Leveraged ETFs Explained

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1 Leveraged ETFs Explained Published by Portfolio Research Partners General Leveraged Exchange Traded Funds are the subject of much recent discussion among investors. Leveraged ETFs are just like regular (unleveraged) ETFs in that they are generally designed to replicate the same directional performance of a market index, sector or investment theme. The structure of the portfolio enables the leveraged ETF to move with greater velocity due to leverage created through the use of various forms of derivatives, including options, futures, and swap agreements. Leverage is a general term for any technique to multiply gains and losses to an investment, and is a key term in the investment world. Investors use leverage to magnify returns from investments. The most common form of leverage is borrowed capital either from a bank or brokerage firm. In both cases, securities are usually pledged as collateral for the borrowed funds. Other forms of creating leverage are to use derivatives such as option and futures contracts and swap agreements. These instruments create leverage by enabling investors to control larger positions of the underlying assets beyond the capital invested. Leverage is great when the trade works out as planned because it magnifies the investment returns, but leverage does have its price. If used incorrectly or if the planned investment outcome does not materialize, losses are magnified as well. The first leveraged ETFs were introduced in the summer of 2006, after undergoing almost three years of review by the Securities and Exchange Commission (SEC). In June 2006, ProShares introduced the first wave of leveraged ETFs, referred to as "Ultra ProShares" by the company. The goal of a leveraged ETF is to increase the exposure to a specific asset class or index through the use of various techniques including borrowed capital and the use of derivatives. Typically, a leveraged ETF will maintain a $2 or $3 exposure to the index for every $1 of investor capital. Leveraged ETFs will invest in a variety of instruments to amplify the exposure to an underlying index. In addition to equities, leveraged ETFs may use derivatives (such as futures and swaps) to gain exposure. Futures allow investors to gain exposure to a benchmark without direct ownership. These products are standardized contracts between two parties that agree to buy (or sell) an underlying index at a future date. Swaps are customized agreements between two parties to exchange sets of cash flows over a set period of time. In an equity index swap, one party generally agrees to pay cash equal to the total return on an index, while the other agrees to pay a floating interest rate.

2 These derivatives contracts are generally much shorter-dated than the typical investment holding period. This timing difference and the daily rebalancing of the fund can create further complexities when utilizing Leveraged ETFs. Leveraged ETFs provide exposure on a daily basis, which means that the holdings of the fund are rebalanced each trading day. Due to the effects of compounding, the return to a leveraged ETF over multiple trading sessions depends not only on the change in the underlying index, but on its directional path as well. If the market is trending in one (i.e., the benchmark consistently gained ground) direction, the change in value may be more than 30%. If the market oscillated (shifting between up and down) during the period in question, returns could be less than 30%, and perhaps even negative. There are also inverse-leveraged ETFs that sell the same derivatives short. These funds profit when the index declines and take losses when the index rises. This enables investors to help manage risks in other investments and to hedge their exposure to sectors in which they are overweight. Another way to think about leveraged ETFs is as an actively managed futures strategy in which the portfolio manager is focused on a particular investment theme and utilizes futures and other derivatives to achieve the investment returns. Daily Rebalancing Maintaining a constant leverage ratio, typically two times the amount of invested capital is complex. Fluctuations in the price of the underlying index change the value of the fund s assets, and this requires the fund to change the total amount of index exposure. Example - Rebalancing a Leveraged ETF Suppose a fund has $100 million of assets and $200 million of index exposure. The index rises 1% in the first day of trading, giving the firm $2 million in profits. (Assume no expenses in this example.) The fund now has $102 million of assets and must increase (in this case, double) its index exposure to $204 million. Maintaining a constant leverage ratio allows the fund to immediately reinvest trading gains. This constant adjustment, also known as rebalancing, is how the fund is able to provide

3 double the exposure to the index at any point in time, even if the index has gained 50% or lost 50% recently. Without rebalancing, the fund s leverage ratio would change every day and the fund s returns, as compared to the underlying index, would be unpredictable. In declining markets, however, rebalancing can be problematic. Reducing the index exposure allows the fund to survive a downturn and limits future losses, but also locks in trading losses and leaves the fund with a smaller asset base. Example - Rebalancing in Declining Markets Consider a week in which the index loses 1% every day for four days in a row, then gains +4.1% on the fifth day, which allows it to recover all of its losses. How would a two-times leveraged ETF based on this index perform during this same period? Day Index Open Index Close Index ETF Return Open ETF ETF Close Return Monday % % Tuesday % % Wednesday % % Thursday % % Friday % % By the end of the week, our index had returned to its starting point, but our leveraged ETF was still down slightly (0.2%). This is not a rounding error. It is a result of the proportionally smaller asset base in the leveraged fund, which requires a larger return, 8.42% in fact, to return to its original level.

4 This effect is small in this example, but can become significant over longer periods of time in very volatile markets. The larger the percentage drops are, the larger the differences will be. Advantages and Disadvantages of Leveraged ETFs Advantages of leveraged ETFs are: They offer an easy and inexpensive way to use leverage without using options or margin. They are available in retirement accounts. They are a great trading tool for short-term traders. Disadvantages associated with leveraged ETFs include: The impact of negative compounding can result in long-term inaccuracy. Many leveraged ETFs trade only a few thousand shares per day, leading to low liquidity. Leveraged ETFs are a high-risk investment that could be dangerous to the uneducated investor Summary Leveraged ETFs, like most ETFs, are simple to use but mask considerable complexity. Behind the scenes, fund management is constantly buying and selling derivatives to maintain a target index exposure. This results in interest and transaction expenses and significant fluctuations in index exposure due to daily rebalancing. Due to these factors, it is impossible for any of these funds to provide the advertised multiple returns of the underlying index for long periods of time. Overall, leveraged ETFs are a useful new vehicle for the right strategy, particularly when investing in sectors or indexes. An investor must exercise due diligence and be cognizant of the risks associated with these powerful new investment tools.

5 About Portfolio Research Partners, LLC Portfolio Research Partners, LLC ( PRP ) was formed to bring to market trading strategies that the principles use personally to manage their own portfolios. These portfolios include fixed income, equities and various alpha creating strategies. PRP s goal is to provide unique and profitable trading and investing strategies to the independent investor s community. These strategies include shorter term directional momentum strategies designed to profit from the short term moves of selected asset classes and sectors, medium term equity income and capital appreciation strategies and fixed income strategies. We believe that the independent investor are under served by the brokerage and investment advisors industry and are hungry for unbiased advice as to investment strategies. As independent investors, the principles of PRP know that there is a deep dissatisfaction with the current array of investment services available to the independent investor community. Our services are targeted at the individual who is looking for alternative strategies that shift the risk/reward equation in favor of the investor and not the market, broker or investment advisor.