Fingers Crossed Behind Back

Index Funds Advisors, Inc. (IFA) has consistently warned investors to stay away from the potentially toxic assets known as leveraged and inverse exchange-traded funds (ETFs). These funds are designed to provide a multiple of the daily returns of an index (before expenses), with the multiple being either a positive or a negative number. For example, if the S&P 500 has a day with a 1% gain, then the expected gain of a 2x leveraged fund is 2% and the expected loss of a 2x inverse fund is 2%. The funds accomplish this through the use of swaps and other derivative instruments, which are unlikely to provide the same level of security for the ETF holder as is provided by ETFs that are backed by actual equity or bond holdings.

Unfortunately, many of the speculators (we won’t call them investors here) in these funds lack a good understanding of the relentless arithmetic of returns, particularly the asymmetry between positive and negative returns1. Returning to our example above, if the 1% up day is followed by a 1% down day, then we may expect the 2x leveraged and inverse ETF holders to be at breakeven. Alas, this is not the case, as both of them will have suffered losses due to the fact that a 2% drop must be followed by a 2.04% gain to end up at breakeven. The essential problem with holding a leveraged or inverse ETF for a long period is that the daily volatility of the market makes it very difficult to achieve a positive return even if the speculator is correct regarding the overall direction of the price movement. For example, in 2008, The Dow Jones US Select REIT Index dropped by 39.2%. However, rather than making the killing they may have expected, buyers of the Proshares Ultrashort Real Estate ETF (SRS) suffered a worse loss than the index itself (50%)!2 The common response of the fund companies is that these funds are intended as hedges to be held for extremely short periods. Of course, investors who take on exposures that they later feel necessary to hedge should question the validity of their investment strategies.

The two primary providers of leveraged and inverse ETFs are ProShares and Direxion Funds, and it seems they are engaged in an arms race to see who can offer the riskiest funds to the speculators to better enable them to blow up their portfolios (it is a safe bet that the overwhelming majority of the buyers of these funds are male) . The latest salvo comes from Direxion which announced that ten of its 2x funds will be converted into 3x funds3. This makes a lot of sense if you accept the premise that 2x funds are for wimps and weenies.

As we have stated before, ETFs are best used to achieve long-term exposures to sensibly constructed indexes as part of a globally diversified portfolio of index funds. Wise investors avoid the sucker’s bet of leveraged and inverse ETFs.


Sources & Disclosure:

This is the difference between arithmetic (simple) averages and geometric (compounded) averages, which account for changes in principal.

Proshares Ultrashort Real Estate (SRS) and Dow Jones US Select REIT Index data provided by Morninstar ®

http://etf.about.com/b/2011/10/19/direxion-ups-some-leveraged-etfs-from-2x-to-3x.htm