ETFs: Losing At Leverage

By Lisa Smith | December 03, 2009 AAA
ETFs: Losing At Leverage

Exchange-traded funds are investments that trade like stocks, but instead of moving up and down with the value of a company, they track an index, or a group of securities such as a basket of commodities. If it is designed to track the largest 500 U.S. companies, then a 1% increase in the value of these companies should give a 1% increase in the ETF.

Leveraged ETFs
Leveraged ETFs are designed to follow daily changes in stock market indexes or other securities. A leveraged ETF with a 2:1 ratio uses financial derivatives and debt to match each dollar of investor capital with an additional dollar of invested debt. If one day the underlying index returns 1%, the fund will theoretically return 2%. While the upside potential is what most brokerage firms tout, the same theory applies for losses.

Leveraged ETFs are under fire. Along with inverse ETFs, leveraged ETFs are the subject of a recent notice from the Financial Industry Regulatory Authority (FINRA) reminding brokers and registered investment advisers that these ETFs are unsuitable to be held by most investors for more than a single trading session due to their complex nature.

Inverse ETFs
Inverse ETFs use derivatives to create a similar effect by betting against the direction of the financial markets. Known as "short" or "bear" ETFs, these products are designed to make money if markets decline. Marketed as a way to reduce your exposure to market risk or enhance portfolio performance, they can also have the exact opposite effect on performance if markets move against the bet. (To learn more about them, read Inverse ETFs Can Lift A Falling Portfolio.)

In Defense and on the Defensive
ProShares, a big player in this space, continues to defend the products, correctly pointing out that retail investors routinely purchase sophisticated investment products. That noted, ProShares UltraShort S&P500 (NYSE:SDS) is advertised as seeking daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P500 Index.

How has the fund done? Since its inception on November 7, 2006, it has not only failed to beat the benchmark, but from January 2, 2009, through July 31, 2009 - a period when the index was up by roughly 6% - the ProShares fund declined by approximately 30%. Investors who were lead to expect "twice the inverse" of daily index performance were not pleased with nearly quintuple that on the downside and have filed a lawsuit.

The ProShares Ultra S&P 500 (NYSE:SSO) shares a similar fate. The fund is up just about double the index for 2009 through October at a net asset value of 31.27% versus 17.05% for the index. But over the three-year period, it lost triple what the index did coming in at -21.79% versus -7.02%. Unimpressed investors have also filed a lawsuit.

Taking a look at Ultra Financials ProShares (NYSE:UYG), a clear pattern beings to emerge. Investors were told that "ProShares Ultra Financials seeks daily investment results, before fees and expenses, that correspond to twice (200%) the daily performance of the Dow Jones U.S. Financials Index." The fund is down 65.76% for the one year through October, while the index is up 9.8%. Paying ProShares to rack up losses that come in at six times the index has not made investors happy. A lawsuit has been filed against them as well.

Ultra MidCap400 ProShares (NYSE:MVV) has fared slightly better. It's 53.51% return through October trounces the index, which posted a gain of only 17%. Longer-term results are less attractive, coming in at -27.4% for the one-year period versus a positive 9.8% for the index and -16.5% for the three-year period versus -7.02% for the index. Again, investors have filed a lawsuit.

The Bottom Line
These complicated, sophisticated investment products have been successfully mass marketed. Not millions or tens of millions, but billions of dollars are now invested in them according to the Wall Street Journal. Whether the money to be made or lost in such sophisticated products is the spoils of victory from a little risk-taking or the punishment for buying products without actually understanding them, there are far less risky ways to invest.

In the current political environment, with massive stock market losses fresh in everyone's mind and regulatory oversight under fire for its complete failure to protect the public from securities fraud on a massive scale in a string of high-profile scandals from Enron to Madoff, the smart money might place an inverse bet on the future of leveraged ETFs. (For additional insight into how these products work, read Dissecting Leveraged ETF Returns and Rebound Quickly With Leveraged ETFs.)

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