I was confronted with my system picking UltraUltra-Short Estate ProShares (SRS). I held my nose and bought it anyway and turned a nice 8% profit in two days, all the time watching it with high anxiety.


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3 Comments so far

  1. Phorgy Phynance on April 30, 2009 6:26 pm

    It isn't exactly the whole story to show leveraged ETFs over the last 1-2 years, which just happens to correspond to the worst financial crisis since the great depression.

    Here is what the long term returns would have looked like if some of the these leveraged ETFs had existed going back to 1995,

    Bloggers Missing it on Leveraged ETFs

  2. Anton Johnson on May 1, 2009 8:30 am

    I choose to turn the 2X and 3X ETFs on their heads, either in pairs or directional, since I prefer to benefit from the fees and daily rebalancing grind.

  3. J Roy Bower on May 1, 2009 4:37 pm

    I discovered a similar lack of comprehension about this topic while working at an institutional money manager recently. They were providing synthetic beta for pension fund's cash positions using futures contracts. Within a few weeks of starting in this group I realized why our tracking to the benchmark was never as close as it should have been. The clients (based on the manager's information/suggestion) were adding the daily P/L from the futures positions into the cash position, so we were constantly over/under levered relative to the "real" cash sitting in the portfolio. Given the reputation of the firm and that they had been doing this for years prior to my arrival, I was absolutely shocked that no one had realized this before.

    When I pointed this out to the PM and MD in the office they looked at me with "deer in the head light" eyes. I suggested that we needed educate everyone involved (internal and external) so they fully understand the implications and the effects this would have on tracking. At least then clients could make an informed decision. I guess I shouldn't have been surprised that nobody thought that was a good idea…

    Unfortunately, I suspect this happens more frequently than it should in the investment world.

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