Leveraged ETFs are often considered as the ultimate investment vehicles in volatile market conditions. Investors who want to hedge their stock portfolio may buy a double short of Dow Jones Financial Index <IYF> or of S&P 500 <SDS> expecting to make daily investment returns of 200% the inverse of the daily performance of the index. Hence, for 1 percent decline of the market, they expect to make a profit of 2 percent.
Exchanged Traded Funds (ETFs) seek for investment returns that are twice the returns of the underlying index for a single day. This explains their efficiency as investment vehicles on a short-term horizon. However, trying to maintain a constant leverage ratio in a portfolio by trading leveraged ETFs on a long-term horizon may result in the portfolio selling off its assets in the worst of timing.
One of the major misapprehensions is that leveraged ETFs are suitable for long-term investment. The answer is a resounding ‘no’, especially in volatile markets. Leveraged ETFs do not offer twice the annual returns of the underlying index. They only double the daily returns of the index. Although, if used properly, they allow investors and hedge funds the opportunity to hedge, the truth of the matter is that the losses of the leveraged fund are 4x the losses of the index on a two-day sessions.
If the market increases by 10 percent in one trading session and declines by 10 percent in the next trading session, the losses of the leveraged fund are 4 percent and not 2 percent. This happens because, as leveraged ETFs are always calculated as a double short of the underlying index, their losses are also calculated based on the same logic. However, after calculating losses, the difference from 1 is greater for the leveraged fund than for the underlying index. Therefore, if the underlying index has losses equal to 1 percent [(1+10%) x (1-10%) = 0.99, that is 1-0.99 = 0.01], the leveraged fund has losses equal to 4 percent [(1+20%) x (1-20%) = 0.96, that is 1-0.96 = 0.04]. The mechanics of the daily recalculation of the leveraged ETFs ultimately leads to a substantial deviation of their returns from the underlying index, which makes them unsuitable for long-term investment.
Investors rebalance their leveraged ETFs by taking the opposite position of the direction of the market. When the index goes up, they reduce the leverage ratio. When the index falls, they increase the leverage ratio to capture the index upturn. However, leveraged ETFs are, by default, designed to maintain a constant leverage ratio. At the opening of the trading session, the leveraged fund maintains equal proportions of debt and equity in the portfolio. If after the trading day, the market has gone up, the fund tends to buy additional shares. Conversely, if the market has declined, the fund tends to sell shares. This is called the Constant Leverage Trap. In effect, leveraged ETFs buy high and sell low to maintain a constant leverage ratio and this has a major impact on the volatility of the underlying index. Eventually, it can lead to major sell-offs in bear markets that may impossible to recover from in the next bull market like it happened in the recession of 2000 – 2002.
Commodity markets are difficult sectors to trade in mainly due to a higher leverage than most investors feel secure with. The introduction of leveraged ETF products has offered investors the opportunity to earn more on index-based securities. However, as these markets are extremely volatile, leveraged ETFs should be used systematically by experienced investors over short periods of time.