Understanding Leveraged and Short ETFs

Posted 08/24/2009, 9:00 am EST by Staff from ETFguide.com

Leveraged and short ETFs attempt to magnify their gains and to provide inverse market performance to various stock, bond and commodity indexes on a daily basis. Because they aim to achieve investment results that usually target the daily returns of their underlying benchmarks, they�re probably best suited for investors with a short-term investment time horizon. Since leveraged and short ETFs are principally designed to achieve daily returns, their long-term performance is likely to deviate from the long-term performance of their respective underlying indexes.

Let�s analyze an example of how the performance for leveraged and short ETFs works.

In FIGURE 1, let�s assume you invest $1,000 in two different ETFs: a triple leveraged ETF and a triple inverse performing ETF. Suppose the underlying index increases by 5% on a single day. After the market close, the triple leveraged ETF gained 15% while the triple inverse ETF lost 15%. Both types of ETFs performed as designed.

FIGURE 1: Market Close on Day 1

Beginning ValuePerformance Return on Day 1Value at End of Day 1Total Performance Return
Index Value 100 +5% 105 +5%
3x Leveraged ETF $1,000 +15% $1,150 +15%
3x Short Leveraged ETF $1,000 -15% $ 850 -15%

As illustrated in FIGURE 2 (see below), let�s suppose the index declines in value by 5% the following day. Over the entire two-day period the index has lost 0.25%. However, the performance for both leveraged ETFs over the same two-day period produce much greater losses of negative 17.25% and negative 2.25%. This example illustrates how the returns of leveraged ETFs are much more exaggerated and dramatic than their underlying indexes. Also, over longer periods of time the performance of the funds is likely to deviate from their underlying benchmarks due to the compounding effect of fund fees, index volatility and tracking error.

FIGURE 2: Market Close on Day 2

Beginning Value on Day 2 Performance Return on Day 2 Value at End of Day 2 Total Performance Return for 2 Days
Index Value 105 -5% 99.75 -0.25%
3x Leveraged ETF $1,150 -15% $827.50 -17.25%
3x Short Leveraged ETF $ 850 +15% $977.50 -2.25%

Let�s assume the same pattern of returns (positive 5% one day followed by negative 5% the following day) for 30 consecutive days. At the end of 30 days, the index lost 3.69%. Interestingly, while both the leveraged long and leveraged short ETFs have opposite daily goals, they both finish the 30 day period with the same 28.91% loss.

FIGURE 3: At the End of 30-Day Period

Beginning Value on Day 1 Ending Value on Day 30 Total Performance Return Over 30 Days
Index Value 100 96.31 -3.69%
3x Leveraged ETF $1,000 $710.81 -28.92%
3x Short Leveraged ETF $1,000 $710.81 -28.92%

What role, if any, should leveraged and short ETFs play inside your portfolio? It�s a good idea to consider the following three issues before deciding whether these specialized ETFs are right or wrong for you.

Your Time Horizon
If you have a very short investment time horizon of just a few days, then leveraged and short ETFs could be right for you. That�s because the investment objective of virtually all leveraged and short ETFs is to achieve short-term investment results that correspond to the daily inverse or daily magnified performance of their respective indexes.

For instance, the Direxion Daily Emerging Markets Bull 3x Shares (EDC) aims to deliver three times the DAILY performance of emerging market stocks within the MSCI Emerging Markets Index. If this particular benchmark increases in value by 1% on any given day, EDC tries to obtain a 3% gain. If emerging market stocks decline by 1% on any given day, EDC should fall by 3%.

Investors that want to bet on the long-term gains or losses of a particular asset class or industry sector should probably not be using daily leveraged and short ETFs. It�s that simple. Product developers are already working on ETFs that attempt to achieve magnified performance returns over longer time periods, not just daily returns. The next iteration of these funds might be better suited for investors that have an intermediate time horizon.

Your Level of Risk Tolerance
A careful assessment of your own willingness to tolerate risk is crucial to your investment success. You should do this before you invest money, not afterwards. Your age, your income and your current investment mix are just a few points to consider. Once you�ve gotten a satisfactory answer, then you can make informed investment decisions. If you�re thinking about investing in leveraged and short ETFs or already own them, have you completed your self-examination?

Your Investment Goals
Any investments you decide to buy should always be compatible with your ultimate investment goals. If you�re an income oriented investor, for example, it would make little sense if the vast majority of your investments consist of growth investments which produce little or no income.

Always make sure the investments inside your portfolio match your goals. This is true for any type of investment, leveraged and short ETFs included.

Tax Considerations
Even though most ETFs limit the amount of tax distributions, there are exceptions. Over the past few years several leveraged and short ETFs had record tax distributions that caught some investors by surprise. In one particular year, a leveraged ETF had a short-term capital gains distribution that was 86% of the fund�s NAV!

Since the underlying securities inside leveraged and short ETFs are options, futures contracts and swaps rather than individual stocks or bonds, the in-kind redemption process does not work to create the same tax-efficient results as conventional ETFs. For example, if a short ETF is redeemed, the fund company is forced to liquidate some of the underlying derivatives to raise cash to pay exiting investors. This is likely to result in a tax distribution gain or loss for remaining ETF investors holding the fund.

Typically, most ETF providers will distribute their annual tax gains or losses during the fourth quarter of each year. While some companies may announce tax distribution dates a few weeks in advance, others may only give a few days notice. Stay alert! If a certain ETF is expected to have a large tax liability and you already own it in a taxable account, it may be wise to sell the fund just before the distribution date. On the other hand, if you�re thinking about buying an ETF with a large pending tax liability, it may be in your best interest to delay the purchase of the fund until after the distribution record date.

Conclusion
Generally, leveraged and short ETFs do well of tracking their indexes when markets are trending in one direction for a short period of time. However, during volatile times or range-bound markets the performance of leveraged ETFs tends to deviate significantly from underlying indexes, especially over longer periods of time.

You should examine the entire spectrum of key factors along with your own financial situation before you�ve convinced yourself that leveraged and short ETFs are right or wrong for you.