Funds that attempt to magnify performance long or short with leverage are the ETF industry's punching bag. Earlier this year, one high profile executive warned they "could blow up" the whole business. Radical views aside, under what circumstances might an advisor use leveraged long/short ETFs? How do these types of funds behave in various market cycles?
Just the Facts Ma'am
A leveraged ETF uses derivatives and debt to magnify the returns of an underlying index. Among the top U.S. providers of leveraged funds are Credit Suisse, Direxion Investments, Deutsche Bank and ProShares. At the end of April, there were 270 leveraged ETFs with around $30 billion in assets, according to Deborah Fuhr, managing partner at ETFGI.
The asset classes covered by leveraged long/short ETFs include commodities, currencies, government bonds, volatility, domestic and international stocks. Despite vocal criticism, these products are transparent, heavily regulated, and have not had a negative impact on financial markets or the ETF industry.
Let's analyze three different market scenarios and how leveraged long/short ETFs react.
Scenario 1: Market Prices Increase
In Table 1, let's assume you invest $10,000 in two different ETFs: a triple daily leveraged ETF and a triple daily inverse performing ETF. What happens after the underlying index increases by 5% on a single day? As illustrated, the triple leveraged ETF gained 15% while the triple inverse ETF lost 15%. Both ETFs executed their daily investment goals as they're supposed to.
Correction: The table above should say $11,500 for the 3X Leveraged ETF Value at End of Day 1.
Scenario 2: Market Prices Decrease
Now let's suppose the index declines by 5% the following day as shown in Table 2. Over the entire two-day period the index has lost 0.25% in value. Yet, the performance for both leveraged ETFs over the same two-day period produces much greater losses of negative 17.25% and negative 2.25%.
As illustrated in Table 2, the performance returns of leveraged ETFs are much more exaggerated compared to the unleveraged benchmark. That should come as no surprise. But keep in mind the performance of leveraged funds over longer time periods is likely to deviate from their underlying benchmarks due to the compounding effect of fund expenses, market volatility and tracking error.
Scenario 3: Market Prices Are Flat
The final scenario is a flat market environment.
Let's assume the same pattern of performance (up 5% one day followed by down 5% the following day) for 30 consecutive days. What happens at the end of 30 days? Table 3 shows the index lost 3.69%. However, both the leveraged long and leveraged short ETF completed the 30 day period with an identical 28.92% loss.
