James Quackenbush, The Daily Record Newswire
Investors beware: the evolution of exchanged traded funds has recently taken a turn for the worse. Since the development of the “Spiders” and “Diamonds” funds, ETFs have grown extremely popular because of their ability to be traded intraday and their low expenses. Due to their increasing popularity, ETFs have evolved through the creation of sector funds, inverse funds, bond funds, commodity funds and currency funds.
Now ETFs have progressed with the creation of leveraged ETFs and have become highly popular with aggressive day trading investors and hedge fund managers that are seeking to profit and gamble on the dramatic swings in the different markets.
Leveraged ETFs are very risky investments. These funds attempt to achieve returns on a daily basis that are two or three times the return of a stated index. To generate these extravagant returns, fund companies implement a number of investment strategies. These strategies utilize a combination of equities and derivatives such as options, swaps and future contracts to capture the magnified returns.
Some of the more risky leveraged ETFs are comprised of only derivatives. Subsequently, due to the price movement of the derivatives, leveraged ETFs must adjust their strategy daily in order to maintain their stated leveraged return.
In 2006, ProShares developed the first movement of leveraged ETFs, which they called Ultra Funds. These funds were developed to double the daily performance of the underlying indices they tracked. One fund for example, ProShares Ultra S&P 500 (SSO), attempts to generate twice the return of the S&P 500 index. If the index was up 3 percent on a given day, the fund would attempt to generate a return of roughly 6 percent. Consequently, if the index was down 3 percent, this fund would be down 6 percent.
Now, more recently, Direxion Funds have established funds offering investors three times the daily performance of the underlying indices they track. This gives investors even more exposure to market volatility on a daily basis. Direxion has developed over 35 triple leveraged funds that track large-cap, mid-cap, small-cap, financials, technology, commodities and international equity indices.
Most of these ETFs are offered in two types: a bull fund and a bear fund. Most notable are their large cap funds, Daily S&P 500 Bull 3X Shares (SPXL), which seeks to correlate to three times the return of the S&P 500 Index, and Daily S&P 500 Bear 3X Shares (SPXS), which seeks to correlate to three times the inverse of the S&P 500 Index.
Leveraged ETFs have become extremely risky and could be considered a way to gamble on the stock market rather than an investment. The performance of these funds has been extremely volatile and some do not achieve their stated returns. On a daily basis, the return of most leveraged ETFs has been fairly accurate, but over the long-term the return will not correlate with the triple return of their stated index.
For example, during the very volatile period from Feb. 9 through March 9, 2009, the S&P 500 Index lost 22 percent. The performance of the Daily S&P 500 Bull 3X Shares fund had a return of -54.4 percent while the S&P 500 Bear 3X Shares fund had a return of 92.9 percent. If these funds return three times the return of the S&P 500 index, these funds should have had a return of -66 percent and 66 percent.
Clearly these funds do not track their indices accurately and the gain or loss can increase dramatically because of the multiplying effect of daily rebalancing and market movements. Remembering that the goal of the leveraged ETFs is to return three times the underlying index on a daily basis, each day Direxion strives to achieve that goal through rebalancing.
However, less consideration is placed on the product’s long-term performance accuracy. Recently the fund company has changed the name of each of their leveraged funds to include “daily” in the name of the ETF to reinforce the fact that these funds are short-term trading vehicles, not long-term investments.
Even though leveraged ETFs have grown popular with aggressive investors and hedge fund managers, these funds are not for everyone. Even the people at Direxion declare that these are volatile and risky investments not meant for the average investor. Additionally, investors should not expect the long-term performance to be triple the underlying index and returns can be more or less than the anticipated return.
As a result, it is important to know before buying a leveraged ETF that the goal is daily return and the losses associated with these funds can be extremely large due to the leverage factor. These funds are meant for professional managers and experienced day traders and should not be viewed as long-term investments, but rather as speculative investment instruments. Long-term investors should avoid such products and ensure that they are not contained within their portfolios.
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James Quackenbush is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor. Offices at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
