Tahoe Market Pulse: Leveraged ETFs – good for day-trading, bad for buy-and-hold
June 22, 2016
Leveraged and inverse funds are popular with active traders, but they are coming under increased regulatory scrutiny. These funds are designed to achieve a multiple of an index's return on a daily basis.
For example, a double-leveraged fund should move twice as fast as the index it tracks. A double-leveraged short fund should move twice as fast as and in the opposite direction from the index it tracks.
It is debatable whether these funds work as advertised. Here is an extreme example: China was one of the worst-hit countries during the 2008 financial crisis, with Chinese ETFs losing half their value from mid-March through mid-November.
In that environment, surely the ProShares Ultra-Short China (FXP) was a good security to own. Not so fast. During that period FXP lost nearly 20 percent of its value.
What's going on? Leveraged and inverse ETFs are designed to match the daily return of their benchmark indexes. The fund typically holds stocks, index futures, swaps, or short positions along with cash equivalents to achieve this daily fund objective on an ongoing basis. So on a given day, if the index is down 1.5 percent, then the double-leveraged inverse ETF should be up about 3 percent.
Over longer periods, however, the returns won't match due to compounding. Adding and subtracting the daily percentage returns over a month doesn't equal the percentage change for that month. Tracking results worsen in periods of high volatility.
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Compounding doesn't always hurt a fund's performance. Suppose a double-leveraged fund rises ten percent three days in a row. Its return would be 33.1 percent.
Assuming the index rose five percent on each of those days, the leveraged three-day return was more than double the 15.8 percent return on the index. Strong uptrending markets are a leveraged fund's friend.
Here are more current statistics: Through last week, the S&P 500 is up 1.3 percent. The ProShares Short S&P 500 (SH) should move to the same degree as the index but in the opposite direction, yet its year-to-date return is -3.5 percent. The Direxion Daily S&P 500 Bull 3X (SPXL) is up twice as much as the S&P 500, not triple.
Bottom line: Leveraged and inverse ETFs work well for day-traders, but because of compounding and tracking error these ETFs and poor buy-and-hold investments.
David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
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