by Louis Basenese, Small Cap and Special Situations Expert
Thursday, July 1, 2010: Issue #1293
You see that ugly 268-point Dow sell off on Tuesday, followed by the 96-point drop yesterday?
Whatever you do, don’t panic and run for cover in triple-leveraged inverse ETFs.
They may promise big returns, should the market really falter. But I’m here to tell you that they’ll do anything but.
You see, triple-leveraged ETFs (whether long or short) pack a nasty surprise. It’s almost unbelievable, actually. And in this volatile market, they’re hardwired for losses.
Here’s what I mean…
The Nuts and Bolts of Leveraged ETFs
Leveraged ETFs have been around about as long as Hannah Montana (only since 2006).
Given such newness, let’s first make sure we’re all on the same page about the general mechanics of how they work…
- Exchange-traded funds are constructed to mirror the movement of some underlying index. If the index rises 5%, the ETF tracking it is supposed to rise 5% (before expenses).
- An inverse ETF simply moves in the opposite direction of the index it’s tracking. So if the index drops 5%, the inverse ETF should rise 5%.
- Apply leverage, however, and the movements are magnified. So if the ETF uses three-times leverage and the index falls 5%, the ETF should rise 15%.
Sounds simple enough in theory, right?
Too bad the reality doesn’t measure up.
Leverage? What Leverage?
Exhibit A: From January to May 15, 2009, the Russell 1000 Financial Services Index fell by 5.9%.
- A long ETF using three-times leverage should have dropped by 17.7% (minus 5.9 multiplied by 3 = minus 17.7%). But it didn’t. It plummeted by 65.6%.
- An inverse ETF using three-times leverage should have been up 17.7%. But it sank by 83.4%.
Talk about not getting what you paid for.
Pick any other period and I promise it will yield similarly confounding results. And the worst offenders will always be the ETFs using three-times leverage.
The question is: Why?
Two Fatal Flaws of Leveraged ETFs
To be clear, I don’t detest all ETFs.
Their advantages include…
- A low-cost way to achieve instant diversification and/or access markets otherwise not readily available.
- Unlike traditional mutual funds, they also provide intraday liquidity.
But when it comes to leveraged ETFs, those benefits are completely nullified by two fatal flaws in the set up…
- Daily Rebalancing: Leveraged ETFs don’t actually buy individual stocks. Instead, they invest in derivatives. And these derivatives require daily rebalancing in order to match the rise or fall in the index. Otherwise, the leverage ratio for the ETF will be off-kilter. As a result, leveraged ETFs can only be counted on to perform as promised for a single day.
- Compounding Hurts: For years, we’ve been wooed by the power of compounding returns. If you’re 18 years old and invest $2,000 per year for three years (and not a penny more after that), they say you’ll end up a millionaire if you simply leave it invested and let compounding work its magic.
But when it comes to leveraged ETFs, compounding often works against us.
Consider an index that drops by 10% on Day 1, then rises by 10% on Day 2.
If you started with $100, the index would be at $90 after Day 1 and $99 after Day 2. Total return: minus 1%.
Now let’s take a look at what happens with an ETF that seeks double the return of the index – i.e. uses two-times leverage. Again, we’ll assume a starting value of $100…
- Day 1: The ETF would be down 20% to $80.
- Day 2: The value of the ETF would rise by 20% to reach an ending value of $96.
- Total return: minus 4% when it should actually only be down by 2%.
If we ratchet up the leverage to three times and extend the holding period, it magnifies the negative impact of compounding. Toss in some market volatility and this tracking gets even worse.
Stocks Are Down… But Don’t Try to Take Advantage With These Leveraged ETFs
In case you didn’t notice, volatility is back. The average daily change of the S&P 500 is above 1% – roughly double the historical average.
So ignore the headlines pegging leveraged ETFs as “the ultimate hedge for individual investors.” The truth is, there’s never been a worse time to own them, particularly the 40 triple-leveraged ETFs currently available.
You see, beneath a simple exterior – and the allure of a novel hedging strategy – there are considerable complexities and risks. And unless you think you can predict each of the market’s upward and downward moves every day, you’ll never get what you bargained for with leveraged ETFs. Heck, even if you could pull off such a feat, the transaction costs would eat your portfolio alive.
I recommend you avoid triple-leveraged ETFs at all costs.
P.S. For a full list of the ETFs that I referred to in this article, just visit this link: http://etf.stock-encyclopedia.com/category/triple-leveraged-etfs.html. You’ll note that the list is actually comprised of 42 ETFs, but you need to exclude the two from Barclays, as they’re Exchange-Traded Notes (ETNs) not Exchange-Traded Funds (ETFs).