The first iteration of leveraged and short ETFs was introduced in 2006. And from that moment, these particular ETFs have captured the fancy of investors and advisors alike.
In just three years, assets in the ProShares ETFs have ballooned from a few hundred million to $26 billion. After less than a year managing ETFs, newcomer Direxion Shares already has $4.1 billion under management. Rydex SGI has around $2.4 billion in leveraged and short ETFs.
Leveraged ETFs attempt to magnify their performance by twice (200 percent) or three times (300 percent) the daily performance of their underlying indexes. Short or inverse ETFs aim to deliver the opposite or inverse performance of their benchmarks. If a stock benchmark declines in value, a short ETF is supposed to increase in value.
Backlash Begins
In June, the Financial Industry Regulatory Authority (FINRA) issued a regulatory alert warning brokers and advisors about the complex nature of leveraged and short ETFs. As a result of this notice, certain brokerage firms like Ameriprise, Edward Jones, LPL Financial and UBS took steps to halt the sales of leveraged and short ETFs by their representatives.
A lawsuit seeking class-action standing against ProShare Advisors, sponsor of the ProShares ETFs, was filed in August. The representing law firm, New York-based Labaton Sucharow, alleges ProShares violated securities law and didn't properly disclose all the risks associated with its UltraShort Real Estate ETF (SRS) in its prospectus and registration filings with the Securities and Exchange Commission. The suit was filed in the United States District Court for the Southern District.
SRS is designed to deliver double the daily inverse performance of the Dow Jones U.S. Real Estate Index. Over longer time periods, however, it's failed to do so. This is not unusual though, because the impact of index volatility, tracking error and fees compounded over time often causes the longer-term performance of such funds to deviate from daily index returns.
The one-year performance through June 30, 2009 for the Dow Jones U.S. Real Estate Index was negative 42.59 percent. Over the same period of time, SRS has fallen by 79.73 percent. SRS has around $1 billion in assets. While other legal actions may soon follow, the lawsuit has yet to interrupt the operation of SRS.
Because they aim to achieve investment results that usually target the daily returns of their underlying benchmarks, today's leveraged ETFs are probably best suited for investors with a short-term investment time horizon. Since leveraged and short ETFs are principally designed to achieve daily returns, their long-term performance is likely to deviate from the long-term performance of their respective underlying indexes.
Analyzing Results
Let's examine an example of how the performance for leveraged and short ETFs works.
In Figure 1, let's assume you invest $1,000 in two different ETFs: a triple leveraged ETF and a triple inverse performing ETF. Suppose the underlying index increases by 5 percent on a single day. After the market close, the triple leveraged ETF gained 15 percent while the triple inverse ETF lost 15 percent. Both types of ETFs performed as designed.
In Figure 2, let's suppose the index declines in value by 5 percent the following day. Over the entire two-day period the index has lost 0.25 percent. However, the performance for both leveraged ETFs over the same two-day period produces much greater losses of negative 17.25 percent and negative 2.25 percent. This example illustrates how the returns of leveraged ETFs are much more exaggerated and dramatic than their underlying indexes.
