Leveraged ETFs: Avoid These 40 Funds At All Costs
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.
Good investing,
Louis Basenese
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).
Any investment contains risk. Please see our disclaimer.
13 Responses to “Leveraged ETFs: Avoid These 40 Funds At All Costs”
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In addition to being the foremost expert on small-cap stocks, Louis is also well versed in special situations including IPOs, mergers and acquisitions, spinoffs and contrarian investments. His commentary has been featured in several media outlets, including MarketWatch. And he's also a top-rated speaker at financial conferences throughout the country. 
Or you could buy a put on the UP leveraged ETF. It goes down when the market goes down, or also if it goes up.
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If you have such a bearish bias on these inverse ETFs even when they should be rising; for those Inverse ETFs that offer options , would it not be easy money to then sell way out of money naked puts?
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Hi Lou,
I read your anouncement the other day of your plan to use Twitter , and this mornings negative response from your clients. I think you need to wake up and listen to your customers. They are paying you for your thoughts on “extremely compelling” stocks and your market insight. This is information your paying customers are not receiving. I , and I am not alone refuse to use Twitter for privacy reasons. You are dividing your thoughts between your paying customers at IU and Twitter, do you honestly think you can determine in advance which thoughts are worthy of IU and which for Twitter. Hindsight is 20/20 we both know that.Your customers are not gaining anything by your decision to dilute your thought process with Twitter.
Regards
Bernie Dolan
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Bernie,
A bit of clarification is needed. I’m using Twitter as a means of communicating “extra” information and insights. Our paying subscribers will ALWAYS get our best ideas and insights.
And there’s no conflict of having to decide what to post on Twitter versus IU, which are both free by the way. I’m using Twitter to notify readers of what I’m reading/researching, as well as provide some passing thoughts on the markets. Some of this stuff never crystallizes into an investment recommendation or doesn’t warrant a full-write up.
For instance, yesterday I shared this nugget of information that I came across that I found interesting: There are currently more S&P 500 stocks trading below their 50-day moving averages than at the March 2009 lows.
That’s not an actionable bit of information, just an observation that I otherwise couldn’t share without Twitter. (Sorry, my editors won’t let me bump a full column from one of my colleagues to share one tiny bit of information).
Another example, I was reading a report on a company that could make a solid contrarian investment after the BP oil spill. I got one page into the presentation and realized many of you would probably like to read it, too. In one click of the mouse (literally), I posted a link to the report via Twitter and went back to my reading.
If I were to use our traditional means of communication I would have had to stop what I was doing… write up a few paragraphs explaining why I got turned onto the report… why the report could reveal an attractive opportunity… and then provide the link.
Then that write-up would have to be copy-edited, a template prepared for online distribution, a test email sent to make sure all the links worked and then it could still take up to an hour for the email to reach everyone on our list.
That seems like a big waste of time (and misuse of corporate resources) just to tell you I’m reading a report. Especially since I can accomplish my goal goal in 2.3 seconds via Twitter, for free
.
In the end, I suggest you monitor my tweets for a couple days (you don’t need to sign up for an account to do so). You’ll see that I’m not giving away any information that I previously reserved for paying customers.
Regards,
Louis & Investment U
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Whwre is the list of the 40 ETF’s to avoid??
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Louis, Thanks for your comments on the inverse ETF’s. I would hope tht your readers who may be interested in buying these ETF funds would do there homework like you mention. Some of us follow other investments letters and a couple of months ago The Elliott Wave said the markets would be in for a sharp (and long lasting)decline. This is why I bought FAZ between 5-3-10 and 5-7-10 and now have a 50+% gain and bought TZA between 5-10-10 and 6-07-10 and have a 22+% gain.. I bought a prudent amount that would handsomely offset my losses from other recommended dividend paying stocks. All taken together I am up about 8% in the last 2 months.
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So what are the 40 triple-leveraged ETFs, or where can I find out?
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Steve, LJ and A Purcell:
For a full list of the ETFs that Lou 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).
Thank you,
Investment U
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When one starts reading an article titled “Avoid These 40 ETFs At All Costs,” one expects to see a list of forty ETF names somewhere. Did I miss it?
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Are you kidding?? I make way more money on triple-leveraged ETF’s than i would on the straight stocks. I get into them as the trend starts, and then get out as the trend dies. if you hold on to them for long-terms (months or longer) then yes you will get sucker-punched in the wallet. But obviously the guy writing this blog doesn’t know about market timing and that there are plenty of people doing it and making money. “Diversification” is for the masses and their small-time conservative 10%/yr trading. Specific dialed-in trading on one or two triple-leveraged ETF’s, with the trends whether long or shorting (or switching to the opposite equivalent ETF), will make you real money. Like 10%/week. You want to play it safe and be small, or you what to do what some of the pro’s do? Your choice.
What to do now? Buy as many shares of ANY leveraged inverse ETF right now (first week of July) and ride it until the DOW hits 9100. Sell half of your shares at your leveraged gain of ~20% in about a month. Set tight stops on the other half for the equivalent of Dow=9300 (~6% in the fund and either get kicked out on a bounce, or ride it down to 8500 or 8000. You don’t think so? Your loss.
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The “Compounding Hurts” criticism is not the fault of the ETF. It is simply a mathematical function and the presence of leverage. it is a definable, visible risk that is not materially different from a margin account without the usual interest or stock loan expense. The issue here is not an ETF issue but an general risk issue and should have been presented accordingly. instead it was used as an evidence item padding an other wise thin body of evidence. The inverses are difficult vehicles and pose significant risk management challenges. The comments gave the impression that the risks were somewhat more specific to leveraged inverses than applicable more broadly than ETFs.
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You don’t know what you’re talking about. I’m sick to death of all these articles that so-called “experts” write, warning against lev’d and inv lev’d etf’s. Your first MAJOR error is that you used a hold time of 4 MONTHS! And you named the date in May, but you didn’t name the date in January. A lev’d or inv ETF on an Index is NOT supposed to be held for 4 MONTH’S !!!!!!! PERIOD! These are Trading vehicles, not long term investment vehicles. Have you read the prospectuses? These instruments are useful in hold times of one day to about three weeks, not more. If you don’t know that, you’re not qualified to write about them. I think you are just jumping on the bandwagon of a hundred other writers I’ve read who are bashing these products. That is your first major mistake. If you knew what you were talking about, you wouldn’t make such a foolish statement. Did you “cherry pick” the worst possible results you could find? I’ll bet you did. I’ve seen many other writers write specifically about FAZ and other Financial based ETF’s. Why do they all write specifically about that small sector, or even that one ETF? It’s probably because that sector of ETF’s has had the worst performance! You totally ignored all of the ETF’s, including lev’d and inverse, that have done nearly perfectly.
I trade TZA and TNA, exclusively. I have made 85.55% (excluding commissions) from November 2009 through today, July 10, 2010. What vehicles have YOU USED to make 85% over the last 8 months??? (without Options) By the way, I make that level of return MARKET DIRECTION NEUTRAL. I couldn’t care less which way the market moves. My system tells me which asset to be in. They both make the same profit, when the market moves in their direction. As my techniques get better, my yields will improve. Also, NOTE: I have done TWO statistical studies on TZA. I studied the correlations between the movement of the Russell and the movement of those two ETF’s. The correlation, even over two or three months, was within 1% or 2% of the theoretical. I did this study over TWO different periods. I don’t remember the dates, but they were long periods, relatively speaking, like a couple months or more. If I make 298% instead of 300%, I’m plenty happy. Also, if you understood daily rebalancing and the Compounding effect, you would know that in strongly trending markets the compounding can actually ADD to the gain, and can make it MORE than the theoretical. For example, if the Russell goes UP for 9 day’s out of ten, or the Russell goes DOWN 9 days out of ten (like it did up until this week), the ETF will make MORE than the theoretical 3X (300%). That is because the compounding HELPS the performance of the ETF. You also ignored THAT fact. You spent 7 paragraphs railing about the negatives of compounding (using absurd numbers) and did not spend ONE paragraph explaining how compounding helps in trending markets. You state “Pick any other time period and it will yield similar results”. Bull. That is just a bald faced lie. You need to study up before writing on something you don’t understand. You have my email address. Please study the relationship between TNA, TZA and the Russell, over any two week period you want, within the last year. Then send me both the BEST AND the WORST case examples you can find. You can’t POSSIBLY find anything that supports your thesis, if you do that. Yes, periods of great volatility: Up, Down, Up, Down every day for two months WILL hurt the return. And if you hold a 3X lev’d ETF for two months during that level of daily volatility, you’re too dumb to be trading. But in a trending market, they do extremely well. Any idiot that doesn’t study something before they buy it, and understand what it is and how it works, deserves to get separated from their money. America is FULL of idiot “investors”, who buy something because Cramer tells them to, but with no clue WHAT they are buying, or why. That is THE FIRST RULE of investing or trading; “Understand what you are buying”. That is just plain rule #1. These lev’d and inv ETF’s are TRADING VEHICLES, NOT INVESTING VEHICLES!!!!! I studied 3X ETF’s for THREE MONTHS before buying my first share. And I have been studying them constantly ever since buying that first share. I understand them better than you do. EVERY ARTICLE that I’ve read ALWAYS uses totally whacked out examples, like you did, with your “down 10% on day one, up 10% on day two. And on and on. That might be OK to explain the basic concept, but it gives a GROSSLY distorted and dishonest example of the “real world” of how these things work. Also, the SAME thing happens with a share of stock. If you buy Ford at 10 dollars and it goes to 5, you’ve lost 50%. But for it to get back to break even at $10, it has to GAIN ONE HUNDRED PERCENT, twice the percentage it went down. How often does an ETF go DOWN 10% in one day and UP 10% the next day? Almost never. I must say, since I use ONLY TZA and TNA, I can’t comment on the tracking accuracy of other leveraged ETF’s. But these two have performed nearly perfectly, when used as designed. You also state “The transaction costs would eat you alive”. Again, this is just a plain lie. You have NO idea what lot size somebody is using. If somebody is moving $5000 in and out of these ETF’s every couple weeks, the “transaction costs”, meaning commissions, are so small as to be virtually unmeasurable, compared to the gain. Using Scottrade, for example, the round trip is $14. 14 dollars out of 5000 dollars is .28 percent. That is barely a quarter percent!!!! Look at my trading results below (all of which are true and Provable). When I make 11.4% in two days, and my commission cost is one quarter percent, making my Net Post Commission Profit 11.15% instead of 11.4%, are my “transaction costs eating me alive”? I don’t think so. If a person is trading $10,000 lot sizes, the commission is half that. I have made 11 trades since November 2009. I have had 8 PROFITS, 2 losses, and One Breakeven. My Cumulative return is 85.55% IN 8 MONTHS. Here are my EXACT pre-commission results, listed as a series of gains and losses, in chronological order, in percentages: 4.56, 11.42, -4.94, 26.37, 10.78, 12.99, 11.37, 2.73, 11.04, .14, -.88. And here is the list of hold times, in days, for all of those same transactions, listed in the same chronological order: 12, 10, 6, 15, 2, 3, 2, 3, 16, 10, 8. Here are the highlights of some of the best trades, which are excerpted from the above numbers: +26.37 in 15 days, +10.78% in TWO days, and 11.37% in TWO days. How many trades have you made in the last year, that yielded 10.78% to 11.37% in TWO DAYS?? Or 26.37% in 15 days? One more thing: Yes, I am fairly smart…..but, I am an ABSOLUTE BEGINNER. I have never traded ANYTHING before November. And I have shown these results in 8 months with NO formal training (but a lot of reading). Pdogg and Joe Rajacic are the only two people whose messages above are accurate. They are both absolutely correct. THEY KNOW WHAT THEY ARE DOING. And Pdogg is RIGHT. Too many people are hoping to make 10% a year, staying totally long with no shorts, and owning 10 stocks, DOING “BUY AND HOLD, ALL THE WAY FROM DOW 14000 TO 6500. A month ago, the Dow closed at EXACTLY the same level it was at TEN YEARS AGO. THEY are the suckers, NOT the knowledgeable self educated people who trade Leveraged ETF’s. Market timing is essential, but it is very easily learned by watching charts and Moving Averages. it’s really not that hard. During the Day Trading fad, most people who did it lost everything, because they had no clue what they were doing. They did SO BAD, that the SEC had to make a rule that requires a minimum account value of $25,000 to Day Trade, to protect people from their own stupidity. I HONESTLY EXPECT to make MORE than a 100% return during my first 12 months trading these two ETF’s. I ALSO expect that my returns will increase greatly as I gain more experience, and continue “tuning” my system. ‘Nuff Said. PLEASE only write articles if you know what you’re talking about.
-Douglas Lee
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Hi Doug,
how have things been going with your Levered ETF’s, since your posting in Invester U?
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