Leveraged and Inverse ETFs

The monthly review of the investment management industry by the Financial Times that came out today has a very interesting article in it about leveraged and inverse ETFs.

According to the FT, such ETFs are:

very popular;

badly misunderstood by most holders; and

too risky for almost everyone.

The article isn’t too clear about how these ETFs work.  The best part of it is a chart that illustrates possible outcomes for various types during a week when the stock market is extremely volatile day-to-day, but ends the week up by 2.5%.  In the example, which isn’t very realistic but illustrates the point, an ETF leveraged 2x in the same direction as the market has a slight loss for the week, and one that’s 2x leveraged in the opposite direction as the market ends the week down 19.4%.

What I think the article wants to say, but doesn’t, is that market timing, which is notoriously difficult to do, ends up being a key factor in the performance of these ETFs.  Timing can go right/wrong in (at least) two ways:

1.  when you start is important (look at the leveraged x2 line on the chart).  If you start off with a loss, it can be hard to recover from.  A different example:  if you buy a stock at $100, it loses 50% of its value and then gains 50%, you’re not at breakeven, you’re down 25%! ($100 x .5 = $50; $50 x 1.5 = $75);

2.  in a leveraged ETF, the maximum leverage is reestablished every day.   So market movements at the end of your holding period can have very large effects on your results.  If you buy  an inverse x2 leveraged ETF for $100, for example, you establish $200 in short exposure to the market.  If you’re successful and your ETF share goes up in value to $200, then your short exposure through the ETF rises to $400.  This means your exposure in dollar terms to the market’s movements has doubled.  (That’s why the inverse x2 ETF in the chart drops so sharply on day 5–its short exposure is 230.4, up from the initial 200.  So its loss on day 5 is 35, not 30.)

An example on the long side:  you invest $100 in an ETF that’s leveraged 3x to the movements of an index.  On day 1 you have your $100 + $200 in leverage = $300 total index exposure.  Suppose the index rises by 33.3% that day.  Then you have $300 x 1.333 = $400 at the end of the day.  You have $200 in leverage, so your equity has risen from $100 to $200.

The ETF releverages you each day.  So on day 2 you have $600 in index exposure, your $200 in equity + $400 in leverage.  Let’s say the index drops by 25% on day 2, bringing it back to where it started the day before.  What happens to you?  You lose $150 of the $600, making $450.  Subtract the $400 in leverage and you’re left with $50, or half what you started with two days before–even though the index you’re leveraged to is unchanged.

It’s interesting to note that flows into leveraged ETFs, especially short-leveraged ones, have grown dramatically this year.  I wonder if these flows will turn out to be the same sort of contrary indicator that odd-lot short sales and the put/call ratio once were.

Here’s the article:   Niche ETFs

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