Just Say No to Leveraged ETFs

11/05/2013 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman of The Blue Collar Investor makes the case for why leveraged ETFs are not appropriate for conservative option strategies such as covered call writing.

Our premium members receive a weekly report of exchange-traded funds (ETFs) appropriate for covered call writing. These lists will never include a leveraged ETFs because we feel that these securities are too risky and suitable only for sophisticated investors with high risk-tolerance. In this article, I will break down the mechanics of how leveraged ETFs work and demonstrate why it is not suitable for many retail investors.

Leveraged ETFs use a series of investment strategies such as short-selling, purchasing put options and using futures contracts to magnify the performance of the index that the ETF is tracking. They are constructed to return 2x or 3x of the underlying index value. As an example, if an index is up 1% in a day, that leveraged ETF would be expected to rise by 2% or 3%that day. Many use the term Ultrain their names.

Daily Re-Balancing and Long-Term Results
Fund managers are driven to trade derivative securities such that at the end of a trading day the fund meets its advertised performance. Because of this daily re-balancing of the funds, the long-term results may not be the same as its advertised objectives. As long as the index increases in value the stated leverage will be met. However, if the index drops in value, the leveraged ETF will be worse off than the expected value based on its stated objective. Let’s set up an example to explain these concepts:

  • Ultra BCI is a leveraged ETF with the objective of generating 2x the returns of index XYZ

  • Share value = $20

  • Index value = $1000

  • On day 1 the index rises 10% to 1100

  • Ultra BCI rises 20% to $24

  • On day 2 the index drops back to 1000, a decline of 9.09% (100/1100)

  • Ultra BCI drops by 18.18%($4.36) to $19.64

  • While there was no change in the index after 2 days, there was a 1.8% decline in share value

QLD: leveraged ETF looking to return 2x that of QQQ (Nasdaq 100):

To further demonstrate how the fund’s leveraged objective does not usually hold true long-term, let’s view a five-year comparison chart of QQQ (black line) versus its leveraged partner QLD (2x) (blue line):

chart
QLD vs. QQQ
Click to Enlarge

Note how QLD performed much better than its stated 2-to-1 objective long-term as QQQ rose precipitously over the past five years.

Tax Implications
Because of the nature of the derivatives employed to reach the fund’s daily stated objectives, investors are subject to a complicated set of tax rules and therefore are not as tax efficient as standard ETFs.

Conclusion
Leveraged ETFs are not appropriate for most retail investors because of the risk and high volatility. It is particularly inappropriate (in the eyes of this investor) for conservative investors utilizing a conservative strategy like covered call writing. For sophisticated investors with high-risk tolerance, this may be a useful security to use.

By Alan Ellman of The Blue Collar Investor

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