More On Leveraged ETFs

I found this abstract on leveraged ETFs:

Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have “leverage” explicitly embedded as part of their product design. While these funds are primarily used by short-term traders, they are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs.

This note provides a unified framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. We show that the daily re-leveraging of these funds can exacerbate volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.

Just because leveraged ETFs are available does not mean you should use them. To me, they are designed for the sophisticated investor and generally not for Main Street.

Several readers have written in on the subject lately and complained about the lack of promised returns when using leveraged ETFs. My very limited experience confirms that. When testing my SimpleHedge concept during the past 1-1/2 years, I included some of these ETFs, namely SDS.

While SDS performed OK in general, I encountered periods where it did not give me the 200% performance I had expected, and which was necessary for the successful outcome of that particular hedge.

My view is that most investors should stay away from using these products and focus on an investment strategy where leverage is not a necessary ingredient. While maximizing returns is important, the increased risk in today’s volatile and uncertain market environment make using leveraged ETFs a questionable approach.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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