Over the last couple of years, a new product has gained in popularity among traders and some investors. The product is a leveraged exchanged traded fund. (ETF). In general, an ETF is a passively managed security that tracks an index, a commodity or a basket of assets like an index fund but trades like a stock on an exchange. Leveraged ETFs are a relatively new kind of ETF that are designed to deliver double (2x) or triple (3x) the return (long) or the inverse return (short) of their respective indexes or market sectors they are attempting to track. Proshares, Rydex and Direxion are three of the more prominent companies that market leveraged ETFs. While two or three times earnings sounds good, can these ETFs deliver these multiples for long-term investors? The devil is always in the details, so let’s take a look under the hood of these leveraged ETF products and see what they are all about.
Daily Performance Tracking
The first thing that investors need to understand is how the returns on these investments are calculated. Let’s look at the Proshares Ultra S&P 500 ETF (SSO). This ETF attempts to provide an investor with 200% of the daily return of the S&P 500 Index. If the S&P 500 increased by 2% one day, you would have expected the Proshares Ultra S&P 500 ETF to increase by 4%, before fees and expenses. Sounds like a winner. Not so fast. If you consider yourself a long-term investor, the key word to focus on is “daily.”
These ETFs can vary wildly from their promised 2:1 or 3:1 performance compared to their benchmarks over holding periods exceeding one day. The main reason is compounding. Leverage works to your benefit when the market moves with your position; however, it multiples your losses when it moves against you. Let’s look at the effect of daily compounding on returns over a two-day period, assuming you own a leveraged ETF that promises to deliver 200% of the daily performance of the S&P 500 index before fees and expenses.
Day 1: Assume the index and ETF starts at a value of 100, and then assume the index increases 5% by the end of the day. The index would close at 105. The ETF would have increased to $110. This gives us a 10% daily return, because it doubled the return of the index.
Day 2: The index starts at 105, and the ETF starts at $110. Assume the index drops by -5% on the second day. The index would close at 99.75, while the ETF would have a -10% loss and close at 99.
If you bought this ETF at the beginning of Day 1 and held through the close of Day 2, the compounded effect would be a compounded loss of 1%, while the index would have a compounded loss of just 0.25%. With a leveraged fund, losses have a much greater effect on a daily basis.
As you can see, the multi-day return on these investments can start to vary wildly over the long term. You would not be wise to think that over a 12-month holding period this investment would provide you with double the 12-month return of the S&P 500. They are not designed to work the way that most long-term investors initially perceive. The prospectus and frequently asked questions on these companies’ websites clearly states that these products are designed to be held for one day at a time, and that holders of these products for longer periods should not expect them to provide a simple multiple of an index’s performance over longer holding periods. They only promise to offer to double or triple the return or inverse return on a daily basis. In the example above, they accomplished their daily goals. However, over the two-day period, they already started to diverge from their performance benchmark—just like the designers of this product said would happen.
“The Leverage Trap”
The second issue with the design of leveraged ETFs for the long-term investor is called the “The Leverage Trap.” These ETFs attempt to keep the leverage ratio constant every day. So let’s look at an example. If the ETF had $100 in equity invested to track the S&P 500, then in order for it to meet its 2:1 promise, it would need to borrow another $100 to double the exposure to the S&P 500. These funds use margin loans and other leveraged financial instruments, such as swaps, futures, options, etc., to create the multiplier effect. Let’s use the same product example from before.
Day 1: Assume the leveraged ETF starts with $100 in equity and $100 in leveraged products to give the investor a 2:1 leverage ratio (i.e., for every $1 investors put in, they control $2 of assets). The index increases 5% on the first day. This means that the equity would increase to $110, while the leverage is still $100. The ETF no longer has exactly a 2:1 ratio. In order for it to maintain this ratio, it has to increase its leverage by another $10 before the next day.
Day 2: The ETF starts with $110 in equity and $110 in leveraged products. Assume the index drops by -5% on this day. The equity in the ETF would drop to $99, while the leverage products are still at $110. Again, in order to get the leverage back down to a 2:1 ratio, the ETF must reduce its leverage to $99.
This is called the leverage trap, because it has the effect of buying high (i.e., putting $10 to work after a 5% up day) and selling low (i.e., removing $11 from the market after a 5% down day). Once this process starts, it is very difficult for you to ever get back on track to match the 2:1 promise over long periods of time. When the ETF sells securities on a down day, it is decreasing the amount of shares you start with the next day. The higher the volatility of the index the ETF attempts to track, the worse the long-term performance compared to its benchmark.
Tax Effect
In addition to “The Leverage Trap,” these ETFs can come with very high turnover, which increases cost and generates short-term capital gains from the constant adjusting of the leveraged portfolio to meet the target leverage ratio. One of the attractive attributes of ETFs in general is their process of redeeming their shares. This is to attempt to eliminate capital gain taxes. Leveraged ETFs often create capital gains taxes for their investors, thus eroding a key benefit to owning ETFs rather than mutual funds.
Conclusion
If you take the time to read the fine print, you will find that leveraged ETFs are not designed for the long-term investor. Even the management of these ETF companies claim that these products were designed with the day trader in mind. They advise that long-term investors should not own these products. At Henssler Financial, we are long-term investors, and do not recommend a leveraged ETF product. However, we will buy a more traditional ETF that does not employ a leverage tactic for temporary exposure into a sector or industry. Do not think that if you buy a 2:1 ETF on the S&P 500 or any other index or sector, that you are going to get your money back twice as fast. The math works against the long-term investor, because it is not designed to be held for more than one day at a time. For more information on leveraged ETFs, contact Henssler Financial at 770-429-9166 or experts@henssler.com
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
