Is It Safe To Own Leveraged ETFs Again?

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These products have long been considered the wildlings of ETF performance:Hold any one of them for longer than one rebalance period and it could spell doom for your portfolio, according to some.

But really, these funds are deeply misunderstood. Thankfully, a recent low-volatility, trending equities market shines much-needed light on them.

I'll explain, but first, a variation on the standard financial disclosure language you’ve seen a million times:Leveraged and inverse funds are designed to deliver what’s in their title—leveraged or inverse returns, on a daily basis only. Investors holding these funds longer than one day do so at their own risk.

Leveraged And Inverse ETFs

Leveraged and inverse funds can wreak havoc on portfolios over the long haul because of their compounding principals.

The only “safe” way to hold inverse and leveraged ETFs long term is in low-volatility, trending markets. In these markets, compounding can actually help you; that is, in the right market, geared ETFs can deliver more than their daily leverage targets over long periods of time. At the very least, they can come close.

This is pretty much what the market has been doing recently.

Take a look at the table below of long-term returns of leveraged and inverse funds. Although most people wouldn’t classify six months as a long-term investment, for funds that are typically held only one day, I'll take the liberty of calling them “long term.”

I’ve compared the “simple multiple return” for various S'P 500 ETFs with their actual, realized return. By “simple multiple return,” I mean the return of the benchmark S'P 500 index over the full time period, multiplied by the leverage factor, with no adjustments for compounding. This is the return an investor would expect if they naively didn’t understand that these were daily compounding funds.

For example, if the S'P 500 Index returned 16.97 percent, a double-exposure S'P 500 ETF would have a “simple multiple return” of 33.94 percent. Meanwhile, an inverse double-exposure version of this fund would have a simple multiple return of -33.94 percent.

 

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6-Month Index/ETF Performance

Source:Bloomberg

 

The returns are surprisingly close for the equity products, considering that this does not imagine any rebalancing activity on the part of the shareholder. For example, the Guggenheim 2x S'P 500 ETF (RSU - News) returned 30.14 percent, falling short of the six-month simple multiple return by only -3.80 percentage points. The inverse version of RSU, the Guggenheim Inverse 2x S'P 500 ETF (RSW - News), returned -28.91 percent, or about -5.02 percentage points off the simple multiple.

Interestingly, things haven’t been so clear on the bond side.

 

 

As you can see, the U.S. 20+ year Treasurys have been deviating from their target returns by much larger percentages of returns than their equity counterparts.

For example, the single-exposure ProShares Short 20+ Treasury ETF (TBF - News) returned -4.40 percent in the six-month period, whereas a simple multiple of the benchmark return was 0.40 percent.

That’s a difference of “just” 4.80 percent, but on a relative basis, it’s enormous.

This performance is quite different from a year ago, when equities were volatile and bonds more stable. In this case, fixed-income levered ETFs were less likely to burn investors when held over the long run. In fact, you can see that the Treasury ETFs did better than the naive multiple would suggest over the time period studied. The ProShares Ultra 20+ Year Treasury ETF (UBT - News) returned 74.20 percent, while the underlying index returned 33.21 percent (which would suggest a 66.43 percent simple multiple). That shows how compounding can actually help leveraged and inverse funds in trending markets.

 

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1-Year Index/ETF Performance

Source:Bloomberg

 

What gives? Well, Treasury markets have become much more volatile over the past few months, while the S'P 500 has become less volatile. The daily price volatility of the 20-year Treasury index from April to October 2011 was 22.19 percent, while the daily price volatility of the S'P 500 was 26.38 percent. But from October through today, the volatility of the 20-year Treasury has been 18.41 percent—greater than the 18.02 percent volatility of the S'P 500. For the last three months, this difference is even more apparent. For the last 90 trading days, volatility for 20-year Treasury bonds was 16.74 percent compared to S'P 500’s 12.48 percent.

Holding levered and inverse funds long term without rebalancing is only safe in low-volatility and trending markets, and only if you monitor the funds on a daily basis. But in those situations, it can work.

Importantly, however, you can’t count on any particular asset class to act in any particular way:Just as you can’t count on Treasurys to always be “safe,” similarly, you can’t count on stocks always to be risky. What holds true today may not be true tomorrow, which makes timing and careful monitoring more important with inverse and leveraged products than with others, because of the effects of compounding returns. The longer investors hold on to one-day products, the more room they create for uncertainty and volatility to creep in.

Still, the next time someone labels these investment vehicles as “evil” or say they can never be held for long periods of time—know that levered and inverse ETFs were probably not being monitored, or were otherwise being used incorrectly.

These products don’t behave erratically—it’s just that their long-term performance is predictable only as far as the market is unpredictable.

 

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