The Dangers of Inverse and Leveraged ETFs

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1 The Dangers of Inverse and Leveraged ETFs The Montage Investment Team Inverse and leveraged ETFs are special types of ETFs, or exchange traded funds, that attempt to track the opposite (inverse) movement or magnified (leveraged) movement of an underlying index. These underlying indices often track a commodity, basket of stocks or bonds, a particular currency, or some other financial instrument(s). ETFs in general are a popular choice among investors because they provide diversification, liquidity, and can have lower trading costs and better tax implications than buying an index s underlying securities. Leveraged and Inverse ETF Design Companies that package these ETFs soon became interested in offering products to investors that would not simply attempt to match indices for an investor, but instead would have daily price movements that were 2 or 3x greater than an underlying index. These were called Leveraged ETFs because the fund managers would use the money invested in the fund to transact in the derivatives market every day. The goal for the fund manager each day is to create a portfolio that will gain twice or three times as much as an index on a given day, while suffering losses that are twice or three times as great when the index falls. Market participants also demanded ETFs that would not track an index or a daily leveraged index return, but an inverse to the performance of an index. Soon, ETF providers were creating products that attempt to match the inverse of the daily price movement, or even 2 or 3 times the inverse (-2x, -3x). For example, a -3x ETF would, on a day that the index it tracks is down 2%, hope to be up by 6%. Montage Investments 4200 West 115th Street, Suite 100, Leawood KS page 1

2 The Risks of Inverse and Leveraged ETFs These types of investment vehicles instantly appealed to very short-term traders with high risk-tolerances who used this additional leverage to make daily, hourly, or minute-by-minute directional bets on different market indices. These funds typically do an excellent job of achieving their objective on a daily basis before fees. The danger arose when investors began buying these funds who were not fully aware of what the implications of holding these funds for longer time periods. These investors typically don t have a full understanding of the products and believe that they can hedge risk or make longer-term bets on the direction of an index, commodity, or currency. The actual risk of these products is pointed out in a disclaimer from ProFunds (maker of ProShares) website, which reads: Each Short or Ultra ProShares ETF seeks a return that is either 300%, 200%, -100%, -200% or -300% of the return of an index or other benchmark (target) for a single day. Due to the compounding of daily returns, ProShares returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily. (Note: the company refers to inverse ETFs as Short and leveraged ETFs as Ultra. Many other ETF providers use similar verbiage, with some calling -2x and -3x funds Ultra Short.) Notice from the company s disclaimer the emphasis placed on for a single day. This is because inverse and leveraged ETFs have daily return goals. A ProShares prospectus explains that they use futures, swaps, or other similar instruments to gain their funds desired return characteristics. Because of the way that these funds are designed, they actually lose value over time due to the compounding of daily returns and as the fund manager has to buy and sell derivatives on usually a daily basis to maintain the fund s stated return. The largest cause of the loss of value to long-term holders (more than one day) of these products is due to the compounding of gains and losses from day to day. The easiest way to demonstrate this effect is through an example: Example 1 Initial Value: An index starts with a value of 100 and a leveraged ETF that seeks to triple the return of the index starts at $100. Day 1: The Index drops 10 points, meaning it has a 10 percent loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 30 percent on that day and have an ending value of $70. Day 2: The index rises 10 percent, the index value increases to 99. For the ETF, its value for Day 2 would rise by 30 percent, which means the ETF would have a value of $91. Resulting Value: On both days, the leveraged ETF did exactly what it was supposed to do it produced daily returns that were three times the daily index returns. But let s look at the results over the 2 day period: the index lost 1 percent (it fell from 100 to 99), while the 3x leveraged ETF lost 9 percent (it fell from $100 to $91). That means that over the two day period, the ETF s negative returns were 9 times as much as the two-day return of the index instead of 3 times the return. Montage Investments 4200 West 115th Street, Suite 100, Leawood KS page 2

3 The above example shows that investors may buy this product believing that they are only taking on three times the risk of the index but actually take on far more, even in a short time span. Investors may be further fooled by looking at leveraged or inverse ETF performance that actually looks close to their stated daily objective over longer time periods. If you do the math, you can see that the 3x leveraged ETF example above would actually perform quite well in a market that only trended one direction. Here is the example under a different scenario: Example 2 Initial Value: An index starts with a value of 100 and a leveraged ETF that seeks to triple the return of the index starts at $100. Day 1: The Index increases 10 points, meaning it has a 10 percent gain and a resulting value of 110. Assuming it achieved its stated objective, the leveraged ETF would therefore increase 30 percent on that day and have an ending value of $130. Day 2: The index rises 5 percent, the index value increases to For the ETF, its value for Day 2 would rise by 15 percent, which means the ETF would have a value of $ Resulting Value: Let s look at the results over the 2 day period: the index gained 15.5 percent (from 100 to 115.5), while the 3x leveraged ETF gained 49.5 percent (it rose from $100 to $149.50). That means that over the two day period, the ETF s returns were actually slightly better than 3x the index (15.5%x3=46.5% while the ETF gained 49.5%). This is due to the way the returns were compounded. A key point to remember is that ETFs do not always achieve their stated goal, and their goal is to achieve a certain return before expenses. Since fund managers must constantly transact in the derivatives market they also incur fees and other expenses that diminish the investor s overall return. Conclusions In summary, leveraged and inverse ETFs are used most often by professional traders to make daily bets on the movement of an index. Investors who hold these products over longer periods than one day incur larger amounts of risk than they may have intended and are often met with returns that are not what they expected. The risks are so great that the SEC has issued a memo outlining the risk of these products to buy-and-hold investors. Investors are advised to always read an ETF s prospectus and understand the structure of any leveraged or inverse ETF that they may invest in so they can fully understand the risks they are taking. Attached are some real-world examples that compare the total return of leveraged or inverse ETFs with the index that they attempt to track daily. Notice that, in the long run, these products can lead to catastrophic losses in value and can even have returns that are opposite to what an investor would expect. Montage Investments 4200 West 115th Street, Suite 100, Leawood KS page 3

4 Real World Examples ProShares Short Financials (SEF) ProShares Short Financials seeks daily investment results that correspond to the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials Index. Investors holding SEF since June 2008 may have expected a positive 25% return (since the index was down 25%), but instead lost nearly half of their investment (47% loss). Direxion Daily Financial Bull 3X (FAS) The Daily Financial Bull 3X Shares seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000 Financial Services Index. Investors holding this leveraged ETF would be happy to see that the Index it tracks has returned 24% since November of 2008, but would be upset to find that holding FAS over that period would have resulted in a 69% loss. Most of this is due to the day-to-day volatility in the underlying index but also from the fund s 1% expense ratio. Montage Investments 4200 West 115th Street, Suite 100, Leawood KS page 4

5 Direxion Daily Treasury Bond Bear 3X (TMV) Direxion Daily Treasury Bear 3x Shares, seeks daily investment results of 300% of the inverse of the price performance of the NYSE 20 Year plus Treasury Bond Index (The Index). The Index is a multiple-security fixed income index that aims to track the total returns of the long-term 20-year and greater maturity range of the United States Treasury bond market. Buy and hold investors that were looking to short treasuries since April of 2009 might have bought TMV instead of shorting treasury bonds in the derivatives market. The bond index returned.39% over that period, while holders of TMV didn t lose 1.17%, but rather suffered a 30.26% loss. ProShares Short Dow30 (DOG) ProShares Short Dow30, formerly Short Dow30 ProShares, seeks daily investment results that correspond to the inverse daily performance of the Dow Jones Industrial Average (DJIA). This example shows that, mostly by the luck of how daily returns compounded together, some inverse ETFs don t suffer quite as much as others. Here the Dow was up 25% over the period shown, while the ETF was pretty close in matching the inverse with a 30% loss. Montage Investments 4200 West 115th Street, Suite 100, Leawood KS page 5