Leveraged ETFs may talk a good game, but are they living up to their claims?

Financially engineered products have become mainstream products for investors. Some live up to their billing while other products require a second look. Such is the case with leveraged and inverse exchange traded funds (ETF)

Leveraged and inverse ETFs are a relatively new tool for deploying leverage in an investment portfolio and shorting the market. First launched in 2006, leveraged ETFs mirror an index but they use borrowed capital in addition to investor equity to provide a higher level of investment exposure.

Typically, a leveraged ETF seeks to maintain a constant leverage level on a daily basis. For example, a "2x" ETF will maintain a $2.00 exposure to the index for every $1.00 of investor capital. Inverse ETFs seek to deliver the opposite of the performance of the index or benchmark they track and are often marketed as a way for investors to hedge or profit from their exposure to downward moving markets. With leveraged ETFs, the funds goal is to have future appreciation of the investments made with borrowed capital exceed the cost of the capital itself. The reality, however, is that leveraged ETFs often do not deliver what they promise. After adjusting for their leverage level, these types of ETFs have a tendency to underperform their respective indexes as the holding period progresses.

Warning label

The market is starting to recognize this tendency. According to a report from State Street Global Advisors, assets in U.S. ETFs rose $20.1 billion in August, up 3.3 percent from the previous month, to $661 billion. However, assets in the subset of leveraged and inverse ETFs were down $2.09 billion, the second consecutive month of declining assets. Leveraged and inverse ETFs account for less than 10 percent of total U.S. ETF assets.

In August 2009, the Financial Industry Regulation Authority (FINRA) issued a warning about leveraged ETFs to individual investors. "Not all ETFs are created equal," says John Gannon, FINRA senior vice president for investor education. "Over time, leveraged and inverse ETFs can deviate substantially from the performance of the underlying benchmark, particularly in volatile periods. They are highly complex financial instruments that can turn into a minefield for buy-and-hold investors."

A rebalancing act

One of the important features of a leveraged ETF is the necessity to "rebalance" every day so that the portfolio can deliver the leveraged performance on a daily basis. A hypothetical 2x S&P 500 Index ETF, which seeks to achieve 200 percent return of the index, demonstrates how this works. At the conclusion of any given day, the leverage in the ETF would most likely be something other than double the return prescribed for the portfolio. If the index was up on the day, the "equity" in the fund's portfolio would have increased dollar for dollar with the stock portfolio of the 2x ETF. As a result, the portfolio would be under-leveraged for the following day. As such the manager would need to buy more exposure in the underlying index through either stock index futures or more stocks for the fund's portfolio.

Likewise, following a down day, the portfolio would be over-leveraged, forcing the manager to reduce exposure to the index by selling either futures or stocks. This daily rebalancing act enables the portfolio to deliver the leveraged performance on a daily basis. It also tends to produce a trail of trading losses. This is most noticeable when the market is trading "sideways" – that is, staying in the same trading range over a period of time. Consider the following scenario, in which the market vacillates between two levels in a consecutive day. The ETF's portfolio manager would buy at the end of the "up day" only to turn around and sell at the end of the next day at a lower price. The result is a negative impact on returns. Meanwhile, the market is stuck in place at the same general level.

Less obvious is the fact that the same dynamic would be at work for the inverse ETFs. If the index drops, the equity in the overall portfolio would increase disproportionately, necessitating more shorting. These positions would be brought back after the market goes up. To summarize, the daily rebalancing act would force the portfolio managers to chase their positions, regardless of the direction of leverage. The structure of leveraged and inverse ETFs can have an unanticipated effect on returns. While on a daily basis, leveraged ETFs deliver as promised, over time, the leverage causes these funds to deviate from their goals. The result is variance-related losses. Richard Co, a director in financial research and product development at CME Group, says "the variance-related loss, which is embedded in the leverage ETF structure, equates to shorting market volatility. So in a volatile market these losses can be significant."

Co provides the following example to illustrate the point. Positions were initiated in a 2x S&P ETF as well as a "minus 2x" S&P 500 ETF in equal dollar amounts. The value of the two positions, including all distributions, was calculated at the end of the month. Intuitively, with equally weighted plus and minus 2x halves in the portfolio, the monthly performance of the opposing ETFs should approximately offset. However, the graph below shows that it is decidedly not so. In volatile months, like those in the third and fourth quarter of 2008, the self-hedged portfolio of leveraged ETFs actually delivered net loses upward of 7 percent in a month.

Further, as the graph illustrates, the plus 3x and minus 3x financial sector ETFs suffered significant losses in the first half of the year, despite the fact that the financial sector was largely unchanged for the first five months of the year. For market participants who anticipate holding a position in a leveraged ETF for any period of time beyond one day, Co says that futures offer better control over the leverage and help them avoid the variance-related losses inherent in leveraged ETFs.

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