It’s important to remember that often what you see is not what you get on Wall Street. As Dave Nadig, Director of Exchange Traded Funds for FactSet, points out, leveraged ETFs are an instructive case in point.

In his December 12th report in FactSet Insight, Nadig highlights recent media coverage suggesting that the SEC is investigating the operations and business models of leveraged and inverse ETFs. Digging deeper into the the issue, he says the problems surrounding leveraged ETFS are really “about swaps, investor education and volatility.”

Leveraged ETFs

Leveraged and inverse ETFs move up or down based in a preset ratio based on the performance of an underlying asset over a one day period.

Let’s say you were very confident the S&P 500 were going to move up tomorrow. One way to profit would be to buy a leveraged S&P 500 ETF that would give you 200% of the index’s daily returns. If the S&P 500 goes up 1% for the day, you make a profit of 2%. By the same token, if you believe the S&P 500 was going to drop you could purchase an inverse-leveraged ETF that moves up when the index goes down.

Understanding swap contracts

Most of these leveraged and inverse funds are 1940 Act-registered mutual funds, much like Fidelity Magellen or Vanguard Wellijngton. However, rather than owning stocks, they just own cash and a “swap contract” of varying size on the S&P 500.

Nadig explains how swap contracts work: “Swap contracts aren’t traded on an exchange, like options, so they’re considered “over the counter” or negotiated derivatives. The ETF issuer calls up a big bank, like Goldman Sachs, and says “I would like to make a bar bet. Every day, if the S&P 500 goes up 1%, you give me 2%, and if GDX goes down 1%, I’ll owe you 2%.” Every night, the issuer and the bank check out who won the bet, and cash moves from one side of the betting logbook to the other.”

Lack of transparency

The first issue with transparency is that most investors know very little about the costs or risks of the swaps they’re buying through the ETF. Keep in mind there is always a small risk that the swap counterparty could go bankrupt overnight, and not make pay, especially i n a situation where the market moved strongly against the counterparty in the swap.

Nadig also points out that unlike options, there’s no exchange to guarantee settlement. Beyond that, no information about how much the issuer is paying for the swap is publicly available nor what policies are in place to handle problems or disputes.

Need for more investor education

Management of investor expectations is the key problem with leveraged ETFs. Because these funds offer “geared returns” for a single day, they frequently actually perform quite counter-intuitively over a longer period of time.

The key thing to keep in mind is that the  the fund has to reset it’s exposure so it can produce the same pattern of returns as it did the previous day.

The fact that it is a series of daily calculations has a major impact on the long-term performance of the fund.

Nadig offers an example of what you see is not what you get: “if the index being tracked is volatile, investors do worse over time than a naïve person might think (you won’t get -20% returns if the market is up 10% over a year, using the above -2X example, you might get -30%). If the market is very non-volatile, you can actually do better (say, being down only 15% when you “should” be down 20%).”

The way leveraged ETFs are structured can lead to some head-scratching situations. Let’s take a look at the -3X and +3X gold miners ETFs so far this year:

leveraged ETFs
leveraged ETFs

The underlying “asset” here is the Market Vectors Gold Miners ETF, which has dropped around 23% this year. Furthermore, the ETF that gives you triple that exposure (the Direxion Daily Gold Miners Bull 3X) is down a disastrous 75% so far in 2015. Here’s the kicker though. Because of gold’ miners extremely volatile trading over the last 12 months, the INVERSE fund,Direxion Daily Gold Miners Bear 3X is not up 75% as many might expect, in reality it has lost slightly more than the regular 1X unlevered ETF.