Leveraged and inverse ETFs

Inverse and leveraged ETFs (Exchange-traded funds) describes several ETF structures which are intended to provide returns in excess of an equivalent ETF benchmark. The purpose of this article is to explain why these ETFs are not intended for long-term investments.

Overview
There are 3 structures:


 * Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track.
 * Inverse ETFs (also called "short" funds) seek to deliver the opposite of the performance of the index or benchmark they track.
 * Leveraged inverse ETFs (also known as "ultra short" funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index.

First, notice that Direxion itself says these funds are for "short-term trading." This is not a detail or a pro forma disclaimer - it is explicitly highlighted in the table below.

The first category, "Long Term Investment" contains 3 ETFs which match a benchmark. The second category contains 2 leveraged ETFs ("Bear 3X") and is titled "Short Term Trading" which is a warning sign that these ETFs will perform differently than those intended for long-term investments. The link "Are Direxion Shares ETFs for you?" is an additional warning sign, as there would be no reason to ask this question if these ETFs performed similarly to ETFs intended for long-term investments.

Brokerages typically require customers to sign a special disclaimer in order to open a margin account. Everyone understands that using leverage in the form of a margin account is taking on a big risk, the risk of losing more than your total investment. It is a mistake to think you can get essentially similar results, more conveniently and without the risk of losing more than your investment, simply by using an inverse or leveraged ETF.

Anyone thinking of using an inverse or leveraged ETF needs to read and understand the fund company's factsheets and prospectus, which disclose the issues in language varying from veiled to clear.

They also need to read the FINRA alert, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors. "The SEC staff and FINRA are issuing this Alert because we believe individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds (ETFs)." Remember that FINRA is part of the finance industry and is not inclined to be alarmist about investment products--when they issue an "alert" it should be taken seriously.

Two example ETFs are used in the following sections:
 * ProShares Ultra S&P500 seeks daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the S&P 500.
 * Direxion Emerging Markets Bear 3X ETF seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the MSCI Emerging Markets Index.

Comparison between "daily" and "long-term" results
Now, let's illustrate how big the difference is between "daily" and long-term results.

The word "daily" means exactly what it says, and it is not a minor detail. Some investors think they see interesting theoretical possibilities for using leverage in long-term investing. If so, they should not think that over long periods of time they can get double the return of the S&P 500 simply by investing in a 2X leveraged S&P 500 ETF.

"Daily" is not a technicality. These products double or triple the long or short index for a single day, so if you are someone who trades in and out of positions on a daily basis, they actually do pretty much what you'd expect. Not so over long periods, and the difference can be huge. We are not talking about a few percent, we are not talking about expense-ratio-sized differences.

There's no secret about any of this and no dispute about it. The ETF companies disclose it fairly clearly in the factsheets, such as "This leveraged ETF seeks a return that is -300% the return of its benchmark index for a single day. The fund should not be expected to provide three times the return of the benchmark’s cumulative return for periods greater than a day (Direxion), and "Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period" (ProShares).

But they don't go out of their way to show you the potential impact. Let's ask: "How much is that in dollars?"

"Will likely differ in amount"
"Differ in amount" means that the "2X" fund might not deliver twice the return of the index. For example, ProShares Ultra S&P 500 ETF, SSO began in 6/2007. $10,000 invested in the pokey old Vanguard 500 Index fund would have gained a total of $6,813 in total return since that time. Did the Ultra fund earn twice that? Did it earn $12,000?

It did not. Amazingly (?), the 2X ETF earned less than the straight, unleveraged, direct investment. Now, let's look at "differ in direction."

"And possibly differ in direction"
This is a veiled way of saying that over periods of more than a day, your ETF could go down even when the inverse or leveraged index it is tied to goes up. This is why ProShares says "Investors should monitor their holdings consistent with their strategies, as frequently as daily." We will illustrated with a deliberately-picked and unusual period of time, but it is a valid illustration of the effect of volatility drag on a leveraged ETF. Before showing the results, let me pose a question.

Over this time period, an investment of $10,000 in Vanguard 500 Index fund lost $846. Knowing this, which of these three investments do you think did the best over that time period?


 * a) Vanguard 500 Index Fund (VFINX)
 * b) ProShares Ultra S&P (SSO), "two times (2x) the daily performance of the S&P 500"
 * c) ProShares UltraShort S&P (SDS) "two times the inverse (-2x) of the daily performance of the S&P 500."

Amazingly (?), the answer is a. If you reasoned that since the S&P 500 lost money, an ETF that shorts the S&P ought to have made money, you fell into the trap.


 * The Vanguard 500 index fund lost $846.
 * Not surprisingly, SSO, 2X ETF for the same index lost. But it didn't lose just twice as much as VFINX, it lost over four times as much-- $4,050.
 * And yet SSD 2X short ETF, the -2X ETF, that you might have hoped would make money, lost even more--$4,595.

That's right- heads you lose, tails you lose. Over that time period you could have been right about the direction of the S&P but still lost money.

And this isn't just a matter of a few percent, this isn't a detail, this isn't an expense ratio difference.

Summary
In short, the providers' warnings are perfectly true. These ETFs are for single-day or very-short-term "trading," speculating, gambling only. They are no good for long-term investing. Regardless of what you might or might not think about the possible usefulness of a long-term leveraged position achieved by using margin, leveraged and inverse ETFs are a completely different thing and do not give even remotely comparable results.