There is a groundswell of controversy about Leveraged ETFs and inverse ETFs these days, and for good reason. These products are generally poorly understood by investors and are usually intended to be held for periods of a single trading day. That’s because they tend to deviate substantially from - and underperform relative to - their benchmarks over intermediate and longer periods of time by design.
Consequently, under most real world scenarios, these ETFs might not meet the objectives of long term buy and hold investors looking to magnify the returns of an index over periods of time longer than a few days or weeks.
Let me explain why.
What’s all the fuss about?
Leveraged ETFs are designed to multiply the return of an underlying index. For example, you might buy a 2X leveraged ETF based on the S&P 500. When the S&P 500 goes up 1% in one day, the ETF is designed to go up by approximately 2%. Similarly, if the S&P 500 drops by 1%, the ETF's value typically falls about 2%.
Inverse ETFs (sometimes called "ultra short" funds) are similar to Leveraged ETFs, but multiply returns in the opposite direction. A 2X inverse ETF based on the S&P 500 would target a rise of 2% if the S&P 500 dropped 1% in a day. Conversely, if the S&P 500 goes up 1% in a day, the ETF would decline 2%.
On the surface, these sound like perfectly straightforward products suitable for someone looking to take a directional bet on the market at higher leverage. But there is a giant caveat. You'll notice that we repeatedly say "in a day." That's because most Leveraged and Inverse ETFs have the objective of achieving their return multiple on a daily basis only. Once the trading day is over, they "reset," which means they don't try to multiply the returns you see over longer periods of time. This means that the value of these ETFs can (and usually do) diverge from the value of the underlying asset.
Let me say that again, the value of leveraged ETFs deviate from their indexes for periods greater than a couple days by design. These deviations can be very substantial, particularly in periods of high volatility. And this has caught a number of investors and advisory brokerages by surprise.
Why leveraged ETFs do not mirror their benchmarks longer term
The SEC and FINRA have issued a joint advisory notice about Leveraged and Inverse ETFs. Here’s their explanation of why the divergences happen:
…let’s say that on Day 1, an index starts with a value of 100 and a leveraged ETF that seeks to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 20 percent on that day and have an ending value of $80. On Day 2, if the index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 20 percent, which means the ETF would have a value of $96. On both days, the leveraged ETF did exactly what it was supposed to do – it produced daily returns that were two times the daily index returns. But let’s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99) while the 2x leveraged ETF lost 4 percent (it fell from $100 to $96). That means that over the two day period, the ETF's negative returns were 4 times as much as the two-day return of the index instead of 2 times the return.
That’s right, in this example, the index ends up down 1% after 2 days and the “2x” leveraged ETF ends up down 4% by design!
Alternatives to leveraged ETFs
While Leveraged and Inverse ETFs may be useful for day traders with a high tolerance for risk, there are other methods for investors seeking to take leveraged directional positions for weeks, months or years.
For example, if you’re looking to increase your leverage over a longer period of time, trading a regular index ETF on margin is a possible alternative, depending on your assets, appetite for risk, and other factors. Index options are another alternative, but these tend to be very risky as well, and options are not suitable for all investors*.
Now, Zecco / Zecco Trading are not in the business of making specific recommendations. So if you’re set on holding a leveraged ETF longer term, that’s your prerogative. Just make sure you understand the risks.
So now we'd like to open it to you. What do you think? Are Leveraged and Inverse ETFs "portfolio killers"? Should they be banned? Do you love them? Do you trade them?
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person should read and understand the Characteristics and Risks of Standardized Options. Hard copies of this document may be obtained by either clicking the link above or contacting Zecco Trading at customerservice@zeccotrading.com. For more information you may also contact the Options Clearing Corporation at One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).