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Understanding The Dangers of Leveraged ETFs

InvestorEducation / Learning to Invest Jul 02, 2009 - 09:19 AM GMT

By: Money_and_Markets

InvestorEducation

Diamond Rated - Best Financial Markets Analysis ArticleRon Rowland writes: You’ve probably heard about leveraged ETFs: Funds designed to deliver twice or even three times the return of their benchmarks.

Just last week, ProShares launched the first triple-leveraged ETFs tied to the S&P 500 index. ProShares UltraPro S&P 500 (UPRO) is a 3x ETF for bulls, while ProShares UltraPro Bear S&P 500 (SPXU) is a 3x leveraged inverse ETF.


What a deal! Wouldn’t it be great to double or triple your gains? Far be it from me to throw water on the party, but I have to tell you it’s not quite so simple.

Yes, leveraged ETFs can be very useful in some circumstances. But before you put a penny into any leveraged ETF, you need to know exactly what you’re getting into.

How They Work …

The good news is that leveraged ETFs almost always do what they’re designed to do. The bad news is that way too many investors don’t understand what these ETFs are designed to do — and expect more than the fund sponsors ever promised to deliver.

Don't take this car off road!
Don’t take this car off road!

Think about it this way: If you want to crash your way through the forest, you buy a Hummer. If your goal is to win a drag race, you get a souped-up Chevy.

But if you try to drive the Chevy across a river, you probably won’t make it, any more than you can hit 150 mph in the Hummer. In either case, you’ve chosen a vehicle that is unsuitable for your purpose. Blaming the manufacturer is pointless; they never told you to use their products as you did.

What people don’t understand about leveraged ETFs: The 2x or 3x leverage factor can change dramatically, depending how long you own the fund. That’s because the leverage is reset every day.

This means that even if a leveraged ETF’s benchmark moves sideways, its value could still melt away like butter in a microwave oven.

Over time, the result can be a huge mismatch between what you think you should get and what you actually do get. In nearly every case, the long-term performance of both the long and inverse versions of leveraged ETFs will underperform their benchmark indexes.

Effects of Daily Leverage

The graph to the left gives a quick illustration: Suppose your benchmark index goes up from 100 to 105 in one day. That’s a 5 percent gain. Then the next day it drops back to where it started at 100. Then the next day back to 105, then back to 100, and so on.

By the time 10 days have passed, the index is back at 100, and an unleveraged investor is at break-even. But a 3x long ETF (green line) based on this index will actually have dropped about 7 percent under the same conditions. A 3x inverse ETF (red line) will be down almost 14 percent!

Why is this?

It’s the magic of compounding at work, only this time it’s working against you. Every day you hold one of these ETFs, your leverage factor drifts a little bit away from where you started at 3x. And if it moves the wrong direction, suddenly you have to dig yourself out of a hole.

Typically the difference isn’t much on any one day. But if you stay in the position for long, the difference will be dramatic — especially if the market you’re trading makes a big swing.

Let’s look at a real-world example …

Suppose last November, when everyone thought the banking system was about to collapse like a house of cards, you decided to buy Direxion Financial Bear 3x Shares (FAZ). This is an inverse leveraged ETF that is based on the Russell 1000 Financial Services Index.

On November 6, 2008, the index value closed at 720.446. Five months later, on April 6, 2009, the index ended the day at 520.629, for a drop of 27.7 percent.

So how do you think FAZ performed during this time? As an inverse fund, it should go up as the index goes down — and because FAZ is leveraged by a factor of three, your gain should be amplified three times over, right?

You might calculate that FAZ would have gone up 83.1 percent for this period (27.7 x 3 = 83.1).

Wrong …

In fact, FAZ actually fell 76.9 percent! Even if you correctly guessed that the financial sector would fall in this period, FAZ didn’t help you profit from your forecast if you held it the entire time. Quite the opposite — you lost money despite being right about the market’s direction.

This ETF dropped right along with the market!

Source: Bloomberg

How can this be? Is Direxion at fault? No, not at all. Their fund does exactly what the prospectus said it will do: Deliver a 3x inverse daily return on the index. Compounding — and your own decision to buy and sell FAZ when you did — are responsible for the rest.

Of course, if you get the timing right, the results can be spectacular!

For example, if you were lucky enough to buy FAZ on January 6 of this year and sell on January 20, you racked up a sweet gain of more than 160 percent. The index only fell by about 32 percent during that time, so your leverage wasn’t 3x — it was more like 5x!

This would have been a nice gain. But still, if you knew ahead of time you would be investing with such high leverage, would you have done it? The answer will depend on how aggressive of an investor you are, and how much confidence you have in your ability to time the markets.

Bottom Line: Leveraged ETFs Can Be Great, But You Must Use Them Correctly!

Leveraged ETFs are mainly intended for short-term trading. And by short-term, I mean a few days at most. Stick around any longer and the results will start to vary wildly.

Market regulators are starting to realize this. Just last month, the Financial Industry Regulatory Authority, or FINRA, warned brokers that leveraged ETFs are too risky for investors who intend to hold for more than one day. Unfortunately, most stock brokers don’t understand how leverage works, either.

If you're a day trader or have an expert guiding you, leveraged ETFs can make you a heap of money.
If you’re a day trader or have an expert guiding you, leveraged ETFs can make you a heap of money.

On the other hand, if you’re a day trader — someone who watches the market minute-by-minute and closes out your positions every evening — then leveraged ETFs can be a great tool.

They can also be useful over longer periods if you know what to expect and watch your ETFs like a hawk, or if you have someone trustworthy watching them for you.

The sponsors of these ETFs are doing their best to educate investors, but it’s hard to get the message out. Here are links where you can get information: DirexionShares, ProShares, and RydexShares. I highly recommend you take some time to educate yourself on these ETFs before you use them on your own.

Best wishes,

Ron

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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Comments

wes rude
12 Jul 09, 14:14
FAZ returns clarified

Here is better explanation why FAZ can be a very wrong investment even in a falling market.


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