Exchange traded funds have grown in popularity in recent years. As they have gained ground they have also become more diverse, and one of the most prominent types of ETFs to emerge has been the Leverage ETF.
Leverage ETFs, which allow investors to double or triple the returns of an index, look brilliant in theory. Who wouldn’t want to earn triple what the Standard & Poor’s 500 Index did last year?
Alas, not all that glitters is gold. And true to form, the bright and promising world of leveraged ETFs is more of a hurdle to avoid and overcome than a tool to mine and use.
The theory: phenomenal. If you are bullish on stocks or even an industry or commodity, there is probably a leveraged ETF for that. Not so bullish? Great! There is a Bearish leverage ETF there for you.
On the surface, leveraged ETFs seem like a straightforward proposition: “A common misconception is that if an investor thinks the market will go up 10% for the year, then he can buy a triple leveraged ETF and earn 30% for the year, ”says Eric Ervin, CEO of Reality Shares, an ETF sponsor with four ETF offers of its own.
However, this is not how they operate.
In practice: a horror show. The main characteristic of leveraged ETFs that generally make them a nightmare is their purpose: to magnify the daily returns of the underlying index – not the weekly, monthly, semi-annual or annual returns. .
Ervin invites you to imagine a hypothetical ETF – let’s call it ETF A, and a leveraged ETF that tracks three times its daily performance, ETF B.
Both start at $ 100 per share. On the first day of trading, ETF A is hammered, taking a 20% hit. He ends the day at $ 80 per share; ETF B did even worse, losing 60% and closing at $ 40. It’s a rough start, but it’s what you expect.
Now here’s where the thought experiment gets interesting. Imagine on day two ETF A rebounded, climbing 24% to close at $ 99.20, just 0.8% of its price two days earlier.
ETF B, meanwhile, gained 72%. But that only drops it from $ 40 to $ 68.80, cementing a 31.2% two-day loss.
“You can see,” says Ervin, that “the market ETF and the leveraged ETF do not have a constant relationship after day one”.
The disadvantages far outweigh the advantages. The imperfect ability of the leveraged ETF to amplify the returns of its reference because any duration longer than one day is a flaw that investors should not overlook. While it is true that for relatively short periods of time, this can work in an investor’s favor.
ETF Direxion Daily Gold Miners Bull 3X (symbol: NUGT), for example, increased 575% for the year through Monday. His goal ? Triple the returns of the NYSE Arca Gold Miners Index, which rose 124% over the same period. Goal achieved !
Gold itself, which can be tracked with SPDR Gold shares (GLD), only increased by 26%.
Now let’s take a look at how NUGT has performed in the longer term.
NUGT has lost 99.1% in the past five years, a period in which its benchmark has fallen by 47.8% and GLD by 24.8%. As of mid-August 2011, NUGT was trading for an adjusted amount of $ 18,175.
It closed Monday at $ 163.90.
This may not surprise you. NUGT is, after all, a 3x leveraged ETF, so maybe it deserved to lose its whole wad. How about ProShares Ultra Gold (UGL), so a 2x leverage gold tracking ETF? It has fallen 55.5% in the past five years, while the GLD has fallen only 24.8%.
The long-term underperformance of leveraged ETFs refuses to go away.
The the costs are disproportionate. “Leveraged and Inverted ETFs” not only suffer from tracking problems, they are also “more expensive than traditional index ETFs,” according to Daniel Kern, chief investment strategist for TFC Financial Management in Boston.
“Proshares Ultra MSCI EAEO (EFO) and Direxion Daily Dev Mkts Bear 3x ETF (DPK) “, two index-linked leveraged ETFs,” both have expense ratios of 0.95% and may have higher indirect trading costs as they rebalance their portfolios. “
Over time, high trading fees end up being an incredible drag on a portfolio’s portfolio. long term performance. If you put $ 10,000 in a market ETF, let it sit for 30 years and assume it charges an annual fee of 0.16%, like the Vanguard 500 Index Fund (VFINX), for example, you will accumulate a pretty penny over time.
Assuming an average annual return of 9.83%, your $ 10,000 would be worth $ 158,769. But what if your expense ratio is 0.95%? You walk away with $ 125,101, or more than $ 33,600 less.
Complexity and timing. Have you ever wondered how sausage is made? How are these modern and improved ETFs able to amplify the returns of their benchmark ETF to begin with? The answer: a lot of really complicated and obscure financial instruments.
Leverage and reverse ETFs use derivatives like options, swaps, and futures to amplify returns without actually borrowing money or using margin.
KC Ma, professor of finance at Stetson University, warns that if trading volumes in these instruments are low, “derivatives will be traded over-the-counter, which involves serious counterparty risk – a risk that the other part of the transaction defaults “.
In addition, as leveraged ETFs are rebalanced daily, they have to buy additional exposure when the index goes up and get rid of it when it goes down; they buy high and sell low.
For traders who use leveraged ETFs to speculate on short-term market movements – the type of active trading for which these ETFs are best suited – even then, his timing must be exquisite.
“The rare success of leveraged ETFs also requires the investor to have a precise ability to synchronize the market in the short term,” Ma said. “There is no such thing.”