These products have long been considered the wildlings of ETF performance:Hold any one of them for longer than one rebalance period and it will spell doom for your portfolio .
But more than anything else, 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—on a daily basis only. Investors holding these funds longer than one day do so at their own risk.
In the "old days," Treasurys were the safe bet, and stocks were risky.
But data suggests that recently things have been a bit different.
The index table below provides price volatility, a measure of the risk of price moves for a security calculated from the standard deviation of day-to-day logarithmic historical price changes, for fixed-income and equity indexes.
|January 2012 to April 2012||Volatility (%)|
|Barclays Capital U.S. 7-10 Year Treasury Bond Index||6.85|
|Barclays Capital U.S. 20+ Year Treasury Bond Index||16.54|
|S'P 500 Index||10.55|
|October 2011 to April 2012||Volatility (%)|
|Barclays Capital U.S. 7-10 Year Treasury Bond Index||7.58|
|Barclays Capital U.S. 20+ Year Treasury Bond Index||19.58|
|S'P 500 Index||19.54|
|April 2011 to October 2011||Volatility (%)|
|Barclays Capital U.S. 7-10 Year Treasury Bond Index||8.79|
|Barclays Capital U.S. 20+ Year Treasury Bond Index||22.19|
|S'P 500 Index||26.38|
A year ago, securities behaved as they should—bonds were less volatile than stocks.
However, about six months ago, this changed, as volatility for the S'P 500 dipped slightly below that of U.S. 20+ year Treasurys—19.54 percent compared with 19.58 percent (highlighted in gray).
When we look at index data from the past three months, this trend is even more apparent, as long-dated Treasurys showed volatility of 16.54 percent compared with 10.55 percent for equities.
But the market isn't completely upside down—some pockets of the fixed-income space remain low risk.
Although U.S. 20+ year Treasurys haven't enjoyed price stability, the U.S. 7- to 10-year Treasurys had the lowest price volatility throughout the three-month time frame, averaging 7.74 percent. This makes sense—interest rates are harder to predict further out into the future since the Federal Reserve has less influence on long-term rates.
As I mentioned above, one way to play a low-volatility equity environment has been in the inverse and leverage space.
Leveraged And Inverse ETFs
Leveraged and inverse funds typically wreak havoc on portfolios because of their compounding principles.
The only "safe" way to hold inverse and leveraged ETFs long-term is in low-volatility, trending markets. In this case, compounding would work the same way it would in your 401(k) or IRA, as earnings are generated from previous returns.
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 meant to be held only one day, I'll take the liberty of calling them "long term."
The matter at hand isn't tracking error, but rather, whether a levered ETF is able to achieve its target returns when held longer than a day. By "target performance," I mean the index returns modified by the fund's leverage factor.
For example, if the S'P 500 Index returned 16.97 percent, a double-exposure S'P 500 ETF would have target returns of 33.94 percent. Meanwhile, an inverse double-exposure version of this fund would have target returns of -33.94 percent.
The table below compares the different target returns for various funds to their actual six-month returns.
|Name||Ticker||Leverage||Target||6-Month Returns||Net Difference||Difference (%)|
|Guggenheim Inverse 2x S'P 500||RSW||-2||-33.94%||-28.91%||5.02%||-15%|
|ProShares UltraShort S'P 500||SDS||-2||-33.94%||-28.97%||4.97%||-15%|
|ProShares Short S'P 500||SH||-1||-16.97%||-15.12%||1.85%||-11%|
|Guggenheim 2x S'P 500||RSU||2||33.94%||30.14%||-3.80%||-11%|
|ProShares Ultra S'P 500||SSO||2||33.94%||29.73%||-4.21%||-12%|
|ProShares UltraPro Short S'P 500||SPXU||-3||-50.90%||-41.64%||9.26%||-18%|
|ProShares UltraPro S'P 500||UPRO||3||50.90%||43.94%||-6.96%||-14%|
|S'P 500 Index||SPX||0||N/A||16.97%|
|ProShares Short 20+ Year Treasury||TBF||-1||0.40%||-4.40%||-4.79%||-1208%|
|ProShares UltraShort 20+ Year Treasury||TBT||-2||0.79%||-9.92%||-10.72%||-1350%|
|ProShares Ultra 20+ Year Treasury||UBT||2||-0.79%||1.72%||2.52%||-317%|
|Barclays Capital U.S. 20+ Year Treasury Index||LT11TRUU Index||0||N/A||-0.40%|
These data show that recently, levered and inverse funds have been returning close to their targets in periods far exceeding one day.
For example, the Guggenheim 2x S'P 500 ETF (NYSEArca:RSU - News) returned 30.14 percent, falling short of the six-month target by only -3.80 percentage points. The inverse version of RSU, the Guggenheim Inverse 2x S'P 500 ETF (NYSEArca:RSW - News), returned -28.91 percent, or about -5.02 percentage points off the target.
On the other hand, long-dated Treasurys have been showing the erratic performance that's usually the trademark of levered equity funds.
To compare the net difference of stocks and bonds on a relative basis, let's look at the percentage of the percentage-performance difference.
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.
In relative terms, it underperformed by -1208 percent, whereas equities on average underperformed by less than -20 percent.
This performance is quite different from a year ago, when equities were volatile and not trending. In this case, fixed-income levered ETFs were less likely to burn investors when held over the long run.
|Name||Ticker||Leverage||Target||1-Year Returns||Net Difference||Difference (%)|
|Guggenheim Inverse 2x S'P 500||RSW||-2||-12.68%||-22.78%||-10.10%||80%|
|ProShares UltraShort S'P 500||SDS||-2||-12.68%||-22.90%||-10.22%||81%|
|ProShares Short S'P 500||SH||-1||-6.34%||-10.20%||-3.86%||61%|
|Guggenheim 2x S'P 500||RSU||2||12.68%||3.19%||-9.49%||-75%|
|ProShares Ultra S'P 500||SSO||2||12.68%||2.80%||-9.88%||-78%|
|ProShares UltraPro Short S'P 500||SPXU||-3||-19.02%||-37.10%||-18.09%||95%|
|ProShares UltraPro S'P 500||UPRO||3||19.02%||-3.97%||-22.99%||-121%|
|S'P 500 Index||SPX||0||N/A||6.34%|
|ProShares Short 20+ Year Treasury||TBF||-1||-33.21%||-29.83%||3.38%||-10%|
|ProShares UltraShort 20+ Year Treasury||TBT||-2||-66.43%||-52.22%||14.21%||-21%|
|ProShares Ultra 20+ Year Treasury||UBT||2||66.43%||74.20%||7.77%||12%|
|Barclays Capital U.S. 20+ Year Treasury Index||LT11TRUU Index||0||N/A||33.21%|
Holding levered and inverse funds long term is only safe in low-volatility and trending markets. But as the past year shows, no one asset class is a "safe" bet when using levered and inverse funds.
Knowing when markets will be low volatility and trending is incredibly difficult, perhaps even impossible.
What holds true today may not be true tomorrow, which is to say that timing is 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.
The next time someone labels these investment vehicles as "evil" when they destroy another portfolio, know that levered and inverse ETFs were probably being used incorrectly.
These products don't behave erratically—their performance is predictable only as far as the market is unpredictable.
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