Leveraged ETFs

Pay Attention to the Math

In the beginning, there were mutual funds that allowed investors to own a diversified portfolio. Sadly the vast majority came with very high sales commissions (knows as front-end loads).

Then a few exchange-traded funds (ETFs) emerged. These soon became popular because they allowed investors to trade in real time, rather than only at the market's closing price. Plus, there were no loads, only regular commissions associated with buying and selling stock.

ETFs became very popular and their numbers increased rapidly. So rapidly that many ETFs were served no purpose -- and more than 500 of the weaker funds went out of business. However, new funds continue to emerge and by autumn 2015, there were more than 1700 ETFs.

Today's discussion focuses on a special type of exchange-traded fund: The Leveraged ETF.

Wikipedia provides a detailed definition: (edited version). Leveraged exchange-traded funds, attempt to achieve returns that are more sensitive to market movements, compared with non-leveraged ETFs. 

Leveraged index ETFs are often marketed as bull or bear funds and generally use futures contracts -- and other feats of  financial engineering --  to achieve the desired return. 

  • A leveraged bull ETF fund seeks to achieve daily returns that are 2x or 3x that of the Dow Jones Industrial Average or the S&P 500.
  • A leveraged inverse (bear) ETF fund seeks to achieve returns that are -2x or -3x the daily index return, meaning that it will gain by double or triple as much as the market loses. 

    As may have been anticipated, investors loved the leveraged ETFs. And therein lies a tragedy.

    The simple truth: Leveraged ETFs were designed for, and should be used only by, day traders.

    Anyone who reads and understands the prospectus for these funds knows how leveraged ETFs work -- and everyone else is trading under a misconception. 

    Even professional traders and financial advisors -- folks who research a product before taking positions, or before advising clients to do so -- also get it wrong.

    In my opinion, these leveraged ETFs are a true scam. Yes, the fund managers mention all warnings in the prospectus, but investors are notorious for not reading such documents. I feel so strongly about this that I am comfortable saying:

    No one in his/her right mind should ever buy leveraged ETFs when they plan to hold overnight, or longer.

    The funds are constructed to incur large trading costs because the portfolio is adjusted daily. More importantly, they are designed so that it is inevitable that they cannot provide the anticipated returns. This is the result of a mathematical truth: Average returns are different (and sometimes wildly different) from compounded returns. 

    Here is a (hopefully) very clear explanation of how this works (from Morningstar): I edited the original.

    "You invest $100 in each of three funds. One is an index. The other two are leveraged funds whose returns are compound daily; one is double-long and the other is double-short.

    "After one day, the index gained 10% and the index value is $110. The double-long adds 20% and ends at $120; the double-inverse loses 20% and ends at $80.

    "On day two, the index loses 10%. The average return is zero (10% -10%)/2.

    • The index closes at $99 because 10% of $110 is $11, and $110 minus $11 is $99.
    • The fund that promises double returns -- but compounds daily -- ends at $96. Note: this fund started the day at $120 and lost -20% (double the index's loss). Thus, the loss is $24 for the day. So, $120 minus $24 is $96.
    • The double-short fund also end at $96 because 20% of $80 is $16, and $80 plus $16 is $96.

    "If this sequence of up 10% one day followed by down 10% the next day repeats 10 times, each leveraged fund would be $81.54. That is a sizable difference from the $95.10 that the index fund would be worth.

    "Repeat this process for six months, and your 'investment' in either of the leveraged funds would stand at only $2.54 -- a 97.46% loss."

    Please remember: Leveraged ETFs are only for day traders -- and are not designed for investors. Do not believe that saving money on commissions (buying 100 shares of a leveraged ETF rather than 200 or 300 shares of the unleveraged variety) is the smart thing to do.It is not a wise investment choice.