The Right Way to Use Leveraged ETFs
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Leveraged ETFs have been growing in popularity over the last years, and so has been the discussion about their advantages and perils for individual investors. For the most part, investors have complained about the fact that these products don't work as expected. The problem, however, remains in investors' ignorance and misuse of these products, which has caused many regrettable damages in portfolios for some time.
These ETFs are designed to provide the double or triple of the return of a certain index on a daily basis. It can be long or short exposure, in which case the ETFs provide double or triple the inverse return of the index in question. This definition has caused a lot of trouble for investors who don't understand the mathematics involved in this kind of leverage.
Before leveraged ETFs became a subject of public discussion many investors believed that they were a correct instrument to profit from investment trends with lower capital and higher returns. On example could be to buy Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS), which is designed to provide the daily triple return of an index comprised of financial services stocks in anticipation of a recovery in the financial sector after the financial crisis.
It was a common mistake to assume that these kind of products implied high volatility, but having a diversified exposure and a long-term horizon should mitigate the risks. With this idea in mind many investors took positions in ETFs like ProsharesUltraQQQ (NYSEMKT: SSO) and ProsharesUltraRealEstate (NYSEMKT: URE), which provide the double of the daily return of technology and real estate stocks, respectively.
The problem is not that these instruments fail to deliver their promise, the big issue is that double or triple the daily return of an index doesn't mean double or triple that return over a month or a year. In fact, the higher the leverage level and the longer the holding period, the most likely it is that the leveraged ETF will become a losing proposition.
An example may clarify the idea; let's suppose an investor buys a simple – unleveraged – ETF at $100 and returns over the next two days are 10% first and -9.1% later. The initial investment would grow to $110 in the first day and go back to $100 after the second day losses, so the investor would be right where he or she started at the end of the two-day period.
A triple leveraged ETF would gain 30% (10x3) in the first day and lose -27.3% (-9.1x3) on the second day. The ending value, however, would be much lower with a $95 price versus a $100 initial value. Please notice that this is due to the mathematics of leverage, and it has nothing to do with the ETF working badly.
|
|
Initial value |
Return day 1 |
Value Day 1 |
Return Day 2 |
Value Day 2 |
|
Simple ETF |
100 |
10% |
110 |
-9,1% |
100 |
|
3X Leveraged ETF |
100 |
30% |
130 |
-27,3% |
95 |
On some occasions, for example when prices go straight up, a leveraged ETF may provide good returns, but markets don't usually keep rising in a straight line for long periods of time. For this reason, medium and long term investors should avoid these kind of instruments.
Actually, there is a smart way in which investors could capitalize on these instruments and take advantage of their characteristics, which implies using them from the short side. Those looking to bet on the upside for the financial sector, for example, could short DirexionDailyFinancialBear 3X (NYSEMKT: FAZ), which is designed to provide three times the inverse daily return of financial sector stocks.
If the stocks in the index start rising, the ETF should decline in value. For long periods of time its leveraged nature would mean that the instrument should decline even if prices move laterally and don't do too much. The investor wins if prices move in the right direction or if they oscillate laterally for some time.
Being short a leveraged ETF may not be the most comfortable exposure for individual investors, but at least it's much better than buying these instruments and having to face their decline in value do to their leveraged nature. There is only one smart way to invest in leveraged ETFs for the long term, and that is on the short side.
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