Leveraged And Inverse ETFs

Leveraged funds may seem like a good idea – if we expect the S&P 500 to be positive, for instance, then getting four times its return seems even better – but long-term investors (and there shouldn’t be any other kind) should be skeptical.

 

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The use of exchange-traded funds (ETFs) has exploded recently, to the benefit of investors. The structure of ETFs operate more tax efficiently than mutual funds. They also generally have lower operating costs than a mutual fund, resulting in lower expense ratios.

Within the ETF world, leveraged and inverse ETFs have also exploded in popularity. Leveraged funds, often called “ultra” funds, attempt to capture two or three times an index’s daily return. Inverse ETFs, also called “short” ETFs, attempt to capture -100%, -200% or -300%% of an index’s daily return.

These products exist for various indexes, including broad market indexes (like the S&P 500), sector-specific indexes or even commodity indexes (like oil and gas). In May 2017, the SEC even approved a request to list quadruple-leveraged ETFs, which will target a return that’s four-times larger than the daily return of a broad index.

Leveraged funds attempt to capture some multiple of the daily return of an index. Investors should question whether these funds actually are able to accomplish that objective and whether that multiple translates into long-term results. Daily returns are for speculators and day traders, but investors care about how the performance of an investment fits into their overall portfolio.

To capture the higher returns, leveraged funds use a variety of derivative products, including futures, swaps and options. This type of strategy is good for traders who want to make a tactical move to capture some anticipated short-term shift in the market. However, these funds capture a multiple of both the good and the bad. For example, if the daily return of the S&P 500 is -2%, then a fund leveraged to a level double that index would return -4%.

Practically, this means much higher volatility from leveraged funds.

To see the impact of this increase in volatility, along with the higher operating costs from employing derivatives, my colleague, Daniel Campbell, reviewed 10 years of history for some of the market’s largest leveraged and inverse ETFs compared to the indexes they track. Data is as of March 31, 2017. For funds with multiple share classes available over the entire period, we used the lowest-cost share class. Funds were grouped by index, and we made every effort to present all leveraged and inverse funds with sufficient history that track the specific indexes. Data is from Morningstar and the presented statistics are calculated from returns retrieved from Bloomberg.

First, I’ll assess how effective the strategies were at capturing the daily return. No triple-leveraged funds existed over the last 10 years, so I can’t evaluate those explicitly, but the table below gives an indication of the difficulty in employing these strategies. For context, I also present results for one low-cost ETF that tracks the given index and was available over the entire period.

By Larry Swedroe, read the full article here.

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