Sunday, January 15, 2012

The Dangers Of Leveraged ETFs

From time to time questions arise about using leveraged ETFs in one's portfolio strategy. We caution longer term oriented investors to not use these type of ETF investments. For example, if an investor believes the market will rise in the near term, why not consider a two or three times ultra bull ETF. In this case an investor would expect the ETF to generated two or three times the return of the underlying index. Well, for an investor, it is not that simply due to how the math calculation works. Let's look a 2x's ultra long or bullish ETF example.
  • Lets assume at the beginning of day 1 an index is trading at $100. At the end of the day the index closes at $90 or down 10%. The leveraged ETF would close at $80 or down 20%.
  • On day 2 the index rises to $99 or up 10%. The 2x's leveraged ETF would increase to $96, that is $80 * 1.20=$96.
  • Over the two day period though the index is down 1% while the leverage ETF is actually down 4% or four times worse than the index return versus the expected two times worse return.
From The Blog of HORAN Capital Advisors

One problem with many of these leverage ETFs is they reset daily and individual investors generally do not rebalance their portfolios on a daily basis. So as one can see, the performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives. More on this topic can be found on the SEC's web site in an article they wrote titled, Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.


Andrew Teasdale said...

I did a graphical analysis of these vehicles that you might find useful.

Exchange Traded Funds said...

Leveraged ETFs are being vilified today because people who do not understand how they work have been burned. This is not the fault of the investment vehicle. It is the fault of the investor and his broker. Brokers have no excuse for not understanding this vehicle, and should ensure their clients are fully versed in the pros and cons before investing.