Leveraged ETFs Are Playing with Fire

07/21/2009 9:00 am EST

Focus: ETFS

Vaughn Scully of Standard and Poor’s warns investors that leveraged ETFs are very volatile and can produce returns far different from what they expect.

There is no dispute about the risks—and the limited propriety—of the rapidly growing number of exchange-traded funds (ETFs) that employ leverage. Approved for sale by the Securities and Exchange Commission in 2006, leveraged ETFs offer investors the ability to double and, more recently, triple the daily gains and losses [of] many of the same market indices tracked by unleveraged ETFs.

They are now some of the most actively traded securities in the US, and sponsors are listing new funds constantly: In late June, ProFunds Group announced two new funds that give triple long and short exposure to the daily return of the Standard & Poor’s 500. (Direxion and Rydex/SGI are the two other major sponsors of leveraged ETFs.)

As leveraged ETFs gain in popularity, they have drawn increasing attention for their extreme volatility. The Financial Regulatory Authority (FINRA), the independent regulator for US securities firms, issued a “Regulatory Notice” in June reminding firms of the risks posed by leveraged ETFs and the need to determine whether they are suitable for each investor’s financial situation.

Leveraged ETFs are designed and managed to provide exposure to the daily return of whatever index or security they track. Due to the effects of compound leveraging, the “daily return” over a period of more than one day is the cumulative result of a series of daily leveraged returns, and not the leveraged return of the index. That means that, over time, the performance of the leveraged ETF will diverge from the performance of the index the fund tracks. Severe losses can ensue for investors who fail to appreciate that divergence.

In a fund prospectus, Direxion provides an example of two $100 investments, one in a triple-leveraged ETF and another in an unleveraged ETF based on the same index. If the index rises 5% one day, the triple-leveraged ETF would rise to $115 and the unleveraged ETF to $105. If the index were to fall by 4.76% on the following day, the unleveraged ETF would return to $100, but the leveraged ETF would decline by 14.28% (triple the 4.76%), or $16.42, leaving an investment worth $98.58. Over longer periods of time, or greater volatility, the difference is further magnified.

Looking at the actual returns leveraged ETFs generate over time makes the point even more clearly. For example, over the 12-month period ended May 31, 2009, ProShares Short Russell 2000 (NYSEArca: RWM), which offers the inverse (unleveraged) return of the Russell 2000 index, returned 9.02%, while ProShares UltraShort Russell 2000 (NYSEArca: TWM) recorded a 10.64% loss.

Overall, the structure of leveraged ETFs indicates that they make sense for use as a trading vehicle, and not as a “buy and hold” investment.

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