Exchange-traded funds have surged in popularity in recent years. As they’ve gained traction, they’ve also become more diverse, and one of the more high-profile ETF types to emerge has been the leveraged ETF.
Leveraged ETFs, which allow investors to magnify the returns of an index by two to three times, sound brilliant in theory. Who wouldn’t want to earn triple what the Standard & Poor’s 500 index did last year?
Alas, all that glitters is not gold. And true to form, the shiny, promising world of leveraged ETFs is more an obstacle to be avoided and overcome than a tool to be harnessed and put to use.
The theory: phenomenal. If you’re bullish on stocks or even an industry or commodity, there’s probably a leveraged ETF for that. Not so bullish? Great! There’s a bearish leveraged ETF out there for you.
[Read: 4 Ways to Protect Your Retirement.]
On the surface, leveraged ETFs seem like a straightforward proposition: “A common misconception is that if an investor thinks the market will increase 10 percent for the year, then they can buy a triple leveraged ETF and make 30 percent for the year,” says Eric Ervin, CEO of Reality Shares, an ETF sponsor with four ETF offerings of its own.
That, however, is not how they work.
In practice: a horror show. The main feature of leveraged ETFs that makes them, generally speaking, a nightmare, lies in their objective: 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 gets hammered, taking a 20 percent hit. It ends the day at $80 per share; ETF B fares even worse, losing 60 percent and closing at $40. That’s a rough start, but it’s what you’d expect.
Now here’s where the thought experiment gets interesting. Imagine on day two, ETF A rebounds, soaring 24 percent to close at $99.20, just 0.8 percent off its price two days before.
ETF B, meanwhile, gains 72 percent. But that only brings it from $40 to $68.80, cementing a two-day loss of 31.2 percent.
“One can see,” says Ervin, that the “market ETF and the leveraged ETF do not maintain a constant relationship past day one.”
Cons far exceed the pros. The leveraged ETF’s imperfect ability to magnify the returns of its benchmark for any time longer than a day is a flaw investors shouldn’t overlook. Although admittedly, for relatively short periods of time, it can work out in an investor’s favor.
Direxion Daily Gold Miners Bull 3X ETF (ticker: NUGT), for instance, was up 575 percent for the year through Monday. Its objective? To triple the returns of the NYSE Arca Gold Miners index, which was up 124 percent over the same period. Objective achieved!
Gold itself, which one can track with SPDR Gold Shares (GLD), was up just 26 percent.
Now, let’s look at how NUGT has performed longer term.
NUGT is off 99.1 percent in the last five years, a period over which its benchmark fell 47.8 percent and GLD lost 24.8 percent. In mid-August of 2011, NUGT was trading for a split-adjusted $18,175.
[Read: Monetary Policy’s Impact on Gold Miners.]
It closed Monday at $163.90.
Perhaps that doesn’t surprise you. NUGT is, after all, a 3x-levered ETF, so maybe it deserved to lose its whole wad. How about ProShares Ultra Gold (UGL), then, a 2x-leveraged gold-tracking ETF? It’s down 55.5 percent in the past five years, while GLD is off just 24.8 percent.
The long-term underperformance of levered ETFs refuses to go away.
The costs are outsized. “Leveraged and inverse ETFs” don’t just suffer from tracking issues, they’re also “more expensive than traditional index-based ETFs,” according to Daniel Kern, chief investment strategist for TFC Financial Management in Boston.
“Proshares Ultra MSCI EAFE (EFO) and Direxion Daily Dev Mkts Bear 3x ETF (DPK),” two leveraged ETFs tied to indices, “both have expense ratios of 0.95 percent 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 long-term performance. If you put $10,000 in a market ETF, let it sit for 30 years and assume it charges a 0.16 percent annual fee, like the Vanguard 500 Index Fund (VFINX), for instance, you’ll rack up a tidy sum over time.
Assuming the average annual return of 9.83 percent, your $10,000 would be worth $158,769. But if your expense ratio is 0.95 percent? You’re walking away with $125,101 — more than $33,600 less.
Complexity and timing. Ever wondered how the sausage gets made? How these juiced-up, newfangled ETFs are able to magnify the returns of their benchmark ETF to begin with? The answer: a lot of really complicated and obscure financial instruments.
Leveraged and inverse ETFs use derivatives like options, swaps and futures to amplify returns without actually borrowing money or using margin.
K C Ma, professor of finance at Stetson University, warns that if trading volumes in these instruments are thin, “the derivatives will be packaged over the counter, which involves serious counterparty risk — a risk that the other side of the trade defaults.”
On top of this, since leveraged ETFs are rebalanced daily, they must buy additional exposure when the index goes up and rid themselves of it when it falls; they buy high and sell low.
For traders who use leveraged ETFs to speculate on short-term market movements — the sort of active trading these ETFs are best-suited for — even then, one’s timing must be exquisite.
[Read: How to Save Thousands of Dollars to Invest in the Future.]
“The rare success of the leveraged ETFs also require the investor to have precise short-term market timing ability,” Ma says. “There is no such thing.”
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Why Leveraged ETFs Are Horrible Investments originally appeared on usnews.com
