Why Investors Still Lose Money Trading Leveraged ETFs

By Dvega/Dtime:

Exchange Traded Funds (ETFs) have been under scrutiny for quite a while now for their performances during periods of high market volatility and deviations from the underlying assets value. Leveraged ETFs are no exception and probably among the most misunderstood financial products. Leveraged ETFs were first launched in 2006 and since then the market for this kind of financial products has grown reaching a total of $50.9 million assets, with more than 275 leveraged ETFs trading on exchanges in 2013. The Financial Industry Regulatory Authority (FINRA) has warned investors about the potential pitfalls of leveraged ETFs and in some cases it has punished banks. On the other hand, investment banks like UBS and brokerage firms like Ameriprise stopped offering leveraged ETFs to their clients.

Leveraged ETFs’ goal is to delivery twice or three times the daily return on a specific underlying index. In order to do so, they have to re-balance their portfolios on a daily basis and keep the proper amount of leverage in order to make sure they deliver exactly twice or three times the daily return on the index. As a consequence, leveraged ETFs are exposed to price erosion: an investor would have to borrow more funds to buy more ETFs as the price of the index goes up. Conversely, the investor would need to buy less ETFs as the price goes down.

Let’s see this with an example. For the sake of simplicity, I assume that the price on the underlying index goes up at Tn and down at Tn+1 by 10%. An investor starts with $100 at day n and wants to invest in a 2X Leveraged ETF. It would have to borrow $100 to invest $200. Assume the market goes up by 10%. The investor makes $220, repays the $100 it borrowed and retains $120. At day Tn+1, the investor would have to borrow $120 to invest $240 in the leveraged ETF. Assume now that prices go down by 10%. The investor loses $24 but still makes $216. It repays the $120 it borrowed at day n and retains only $96. Again at day Tn+2, the investor would have to borrow $96 to invest $192 in the ETF. Prices go up by 10% and the investor makes $211.2. It repays the $96 it borrowed at day Tn+1 retaining $115.2. And so on and so forth.

The effects of a relatively “long-term” investment in a leveraged ETF look like this:

chart1

Natural decay for a 2X and 3X Leveraged ETF – Volatility window -10%/+10%

As we increase the volatility window from ±10% to ± 20% (that is, prices go up and down by 20%), the exponential decay is even more magnified: chart2

Natural decay for a 2X and 3X Leveraged ETF – Volatility window -20%/+20%

It seems clear that the daily compounding is amplified as markets experience periods of high volatility. The higher the volatility, the more adversely affected is the leveraged ETF. In addition, expenses are high as leveraged ETFs require active portfolio management. The most popular leveraged ETF (ProShares Ultra S&P 500) has expenses of approximately 0.9% while “vanilla” ETFs without leverage cost 0.1% or less. Price erosion is even more accentuated in the 3X leveraged ETF because of the expenses, which are even higher than in the 2X as portfolio management is more challenging.

Leveraged ETFs should be seen as extremely short-term bets on specific market moves or as a way to hedge some specific market exposure: therefore as mere investment vehicles. On the long-term, leveraged ETFs do not replicate the underlying index. Big deviations from it are expected.

The lesson here is a lesson on leverage. Passive investors should avoid building long-term strategies using leveraged ETFs. They are more suited for institutional investors who are primarily engaged on active trading.

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DvegaDtime

QUANTessential Financial Engineer. Ivy Leaguer.

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  • Frederick

    Great post. Thanks.

  • jerry

    This argument against leveraged ETFs has always confused me. Let’s look at the trailing 6mo return from SSO vs SPY as an example. From Feb 11 until now we have:
    SSO $68.24-$85.33 (+25.04%)
    SPY $151.77-$169.31 (+11.56%)

    If you held SSO over that time period, how are you not getting that return, ignoring expenses for the time being?

  • Conscience of a Conservative

    Someone please tell me again why investors are better off with ETF’s or ETN’s as a long term investment over holding a low fee class C mutual fund, or even a basket of stocks that one does buys and then holds.

    A couple of points that are often lost. First soe ETF’s are actually synthetic and provide counter-party exposure and second when they do hold securities often these are lent out and the holders of the ETF’s do not get the full profit.

  • http://kiddynamitesworld.com Kid Dynamite

    i think there must be a typo in the intro paragraph where it says:

    “since then the market for this kind of financial products has grown reaching a total of $50.9 million assets, with more than 275 leveraged ETFs trading on exchanges in 2013″

    billion not million maybe? it’s way more than 50.9 million…

  • DvegaDtime

    Thank you for the careful reading. Yep, it’ billion not million, just changed it.

    http://www.etftrends.com/2013/08/leveraged-etfs-assets-flirt-with-51-billion/

  • quark

    LOL

  • Peach

    The example is misleading, even without the leverage you would have decay of something moving +- 10% every other period, basic math. What you dont get is proportionall increase in exp return for the additioanl risk your taking if the underlying moves up and down (as stock markets do..).

  • Peach

    Actually this article is flat out wrong. Add a positive multiperiod trend and you will make more than twice what u put in, the leverage recalculation effect can also work in your favor.

  • Peach

    The example is misleading, even without the leverage you would have decay of something moving +- 10% every other period, basic math. What you dont get is proportionall increase in exp return for the additional risk your taking if the underlying moves up and down (as stock markets do..).

    Actually this article is flat out wrong. Add a positive multiperiod trend and you will make more than twice what u put in, the leverage recalculation effect can also work in your favor.

  • http://www.fanbrowser.com/ Cowpoke

    I’ll be honest, I lost a few grand Gamb.. Urr I mean Investing in the ETF’s FAZ and FAS after the financial collapse.
    I just looked at it like Sports online betting before they closed that loop hole in congress.

    I have also played with the Beta stocks and YES was holding one when the DEEP Water Horizon happened. Not a big loss as I jumped ship quick but when you dance with the devil you know the rules.

  • Andrew P

    There are better articles that describe the decay phenomenon. Rapid decay is more of a problem for inverse ETFs. SSO has actually performed pretty well since the 2009 crash (because the market direction has been up), but if you look over its whole history you see the decay caused by the big crash. SSO has still not returned to its 2008 highs.

    http://seekingalpha.com/article/1578782-leveraged-etfs-for-the-long-term-rockets-to-the-poorhouse?source=yahoo

    This one describes shorting inverse ETFs.

    http://seekingalpha.com/article/1315731-short-selling-a-pair-of-leveraged-etfs-a-goldmine-or-a-bad-idea?source=kizur