Leveraged and Inverse ETFs Demystified: Part I

ETFs as we know them have been in existence for less than 20-years, but in that time they revolutionized the investing landscape. Diversification, low-cost, tax efficiency, and trading flexibility make them one of the most attractive tools a speculator can employ. For the first time average investors have access markets previously only available to Wall Street insiders. Indexes, bonds, commodities, futures, currencies, and international markets are now as easy to trade as Apple and Procter & Gamble.

It didn’t take long for enterprising and forward thinking fund companies to package futures, equity swaps, and options into supercharged ETFs. These inverse and leveraged ETFs flip and magnify the daily performance of the S&P 500, NASDAQ, and Dow. But they didn’t stop there, you can find inverse and leveraged ETFs that cover popular industry sectors like biotech, financials, semiconductors, and even entire international markets.

Since ETFs trade like stocks on public exchanges, they have opened a whole new world of investing possibilities for people stuck in retirement accounts that prohibit margin and shorting. But with power comes responsibility. There is no free lunch and these dynamic ETFs come with risks that everyone who uses them needs to understand.

The benefits of leverage are obvious, as are the risks. Make a great call and your profits are magnified, get it wrong and the losses are compounded. But there are other quirks to these vehicles that are less intuitive. Between the way these securities are constructed and the fact that the leverage is reset daily, means there is an accumulation of slippage that grows over time. This prevents them from maintaining their stated leverage over periods longer than a single day.

The easiest way to visualize the compounding problem is through an exaggerated example. If you bought XYZ stock for $100 and experience a 50% decline, that leaves you with $50. From there the stock rebounds 50%, but rather than recover all your losses, the 50% gain only moves XYZ back to $75, well short of your original investment. Further, it doesn’t matter which order the gains and losses occur. Flip the example and a 50% gain pushes the stock up to $150, but the subsequent 50% decline drops it all the way back down to $75. The “math problem” where losses loom larger than gains is evident in all forms of investing because losses carry more weight proportionally than similar gains.

This “math problem” is compounded in leveraged ETFs because the magnified losses are always slightly larger than the gains, meaning when the underlying index makes a round-trip back to the same level, the leveraged ETF will always be slightly lower. The larger the interim volatility and the longer the holding period, the greater the slippage will be.

This slippage is quantifiable if we make assumptions about volatility and holding period. For example, if a $100 index goes up and down $1 every day for a year (250 trading sessions), a 3x ETF will lose approximately 7% in value even though the index ends the year exactly where it started. If daily volatility doubles to $2, then the annual slippage more than quadruples to 26%!

Most of the criticism aimed at leveraged EFTs focus on this “math problem”. Academics and ivory tower types shout how dangerous this slippage is for the blissfully ignorant investor. The way they spin it makes it sound like leveraged ETFs are the investing world’s version of lawn darts, dare to trade them and you will almost certainly die a painful death. Some are so offended by these trading vehicles, they have launched crusades to regulate them out of existence. But as with most things in the market, the hype usually far exceeds the reality as we will see in Part II of this article.

One thing is indisputable, leveraged ETFs expenses are far higher than their non-leveraged siblings. Popular non-leveraged ETFs like SPY have expense ratios as low as 0.09%, but the equivalent 3x leveraged ETF’s expenses are 10x as high at 0.92%. While this is expensive in comparison, it is still less than most professionally managed mutual funds or what typical fee based financial planners charge.

The least quantifiable risk is 3rd party and liquidity risk. Since these instruments rely on derivatives like futures, options, and swaps, there is a chance that under extreme circumstances the 3rd party will be unable to uphold their side of the trade. This could leave the ETF investor with an IOU or a bankruptcy notice instead of the cash. Alternately the ETF could be forced to buy and sell underlying positions at unfavorable prices in illiquid markets. Fund companies have safeguards in place to prevent such occurrences, but in a black swan scenario anything could happen. While this sounds scary, risks like these are the price of admission for any speculative activity, not just leveraged ETFs.

Now that we understand the theoretical risks involved with leveraged and inverse ETFs, the next step is to move out of the classroom and into the real world. The second part of this article analyzes the actual performance of various leveraged and inverse ETFs over time to see if these fears and warnings are deserved. (Spoiler: Some leveraged ETFs perform well, while others are incredibly toxic to your portfolio!)

Part II of this article is available to everyone who Registers for Free Email Alerts.

(Note: Part II will be published the week of August 24th and will be sent to all Alert Subscribers at that time)

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