Regarding Leveraged ETFs

I am a skeptic on leveraged ETFs in one way.? My view is that the more levered they get, the less likely they are to replicate the behavior of their index, however levered.

To get high amounts of leverage, they must rely on futures, options, swaps, and options on swaps, and the higher the amount of leverage they attempt to replicate, the greater the amount of slippage they will experience versus their multiplied index.? There is also slippage from rolling futures from month to month.

Here’s my challenge, and I may do this myself, or, though I encourage others to do it.? Add the performance of the bullish and bearish funds of an index together, for a given amount of leverage.? If there is no friction or fees, they should do as well as T-bills.? My guess is the higher the leverage the lower the aggregate returns.

Let the games begin.? Does anyone want to run this analysis before I do it, say, six months from now?

9 thoughts on “Regarding Leveraged ETFs

  1. While not exactly what you are asking, I did look at buying equal amounts of both ultra long and ultra short ETF’s at the beginning of each of the past two years. I used the SP500, SP400, SP600 and Nasdaq 100, buying equal dollar amounts at the begining of each year.

    In 2007 the stategy was a loser ranging form 4-6%, but in 2008 thru the middle of November, the method had gains ranging from 28% for the SP500 to 45% for the SP400. The figures do not include dividends.

    I’m not sure what to make of it, but I did find it interesting.

  2. Hello David,

    You are touching upon an issue that I see tremendous confusion regarding, even at the “professional” level. I’ve actively used these instruments on behalf of my clients and done so with significant success – we are having our best relative performance year ever and best absolute since 2003.

    These products are designed to generate twice the DAILY returns of the target index. This is a critically important distinction from twice the return over a period of time. There is an inherent compounding that occurs due to this daily leverage that makes these vehicles generate superior returns to their underlying index during trending markets and very poor results during choppy periods.

    The leveraged vehicles should only be used for short to intermediate term strategies in my opinion. We have used them for 1 day to 2 months typically. Any longer term time frame will likely chop up any returns and be very disappointing to the holder. Better to use the un-leveraged ETF’s for longer holding periods.

    Finally, I think your take on examining the difference between the long/short version is spot on….I only wish I had the time to do it myself!

  3. After additional thought and reading GJ’s excellent comment, I need to change my view about David’s exercise. The daily compounding of returns in such an exercise would produce precisely the results that GJ sites. In a trending market like we have had over the past year (for the most part), the daily leverage would reduce the “wrong way” etf (the ultra long over the past year) which serves to decrease the size and impact of that bet naturally. Quite simply the compounding occurs on a smaller number.

    The Ultra short etf would compound at every larger amounts and create a situation where those gains more than offset the decreasing losses from the ultra long. This would also be the case during markets that trend higher – just with the inverse determinants of returns.

    2007 was a non-trending year and the choppiness generated returns worse than t-bills because of it.

  4. As James Dailey pointed out, these products generate twice the daily returns of the target index, so they suffer from the “constant leverage trap”. This article includes a 15 year backtest on the double ETFs and gives a great idea of the long term results:

    http://seekingalpha.com/article/31195-leveraged-etfs-a-value-destruction-trap

    This ignores the problems you site, such as slippage and the like. If the market is largely monotonic, you will get much larger than 2x returns from a 2x etf, due to the daily compounding effect. With extreme volatility, you end up getting killed over time.

  5. The friction of the leverage for these ETFs is a given and easily shown with a simple spreadsheet. The decline of the NAV performance with regard to the underlying index occurs whether the leverage is positive or negative. However, I think you need to tell the whole story. That is, indicate where levered ETFs can help improve your portfolio over the short term as a hedging instrument.

    Or, better yet, ask the question “who would want to own these over a long term anyway?” I use the levered ETFs strictly for day trading and short-term swing trades. While I am holding them for swing trades I also write covered calls. The high volatility creates incredible option premiums even over short contract periods. They are perfect for these types of short-term trades.

  6. David:

    Leveraged ETFs are an excellent hedging instrument. You can of course generate the same returns with 1/2 the capital by using the a 2x leveraged ETF (and rebalancing). And of course because they come in bullish and bearish flavors investors now have access to (relatively, some of the ETFs do not track properly) constant negative covariance investments that do not require them to personally use margin to short stocks. Of course put and call options are superior in this regard but many investors who use ETFs are not comfortable with options…. And for those of us who like trade volatility of course, the options on the leveraged ETFs are fun fun fun (and the market makers have no idea what they’re doing).

    The problem with your thinking, is that you’re assuming that investors will hold the ETFs, but they are only designed to replicate some multiple of the DAILY return on the index. ie: ETFs are for trading not for holding, which includes a rebalanced portfolio of bullish and bearish ETFs .

    The analysis you refer to as been done already.
    http://seekingalpha.com/article/35789-the-case-against-leveraged-etfs

    I’m really sick of hearing people talk of protecting small investors by keeping them away from complex products. There is no worse nor risky investment than equity which is shoved down the small investor’s throat at every turn.

  7. I notice that there are lots of Ultra(long) and UltraShort ETFs that provide 2x leverage. The new Direxion ETFs even provide 3x. But why aren’t there any plain old 1x short ETFs? I want to short stocks in my IRA, but cannot do it at 1x leverage without buying an ultrashort (2x) product. This is too much volatility for me. But I don’t want to commit more capital by offsetting it with the 1x long ETF — plus it wouldn’t be a delta-neutral hedge anyway.

    Can anyone explain why there are no 1x short ETFs? Or perhaps there ARE some and I just don’t know about them.

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