Investment Analysis Of Leveraged ETFs

Qingquan Tony Zhang

University of Chicago – Booth School of Business

Thomas Judge

University of Chicago, Booth School of Business, Students

February 16, 2016

Abstract:

Due to the lower management costs and higher liquidity versus traditional mutual funds, the ETFs category has recently expanded at a faster pace than anytime before. The transparency in publicly traded ETFs gives investors access to diversified portfolios that were only available to large institutions before. In this paper, we study the ETFs’ features, benefits and disadvantages from the asset management perspective with an emphasis on the structure and risk analysis of the leveraged ETFs. Our research indicates that ETFs, though attractive in many aspects, should be managed with caution. The leveraged and inverse ETFs can result in huge negative returns due to value decay effects and high bid-ask trading spreads.

Investment Analysis Of Leveraged ETFs – Introduction

The most recent turmoil in global capital market has been a driving force for the wide adoption of the Exchange Trade Funds (ETF), particularly the highly leveraged ETFs, for instance, elocityShares 3X Long Crude ETN linked to the S&P GSCI Crude Oil (UWTI), ProShares Trust Ultra VIX Short Term Futures ETF (UVXY) andProShares Ultra Gold(UGL). In January 1993, the American Stock Exchange and State Street Global Advisors launched the first popular U.S. ex-change traded fund (ETF), the Standard & Poors Depository Receipt (SPDR). Commonly known as Spiders, ownership interests in this ETF was designed to track the performance of the S&P 500 index. As we all know, The S&P 500 index uses the value-weighted approach, thus focusing on the market performance of the 500 largest-capitalization stocks publically listed on U.S. exchanges which encompass over 70% of total value of U.S. equities. After a relatively slow start, the U.S. ETF industry evolved at a rapid pace.

According to the research report, the ETF industry assets under management (AUM) grew from $34 billion to $777 billion between 1999 and 2009. Since the financial crisis in 2008, the ETF industry has been quickly expanding and garnering greater assets, sometimes at the expense of the mutual industry. At its current pace, ETF assets under management could easily double in just a few more years as more independent advisers utilize the low-cost investment instrument to construct their optimal portfolios. According to McKinsey & company, over the last ten years, assets in ETFs have expanded over 30% annually, compared to a 5% to 6% growth in mutual funds. The global ETF family assets have been projected to increase to between $3.1 trillion and $4.7 trillion from a little over $1.5 trillion today. Particularly, with the evolution of the industry, the ETFs, especially the leveraged ETFs have become a greater variety of ETFs and more complex in the structure. Such an evolution has also created new opportunities and challenges for investors, market participants and regulators. However, only few research have been dedicated to the long term performance of the leveraged ETFs. In this article, we aim to provide a systematic analysis of structures, risks, and long term performance of this ETF category.

Leveraged ETFs

The ETFs Sponsors

The current largest ETF providers include:

  1. iShares, a family of ETFs managed by BlackRock. iShares, the largest ETF provider in the world, with more than 440 funds and over $480 billion of assets under management. Their family of ETFs is built around virtually every leading index provider: Barclays Capital, Dow Jones, FTSE, JPMorgan, Morningstar and S&P.
  2. IndexIQ is a developer of index-based Alternative Investment ETFs covering multiple asset classes. Their lineup includes ETFs providing exposure to Hedge Fund Styles, Commodities, Natural Resources, Real Return, Inflation Hedging, and Single-Country Small Caps.
  3. IndexIQ is a developer of index-based Alternative Investment ETFs covering multiple asset classes. Their lineup includes ETFs providing exposure to Hedge Fund Styles, Commodities, Natural Resources, Real Return, Inflation Hedging, and Single-Country Small Caps.
  4. State Street Global Advisors (SSGA) manages a family of ETFs in the U.S. and Canada known as SPDRs, as discussed above. This name was taken from the first member of the family, the S&P Depositary Receipts fund, which uses the call symbol SPY. SPY is the largest ETF in the US, and tracks the S&P500 stock market index. SPDR funds are formulated as unit investment trusts. As of 2006, the SPDR portfolio had $102 billion in assets under management.
  5. Direxion Shares provides multi-directional and leveraged ETF products. They offer 2x and 3x ETFs, that provide 200% or 300% leverage and the ability for investors to navigate changing markets with flexibility. Direxion Shares ETFs include the first Short Small Cap Fund, first leveraged Long 10-Year Bond Fund and first 300% Leveraged ETFs.
  6. EG Shares, by Emerging Global Advisors (EGA) ETFs, allow investors to access exposure to emerging markets and are usually be targeting focused on specific sectors or themes. EGA offerings are derived from their research into the ever-shifting world of emerging markets and track indices for emerging market exposures. EGA believes the difficulties inherent in emerging markets make ETFs the right choice for price exposure to those markets.
  7. ProShares is the worlds largest manager of inverse and leveraged funds, offering 115 ETFs that provide exposure to U.S. and foreign equities, fixed-income, commodity, currency and volatility benchmarks. Like other ETFs, ProShares allow investors to gain exposure to market indices. But ProShares attempts to implement complex investment strategies in a single trade, which add transaction cost for investors. Products include Short, Ultra, Alpha and Volatilty ProShares.

Leveraged ETFs

Leveraged ETFs

See full PDF below.