The Problem with Leveraged ETFs

Posted on August 30, 2018 by Gemmer Asset

“When you combine ignorance and leverage, you get some pretty interesting results.”

 

-Warren Buffett

 

With the proliferation of ETFs over the past 20 years just about every asset class you can think of has at least a handful of ETFs to choose from. Because of this, providers have had to get creative in bringing “unique” products to market. Some of the more interesting (trying to be kind here) recent offerings have included (yes these are/were real ETFs):

 

  • The Obesity ETF (SLIM) – Basically a mix of biotech, healthcare and weight loss supplement companies. Thinly traded I might add…

 

  • Global X Millennials Thematic ETF (MILN) – Even ETFs are becoming gentrified

 

  • Spirited Funds Whiskey ETF (WSKY) – liquidated in June of 2018 – no pun intended

 

  • Quincy Jones Streaming Music, Media & Entertainment ETF (QJ) – Filed with SEC

 

  • LocalShares Nashville Area ETF (NASH) – No, its not a country music ETF – Also liquidated in 2018

 

Taking some of these ETFs seriously is a tough task, and many of them are just glorified sector funds with a marketing gimmick attached. They however aren’t the worst offenders in the space. No, that title belongs to leveraged ETFs.

 

Leveraged ETFs are for investors who aren’t satisfied with only getting the return of whatever index they want to track, they’re for the people who want more. For example, an investor who wants exposure to two times the S&P 500 return could buy the The Direxion Daily S&P 500® Bull 2X Shares (SPUU). Its stated purpose is to “seek a return that is 200% the return of its benchmark index on a single day.” It is this last part that makes holding these types of leveraged ETFs, for even a few days, problematic.

 

When 2 – 2 = -1

 

A simple example will illustrate this point. Let’s say that on Day 1, an index starts with a value of 100 and a two times leveraged ETF seeking to double the return of the index starts at $100. If the index drops by 10 points on Day 1, it has a 10% loss and a resulting value of 90. The leveraged ETF would therefore drop 20% on that day and have an ending value of $80. On Day 2, if the index rises 11.1%, the index value increases back to 100. For the ETF, its value for Day 2 would rise by 22.2%, which means the ETF would have a value of $97.8. If you look at each day independently, the ETF performed its stated objective, but if you look at the period as one time frame, the return for the ETF is -2.2%, while the index is flat. The same dynamic occurs with inverse ETFs which seek to yield the inverse return of a particular index. On a single day, these instruments can work as intended, but holding onto them often erodes returns.

 

Here is a year to date chart of the S&P 500 Index versus the two times leveraged ETF (SPUU):

 

 

Year to date the total return of the S&P 500 is +10.3%. Two times that should be +20.6%. SPUU is up only 17.8%, a -2.8% difference in less than 9 months.

 

These things are expensive too. The Direxion Daily S&P 500® Bull 2X Shares ETF we mentioned above has an net expense ratio of 0.67%, while Vanguard’s S&P 500 ETF costs just 0.04%.

 

This year has been positive, so despite the fact that performance hasn’t truly been two times the S&P return, you probably don’t mind being up “only” +17%. What happens when returns aren’t so positive? In 2015, the S&P was up +1.4% and SPUU was actually down -1%. Markets were relatively choppy during the latter half of that year and that daily characteristic of leveraged ETFs eroded returns. ProShares Ultra S&P 500 ETF is another example of a 2 times levered ETF. It has the same objective as SPUU, and as you’d expect, the laws of mathematics don’t change just because the name does.

 

 

In 2011, when the S&P 500 was up +2.1% you’d expect the PowerShares ETF to be up north of that right? Well, it was down nearly -3%.

 

Up until this point, we’ve just given examples of levered ETFs that track the S&P 500. There are some that track oil, currencies, emerging market countries etc. Some will even seek to lever returns up to 4 times!! More volatile asset classes, more leverage… Just take the dynamics above and magnify them.

 

Maybe I’m unfairly criticizing these things. They can make some sense for active traders whose holding period is measured in minutes, not years. If you read the fine print, they generally perform as advertised (i.e. on a daily basis), but they also do a number of things wrong in my opinion: 1) They encourage short time horizons 2) they’re unduly expensive and 3) the name alone causes investors to assume they’re getting a type of exposure that in reality, is not the case.

 

So even if you think an index is due for a banner year, beware leveraged ETFs because +2 and -2 may not sum to zero.

 

 

 

 

Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.

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