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Why Geared ETFs Aren’t For Everyone

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·4 min read
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Leveraged and inverse ETFs are popular. Out of the more than 2,900 U.S.-listed ETFs out there right now, about one in 12 is a leveraged or inverse product.

Products like the ProShares UltraPro QQQ (TQQQ), the Direxion Daily Semiconductor Bull 3X Shares (SOXL) and others have multiple billions of dollars in assets.

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

To be sure, the unsavory reputation that leveraged and inverse ETFs have received isn't completely unwarranted. Consider the ProShares Ultra Bloomberg Crude Oil (UCO) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY). Both are down more than 99% since inception―a breathtakingly horrible return by any measure.

 


 
But that doesn't mean they haven't done exactly what they were designed to do, which is provide, respectively, 2x and 1.5x daily leveraged exposure to the indexes they track. They are bets that oil and the Cboe Volatility Index (VIX) will go up. For UCO, that means 2x exposure to crude oil futures, and for UVXY, it means 1.5x exposure to VIX futures.

They key word is “daily”―these products only promise to deliver leveraged returns on 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 UCO is trading at $20.

If oil rises by 10% to $110 on the next day, UCO will increase by 2x that amount, or 20%, to $24.

However, if oil declines back to $100 on the following day―a loss of 9.1%―UWTI will drop 18.2% to $19.63. That translates to a two-day loss of 1.8% for UCO 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 (oil is the same price it was 10 years ago)—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 2x the index.

It's the longer-term holders, 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. But 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 double-leveraged exchange-traded product that tracks the index will rise by 20% in each of those five days, ending with a gain of 148.8%

In this case, the geared product will have delivered almost 2.4x 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 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 2,287% since its inception in 2008, compared with a return of 454% for the S&P 500. That's almost 5x the return.

 


 
Bull Market Timing

Of course, just because SPXL has performed well during the last decade doesn't mean it will do so going forward. In fact, this year, it’s down 43.6% compared with a loss of 15.4% for the S&P 500. 
 
SPXL, with $2.3 billion 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 are by no means buy-and-hold-forever products.

 

Follow Sumit on Twitter @sumitroy2

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