Leveraged ETFs

by Jay Pestrichelli on March 29th, 2012

For anyone that considers himself or herself a follower of the markets, I’m sure you’ve heard of leveraged ETFs. It seems to one of the first assets traders talk about when you ask what their into. Recently at the Traders Expo in NYC, almost all of those that attended our workshop had a question about a leveraged ETF. But as I put this into perspective there are just way to many people using these vehicles the without an understanding of how they work.

Hopefully you’ve heard the warnings about leveraged ETF that they are meant as day-trading products, but do you understand why that is the case? More importantly, have you heeded the warning?

For those of you that haven’t heard the warnings before, here’s the 10,000 foot story. The effects of negative compounding hamper leveraged ETFs. It’s similar to the concept discussed in the Buy and Hedge book about volatility. The more volatile a portfolio, the harder it is to make the math work for you. The same is true for leveraged ETFs. Remember that these leveraged products seek to perform a multiple of the daily change of their underlying index.

For example, if the SPX (S&P 500) is up 2% one day, than the 2X leveraged ETF, SSO, will be up 4% for that day. The same applies to the 3X ETFs as well. This created a more volatile performance and over time, the normal ups and downs of the market will cause them to underperform. Very much like the example we use in the book that compares a portfolio that is +/- 10% vs. one that is +/- 30%. Over time the higher volatile portfolio. See one of our first blog posts about this concept here.

Here’s what we mean: Take for example an index that starts out at 100. And lets say for illustration purposes, it moves up and down 1% alternating every day over the next 20 days. After 20 days, the index itself would be worth 99.6%, but the 2X would only be worth 98.4 and the 3X only worth 96.5

But is that really the case with these ETFs? Afterall, they are more diversified and hold a basket of assets and should yield a smoother performance than just owning a stock, right? The answer is…sometimes.

In typical trading environments (whatever typical means), these ETFs will underperform over time. In short times of strong trends, up or down, these leveraged ETFs will outperform. The trick with them is to time them right, and we all know that timing the markets is something we don’t advocate for at Buy and Hedge. It's a hard game to win.

2011 is a great example of how these ETFs perform as the S&P was essentially flat for the year. The SPX index was up 0.5% but SSO was down 3.5% and that includes its penny dividend. Even more pronounced is the comparison to SPY that with its dividend was up 1.9% compared to SSO being down 3.5%. That’s a difference of nearly 5%

Lets compare the QQQ’s (Nasdaq 100). The QQQ’s were up 3.4% in 2011 including its dividend compared to the Triple Q’s TQQQ that were down by 7.3%. The expectation would have been to be up 3X around 10%, however the ETF was down by 7.3%. That’s a 17% swing worse than the uninformed investor would have expected. Also look at how the inverse triple Q’s performed, SQQQ. With the Q’s up 3.4% we would have expected the SQQQ to be down 10%, instead it was down 32.9%.

As I said before, there are times these ETFs will outperform during strong trends. The math compounds to the benefit of the ETF, but again, this only happens during strong up trends and timing is key.

For example, lets look at the first 2 months of 2011. The market began an incredible rally with technology as one of the leading sectors. So lets use the Q’s again as a comparison. The Q’s, including dividends were up 15.6% and only had 11 down days out of 40. The TQQQ was up 52.4% over the same period of time.

We’ll remind you again that over time all of these leveraged ETF will feel the impact of negative compounding and deliver sup-index returns.

The negative compounding effects both the bull and bear leveraged ETFs equally. It can’t be avoided because it’s just a fact of math. Just to drive home the point, let’s compare the financial ETF, XLF to two triple ETF FAS, and FAZ (both very popular).
Over time you can see how they both depreciated in value while the underlying ETF was almost flat. FAS was down 30% for the year and FAZ was down about 50%.

Again this chart shows how if you had timed it right and got into FAZ just before the August sell off, you would have been able to get some nice returns. But alas, over time, these will erode in value.

Keep this in mind when trading these kinds of vehicles and use them what they are designed for, day-trading and very short term trades. Do not use them as a piece of your long-term portfolio.

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Rick - March 29th, 2012 at 12:58 PM
That is something I was not aware of. I would guess the vast majority of invertors are not aware of this either! Thanks for sharing this!

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