TF could be just what you need.">
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TRADER'S NOTEBOOK


Leveraged ETFs

10/22/09 08:47:11 AM PST
by John Devcic

If you’re into short-term index strategies, a leveraged ETF could be just what you need.

Exchange traded funds (ETFs) have grown by leaps and bounds since their introduction. Embraced by institutional investors as well as self-directed traders and investors, ETFs are almost as widely accepted an investment vehicle as mutual funds. Leveraged ETFs are no longer the new kids on the block. They are becoming popular nonetheless, promising double or triple the return of a normal ETF. Investors are beginning to add these to their portfolio. Is a leveraged ETF the right fit for your portfolio?

LEVERAGED ETFS
Leveraged ETFs were first introduced in 2006 by ProShares. That first leveraged ETF known as Ultra ProShares is still around today. The concept of a leveraged ETF is pretty easy to understand. Leveraged ETFs track an index, so they do not outperform one. While tracking the index, a leveraged ETF is designed to double or triple the return of that index for that trading day. Yes, that’s right! Say the Dow Jones Industrial Average (DJIA) goes up 1% tomorrow and you own the leveraged ETF that tracks the DJIA; you would have made a 2% return. There are two important concepts about leveraged ETFs that need to be understood:

  1. A leveraged ETF is designed to double or triple the return of the index it tracks, up or down. The leverage works both ways. If you are correct in your analysis and believe a particular market is going to go up, you could indeed double your return. If you are wrong, however, things are going to get bad quickly.
  2. The second important concept to remember about leveraged ETFs is they are designed to double or triple the return of the index they track on a daily basis. These leveraged ETFs are not meant to be buy & hold instruments. It is important to differentiate the idea of doubling or tripling a daily return versus doubling or tripling a long-term return. Most self-directed investors look at investments for the longer-term time horizon. The nature of leveraged ETFs is not conducive to investing for the long term; they are strictly short-term investment plays. The concept of leveraged ETFs is easily understood, but the complexity lies in how these leveraged ETFs actually work.

UNDER THE HOOD
Leveraged ETFs use derivatives such as index futures, equity swaps, and index options in order to double or triple the return of the market they track. I mentioned earlier that leveraged ETFs double or triple the return of the market they track daily because they reset it daily. Management will have to hold an equal amount of debt and equity at all times.

Say a fund has $200 million invested. It will have to go out and borrow that exact same amount. That $400 million in the fund will be invested in the index it is set to track. In order to borrow that $200 million, the fund uses derivatives. Every single trading day, the assets in the fund will either go up or down. This change causes the leverage ratio to change. This means total assets are not equal to total debt. By the end of the trading day, the fund’s leverage has to be reset.

Simply put, if the fund tracks go down, the fund will have to sell shares in order to reduce its debt level. If the index goes up, the fund will have to buy shares. A leveraged ETF will incur a lot of expenses from this daily resetting. Over a long period of time, the performance of these leveraged ETFs will diverge from the index that the fund was set out to track. This is why a long-term approach to these indexes is a gigantic mistake. It is best described in a prospectus: “Over the course of a year, a fund using triple leverage for a long exposure to an index experiencing 20% volatility would lose 11% of its value even with no net change in the index.” Clearly, this is not an ETF you can buy and hold as a long-term play.

THE GOOD, THE BAD, AND THE UGLY
The good:
There’s no need for margin since margin is already built into the fund. If you do use margin to buy shares of this type of ETF, you need to realize that you change the leverage from 2x or 3x returns to 4x and 6x returns, respectively. You are using leverage without having to rely on options or margin.

  • Short-term trading — If you are tracking an index and believe the index will go higher or lower that day, you can use leveraged ETFs to quickly capitalize on this short-term move.
  • Using derivatives — Most self-directed investors and traders will not be able to add the power of derivatives to their portfolio without a lot of hassle. Leveraged ETFs allow you to profit if your analysis is correct using derivatives.

The bad:
These funds will incur lots of management fees due to the daily rebalancing of the fund that other ETFs just won’t have.

  • Leveraged ETFs can be dangerous — If you are an investor who doesn't understand the potential for losses in these ETFs, you could see massive losses quickly even if the tracked index is slightly down or trading sideways.
  • Thinly traded — Some leveraged ETFs are not heavily traded, so closing a position could be a problem. It is critical that a potential investor look at trading volumes of the leveraged ETF that he or she is interested in. With new leveraged ETFs appearing all the time, you will need to keep a close eye on trading volumes.
  • Short-term play — These are ETFs that, because of daily resetting, can cause compounding losses to mount if an investor decides to buy and hold onto a losing position. Even if the index that the leveraged ETF is tracking is trading sideways, you could still see a loss in your leveraged ETF. Losses can mount fast if the investor is not careful.

The ugly:
Due to their popularity, leveraged ETFs have come under scrutiny recently from both politicians and financial regulators. This is all in an effort to protect an investor who may believe these funds are something they are not. They are not long-term buy & hold ETFs. If an index is up 10% for the year, this does not mean the ETF will be up 20% or 30%. Both the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) have warned individual investors that these leveraged ETFs are not buy & hold instruments. They feel that while the current prospectuses do indeed point out this fact, they feel that more information and a clearer message needs to be delivered by these leveraged ETF companies. Recently, Massachusetts has decided to review the sales practices of the leveraged ETFs.

THINK SHORT TERM
Leveraged ETFs have been used by savvy daytraders and investors since 2006. Self-directed investors and traders who plan on incorporating leveraged ETFs into their investment strategy need to learn all they can.

The most important thing to remember about these leveraged ETFs is that they are not, nor should they be, used as a long-term play. They are designed to be used in short-term trading strategies. Do not expect a leveraged ETF to return double or triple the index it tracks over the long term. Leveraged ETFs are a knife that cuts both ways. Leverage is a wonderful tool to have because wins become bigger, but so do losses. Caution is the rule when it comes to leveraged ETFs. If you are not interested in buying and selling these ETFs on a daily basis, you should not be involved.

That said, if you have a short-term index strategy, a leveraged ETF can be a fantastic tool. All powerful investments need to be understood before being used appropriately.

SUGGESTED READING
Devcic, John [2009]. “Get Shorty,” Technical Analysis of STOCKS & COMMODITIES, Volume 27: November.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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