Many professional traders, analysts, and investment managers love to hate leveraged exchange-traded funds (leveraged ETFs), which are funds that use financial derivatives and debt to amplify the returns of an underlying index. However, ETFs do not always perform as expected based on their names, which often include the terms “ultra-long” or “ultra-short.”
Many people looking at the returns of an ETF, compared to its respective index, get confused when things don’t seem to add up. Investors should be aware of the following factors when considering this type of ETF.
How leveraged ETFs work or don’t work
If you look at the descriptions of leveraged ETFs, they promise two to three times the returns of a respective index, which they do, on occasion. Leveraged ETFs drive results, not by borrowing money, but by using a combination of swaps and other derivatives. Let’s look at some examples of how ETFs don’t always perform as expected.
The ProShares Ultra S&P 500 (SSO) is an ETF designed to meet or exceed twice the performance of a single day of the S&P 500. If the S&P 500 returns 1% on any given day, the SSO should return approximately 2%. But let’s see a real example. During the first half of 2009, the S&P 500 was up approximately 1.8%. If the SSO had worked, I would expect a return of 3.6%. In reality, the SSO dropped from $ 26.27 to $ 26.14. Instead of returning 3.6%, the ETF remained essentially flat.
It’s even more concerning when you look at SSO alongside its counterpart, the ProShares Ultra Short S&P 500 (SDS), which is designed to return twice the opposite of the S&P 500’s performance for a single day. During the 12 months ended June 30, 2009, the S&P 500 was down nearly 30%. SSO performed quite well and was down 60%, as expected. However, the SDS was down 20%, when it was expected to increase 60%.
Why the gap in performance?
So now that we’ve seen some examples of how ETFs don’t always do what they’re supposed to do, let’s examine why. ETFs are actually designed and traded to track the daily movements of a corresponding index. You may wonder why it would be important, since if you track your index correctly every day, it should work for an extended period of time. That is not the case.
One reason is the expense ratio. The most popular leveraged ETFs will have an expense ratio of about 1.04%, which is considerably higher than the approximate average expense ratio of 0.45% for all ETFs overall as of 2019. This high expense ratio is basically an administration fee, and it will reduce your profits and help exacerbate your losses.
Impact of daily resetting of leverage
A high expense ratio is at least transparent. What many investors fail to recognize is that leveraged ETFs rebalance on a daily basis. Since leverage must be restored on a daily basis, volatility is your biggest enemy. This probably sounds strange to some traders.
In most cases, volatility is a friend of the trader. But that’s certainly not the case for leveraged ETFs. In fact, volatility will crush you. This is because the compounding effects of daily returns will actually alter the math and can do so in a very drastic way.
For example, if the S&P 500 is down 5%, a fund like the SSO should be down 10%. If we assume a share price of $ 10, the SSO should drop to about $ 9 after the first day. On the second day, if the S&P 500 rises 5%, over the two days the return on the S&P 500 will be -0.25%. An unaware investor would think that SSO should drop 0.5%. The 10% increase on the second day will cause the stock to go up from $ 9.00 to $ 9.90, and the SSO will actually go down 1%.
Typically, you will find that the more volatile the benchmark (the S&P 500 in this example) is for a leveraged ETF, the more value the ETF will lose over time, even if the benchmark ends flat or has a zero return. % in the end. of the year. If the benchmark went up and down dramatically along the way, you may end up losing a significant percentage of the ETF’s value if you bought and held it.
For example, if a leveraged ETF moves within 10 points every other day for 60 days, you are likely to lose more than 50% of your investment.
Advantages and disadvantages
Capitalization works up and down. If you do a little research, you will find that some bullish and bearish ETFs that track the same index performed poorly for the same period of time. This can be very frustrating for a trader, as they do not understand why it is happening and consider it unfair.
But if you look closer, you will see that the index being tracked has been volatile and limited by a range, which is the worst case for a leveraged ETF. Daily rebalancing should take place to increase or decrease exposure and maintain the fund’s target. When a fund reduces its exposure to the index, it keeps it solvent, but by blocking losses, it also leads to a smaller asset base. Therefore, larger returns will be required for you to be able to match the trade again.
To increase or decrease exposure, a fund must use derivatives, including index futures, equity swaps, and index options. These are not what you would call the safest commercial vehicles due to counterparty and liquidity risks.
If you are a novice investor, stay away from leveraged ETFs. They can be tempting due to the potential high returns, but if you’re inexperienced you’re much less likely to know what to look for when doing your research.
The end result will almost always be unexpected and devastating losses. Part of the reason for this will be to hold on to a leveraged ETF for too long, always waiting and hoping for things to change. Meanwhile, its capital is slowly but surely being chewed up. It is strongly recommended that you avoid this scenario.
If you want to trade ETFs, start with Vanguard ETFs, which often have low betas and extremely low expense ratios. You may not have a profitable investment, but at least you won’t have to worry about your capital vanishing for no reason.
Long-term investment risk
Until now, it is obvious that leveraged ETFs are not suitable for long-term investments. Even if you did your research and chose the correct leveraged ETF that tracks an industry, commodity, or currency, that trend will eventually change. When that trend changes, the losses will accumulate as fast as the gains accrued. On a psychological level, this is even worse than jumping in and losing from the start, because you had accumulated wealth, counted on it for the future, and let it slip away.
The simplest reason that leveraged ETFs are not for long-term investments is that everything is cyclical and nothing lasts forever. If you are investing for the long term, it will be much better to look for low-cost ETFs. If you want high long-term potential, look for growth stocks. Of course, don’t allocate all of your capital to growth stocks, you need to diversify, but it would be a good idea to allocate some capital to high-potential growth stocks. If you choose correctly, you can see returns that far exceed those of a leveraged ETF, which is saying a lot.
Leveraged ETF potential
Is there a reason to invest or trade leveraged ETFs? Yes. The first reason to consider leveraged ETFs is to be short without using margin. Traditional shorting has its advantages, but by opting for leveraged ETFs, including reverse ETFs, you are using cash. So while a loss is possible, it will be a cash loss, not more than what you entered. In other words, you won’t have to worry about losing your car or home.
But that’s not the main reason to consider leveraged ETFs. The main reason is the high potential. It may take longer than expected, but if you spend time and study the markets, you can make a lot of money in a short period of time by trading leveraged ETFs.
Remember how volatility is the enemy of leveraged ETFs? What if you studied and understood the markets so well that you had absolute conviction in the direction of the near future of an industry, a commodity, or a currency?
If that was the case, then you would open a position in a leveraged ETF and soon see exceptional profits. If you were 100% sure about the direction of what the leveraged ETF was following and it depreciated for a few days, then you could add to your position, which would then lead to an even bigger profit than originally planned on the way up. .
However, the best way to make money with leveraged ETFs is to invest in trends. V-shaped recoveries are extremely rare. With that being the case, when you see a leveraged or inverse ETF constantly moving in one direction, that trend is likely to continue. It indicates a growing demand for that ETF. In most cases, the trend will not reverse until the buy is sold out, which will be indicated by a fixed price.
The bottom line
If you are a retail investor or a long-term investor, stay away from leveraged ETFs. Generally designed for short-term (daily) plays on an index or sector, they should be used that way, otherwise they will consume your capital in more than one way, including fees, rebalancing, and accumulated losses.
If you’re a deep researcher who’s willing to spend full days understanding the markets, leveraged ETFs can present a great wealth-building opportunity, but they are still high risk. Trade strong trends to minimize volatility and maximize capitalization gains.