These products have long been considered the wildlings of ETF
performance:Hold any one of them for longer than one rebalance
period and it could spell doom for your portfolio, according to
some.
But really, these funds are deeply misunderstood. Thankfully, a
recent low-volatility, trending equities market shines much-needed
light on them.
I'll explain, but first, a variation on the standard financial
disclosure language you've seen a million times:Leveraged and
inverse funds are designed to deliver what's in their
title-leveraged or inverse returns, on a daily basis only.
Investors holding these funds longer than one day do so at their
own risk.
Leveraged And Inverse ETFs
Leveraged and inverse funds can wreak havoc on portfolios over
the long haul because of their compounding principals.
The only "safe" way to hold inverse and leveraged ETFs long term
is in low-volatility, trending markets. In these markets,
compounding can actually help you; that is, in the right market,
geared ETFs can deliver more than their daily leverage targets over
long periods of time. At the very least, they can come close.
This is pretty much what the market has been doing recently.
Take a look at the table below of long-term returns of leveraged
and inverse funds. Although most people wouldn't classify six
months as a long-term investment, for funds that are typically held
only one day, I'll take the liberty of calling them "long
term."
I've compared the "simple multiple return" for various S&P
500 ETFs with their actual, realized return. By "simple multiple
return," I mean the return of the benchmark S&P 500 index over
the full time period, multiplied by the leverage factor, with no
adjustments for compounding. This is the return an investor would
expect if they naively didn't understand that these were daily
compounding funds.
For example, if the S&P 500 Index returned 16.97 percent, a
double-exposure S&P 500 ETF would have a "simple multiple
return" of 33.94 percent. Meanwhile, an inverse double-exposure
version of this fund would have a simple multiple return of -33.94
percent.
%20returned%2030.14%20percent,%20falling%20short%20of%20the%20six-month%20simple%20multiple%20return%20by%20only%20-3.80%20percentage%20points.%20The%20inverse%20version%20of%20RSU,%20the%20Guggenheim%20Inverse%202x%20S&P%20500%20ETF%20(NYSEArca:RSW),%20returned%20-28.91%20percent,%20or%20about%20-5.02%20percentage%20points%20off%20the%20simple%20multiple.%3C/p%3E%0A%3Cp%3EInterestingly,%20things%20haven%E2%80%99t%20been%20so%20clear%20on%20the%20bond%20side.%3C/p%3E%0A%3Cp%3E%C2%A0%3C/p%3E%0A%3Chr%20class='system-pagebreak'%20/%3E%0A%3Cp%3E%C2%A0%3C/p%3E%0A%3Cp%3EAs%20you%20can%20see,%20the%20U.S.%2020+%20year%20Treasurys%20have%20been%20deviating%20from%20their%20target%20returns%20by%20much%20larger%20percentages%20of%20returns%20than%20their%20equity%20counterparts.%3C/p%3E%0A%3Cp%3EFor%20example,%20the%20single-exposure%20ProShares%20Short%2020+%20Treasury%20ETF%20(NYSEArca:TBF)%20returned%20-4.40%20percent%20in%20the%20six-month%20period,%20whereas%20a%20simple%20multiple%20of%20the%20benchmark%20return%20was%200.40%20percent.%3C/p%3E%0A%3Cp%3EThat%E2%80%99s%20a%20difference%20of%20%E2%80%9Cjust%E2%80%9D%204.80%20percent,%20but%20on%20a%20relative%20basis,%20it%E2%80%99s%20enormous.%3C/p%3E%0A%3Cp%3EThis%20performance%20is%20quite%20different%20from%20a%20year%20ago,%20when%20equities%20were%20volatile%20and%20bonds%20more%20stable.%20In%20this%20case,%20fixed-income%20levered%20ETFs%20were%20less%20likely%20to%20burn%20investors%20when%20held%20over%20the%20long%20run.%20In%20fact,%20you%20can%20see%20that%20the%20Treasury%20ETFs%20did%20better%20than%20the%20naive%20multiple%20would%20suggest%20over%20the%20time%20period%20studied.%20The%20ProShares%20Ultra%2020+%20Year%20Treasury%20ETF%20(NYSEArca:UBT)%20returned%2074.20%20percent,%20while%20the%20underlying%20index%20returned%2033.21%20percent%20(which%20would%20suggest%20a%2066.43%20percent%20simple%20multiple).%20That%20shows%20how%20compounding%20can%20actually%20help%20leveraged%20and%20inverse%20funds%20in%20trending%20markets.%3C/p%3E%0A%3Cp%3E%C2%A0%3C/p%3E%0A%3Cp%3E%3Cimg%20src=)
Source:Bloomberg
What gives? Well, Treasury markets have become much more
volatile over the past few months, while the S&P 500 has become
less volatile. The daily price volatility of the 20-year Treasury
index from April to October 2011 was 22.19 percent, while the daily
price volatility of the S&P 500 was 26.38 percent. But from
October through today, the volatility of the 20-year Treasury has
been 18.41 percent-greater than the 18.02 percent volatility of the
S&P 500. For the last three months, this difference is even
more apparent. For the last 90 trading days, volatility for 20-year
Treasury bonds was 16.74 percent compared to S&P 500's 12.48
percent.
Holding levered and inverse funds long term without rebalancing
is only safe in low-volatility and trending markets, and only if
you monitor the funds on a daily basis. But in those situations, it
can work.
Importantly, however, you can't count on any particular asset
class to act in any particular way:Just as you can't count on
Treasurys to always be "safe," similarly, you can't count on stocks
always to be risky. What holds true today may not be true tomorrow,
which makes timing and careful monitoring more important with
inverse and leveraged products than with others, because of the
effects of compounding returns. The longer investors hold on to
one-day products, the more room they create for uncertainty and
volatility to creep in.
Still, the next time someone labels these investment vehicles as
"evil" or say they can never be held for long periods of time-know
that levered and inverse ETFs were probably not being monitored, or
were otherwise being used incorrectly.
These products don't behave erratically-it's just that their
long-term performance is predictable only as far as the market is
unpredictable.
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