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How To Trade Leveraged ETFs

Sumit Roy

Leveraged and inverse ETFs are prolific. Out of the more than 1,800 U.S.-listed ETFs out there right now, about one in seven is a leveraged or inverse product.

They're extremely popular too. Products like the VelocityShares 3x Long Crude Oil ETN (UWTI), the Direxion Daily Gold Miners Bull 3X ETF (NUGT) and others each have more than $1 billion in assets.

Yet despite their popularity, the leveraged and inverse ETF space is surrounded by controversy. Many believe these products should be outright banned due to their volatile nature. Some even consider them tools for gamblers, as they point to the tremendous losses that some of these products have seen.

To be sure, the unsavory reputation that leveraged and inverse ETFs have received isn't completely unwarranted. The aforementioned UWTI and NUGT are both down more than 99.4% since inception―a breathtakingly horrible return by any measure (Can An ETF Go To Zero?).

Returns For UWTI & NUGT Since Inception

But that doesn't mean they haven't done exactly what they were designed to do, which is provide 3x-daily leveraged exposure to the indexes they track. This is a bet that oil and gold will go up. For UWTI, that means 3x exposure to front-month crude oil futures, and for NUGT, it means 3x exposure to a basket of gold miner equities.

They key word is “daily”―these products only promise to deliver 3x the return of their underlying index over a one-day period. Over longer-term periods, the pattern of returns between the index and the products can deviate significantly due to the effects of daily rebalancing.

Daily Rebalancing

To illustrate this effect, consider a hypothetical example where oil is trading at $100/barrel and UWTI is trading at $20.

If oil rises by 10% to $110 on the next day, UWTI will increase by 3x that amount, or 30%, to $26.

However, if oil declines to where it was at $100 on the following day―a loss of 9.1%―UWTI will drop 27.3% to $18.91. That translates to a two-day loss of 5.5% for UWTI even though oil is simply back to where it began.

For ETPs tied to volatile flat-to-down-trending areas of the market—such as oil and other commodities—this rebalancing effect has a detrimental effect on returns over time.

For very-short-term traders, that's not a concern. They can use these ETPs to trade in and out of the market in an attempt to capture quick gains that will be close to 3x the index.

It's the longer-term and retail traders—who often don't know how these products work—who end up disappointed or devastated.

Does that mean these products should be banned? Not necessarily. In any case, more investor education is needed, particularly for retail investors who are heavy users of leveraged and inverse ETPs.

Positive Compounding

All that said, it's not possible to make the blanket statement that all geared products perform poorly over longer time horizons. For areas of the market that are trending higher, the daily rebalancing effect can have a decidedly positive effect on returns.

Consider an index that rises 10% five days in a row from a starting value of 100. On day five, the index will be trading at 161.1, a gain of 61.1%. A triple-leveraged ETP that tracks the index will rise by 30% in each of those five days, ending with a gain of 271.3%

In this case, the geared product will have delivered almost 4.5x the return of the underlying index―better than the advertised leverage factor.

Of course, no index or asset goes straight up without at least some volatility. But this example shows that certain leveraged products can be viable to hold over longer-term periods.

One product that fits the bill is the Direxion Daily S&P 500 Bull 3X Shares (SPXL), which is up an enormous 1,830% since the current bull market began in March 2009, compared with a return of 245% for the SPDR S&P 500 ETF (SPY | A-97). That's almost 7.5x the return.

7-Year Return For SPXL, SPY

Bull Market Timing

Of course, just because SPXL has performed well during the last several years doesn't mean it will do so going forward. In fact, during the past year, it’s down 11.9% compared with a loss of less than 1% for SPY.

1-Year Return For SPXL & SPY

That's because the S&P 500 has been flat and volatile during the past year, and geared products perform poorly under those conditions (and even worse in bear markets). SPXL, with $606 million in assets, and similar ETPs perform well in up-trending markets with minimal downside volatility―the typical conditions of a bull market.

That makes them great market-timing tools for aggressive investors with time horizons up to several years, but they're by no means buy-and-hold-forever products.

Contact Sumit Roy at sroy@etf.com.

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