Leveraged and inverse ETFs

Inverse and leveraged ETFs are products with goals like these:

"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."

They are not suitable for Boglehead investing. In fact they are not suitable for investing at all, only for short-term "trading" (speculation). The companies that provide them say so.

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. But everyone understands that using leverage, in the form of an actual loan or margin account is taking on a big risk--actually, the risk of personal financial ruin. Brokerages typically require customers to sign a special disclaimer in order to open a margin account.

Investors who have not done their homework sometimes think that they can get the results of leverage without the risk, without signing a special agreement, simply by purchasing shares of a leveraged ETF. This is a serious mistake.

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.

The purpose of this article is give illustrations to show just how big the difference is between "daily" and long-term results. "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 huge.

There's no secret about this and no dispute. Direxion states it clearly enough:



The ETF companies put clear language 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."

But, let's look at what this really means. "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. So, did the Ultra fund earn anything close to double that amount?



It did not. Amazingly (?), the 2X ETF earned less than the straight, unleveraged, direct investment.

But it can be even more amazing. The qualification "returns over periods other than one day will likely differ in amount and possibly direction" is a polite way of saying that your ETF could lose money even when the leveraged index it is following gains. "For traders direction matters," but for longer-term investments, guessing the right direction can be a heads-you-lose, tails-you-lose proposition. To be clear, this is a specially-chosen period of time, but it illustrates the issue of volatility drag on a leveraged ETF. Before showing the time period, let's pose a question.

Over this time period, an investment of $10,000 in Vanguard 500 Index fund lost $846. Knowing this, with hindsight, which of these would you pick as having been best investment 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).

The pokey old index fund lost $846. The 2X ETF for the same index lost, not just twice that, but a whopping $4,050. And yet the 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.



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 true long-term leverage of a margin purchase, leveraged and inverse ETFs are a completely different thing and do not give even remotely comparable results.