The ETF marketplace has gotten a lot more interesting recently. With over 500 ETFs tracking everything from commodities to currencies, ETFs have brought low-cost access to areas of the market where individual investors were not welcome just a few years ago. This great opening up has been good for investors, but it has also exposed them to new kinds of risks … risks which, in many cases, they do not understand.

Case in point is the new line of leveraged and inverse-leveraged ETFs from ProShares. Leverage has long been reserved for sophisticated investors, with individuals effectively barred from the space by restrictions on options accounts and high fees on the few available leveraged mutual funds. The ProShares ETFs, launched in June 2006, opened things up by allowing levered access to the market with an expense ratio of just 0.95%. Investors have responded by pumping more than $3 billion in assets into the funds.

Do investors understand what they are getting?

Let’s do the math

The ProShares ETFs promise to deliver 200% (leveraged) or negative 200% (inverse leveraged) of the daily performance of major market indexes. So far, the funds have delivered on that promise perfectly: daily tracking errors are almost too small to measure.

But here’s a pop quiz: If the Nasdaq- 100 index rises 10% next year, how much will the ProShares Ultra QQQ ETF (AMEX: QLD) go up?

20%? Wrong. The real answer is: There’s no way to know.

While ProShares ETFs successfully double the daily performance of the underlying indexes, they don’t come close to doubling the long-term return. The reason is simple—compounding.

Let’s imagine that we have an index trading at a value of 100. I invest $100 in a fund designed to deliver 200% of the daily performance of that index. On Day 1, the index jumps 10% to 110, and my investment jumps 20% to $120. Perfect.

But on Day 2, the index falls 10%, taking my investment down 20%. Here, the numbers start to get out of whack. The 10% drop takes the index down 11 points (110/10=11), to 99. My investment, however, drops $24 (120/20=24), to just $96. (See Figure 1.)

Look what’s happened: the index is now down 1% from where it started, while my investment is down 4%. Keep doing that kind of adjustment for a year or more and the discrepancies can get huge.

This isn’t just a theoretical exercise. Figures 2 and 3 show how the initial leveraged and inverse leveraged ETFs have performed since inception. The numbers include data from June 21, 2006 for the leveraged ETFs and July 13, 2006 for the inverse-leveraged ETFs, which were the longest periods available through May 11, 2007, at press time. Of course you also have to factor in the 95 basis point expense ratio, but that becomes insignificant when you look at the compounding effect at work in the funds.

It’s not even close. In their 10-11 month history, these funds have delivered between 118.8% and 162.2% of the return of the underlying indexes. Anyone looking to double the return on these indexes over the past ten months lost out.

This is not a new problem for ProShares. The company is a division of ProFunds, which has been running leveraged open-end mutual funds for years. Over the past five years, their longest-running fund, the ProShares UltraBull S&P 500 fund, has delivered about 144.6% of the performance of the S&P 500.

ProShares has done nothing wrong.

This is a critical point: The ProShares ETFs do exactly what they promise—they double the daily performance of the underlying indexes. ProShares has never said that the funds deliver 200% of the long-term returns. The prospectus for these funds even has a section—in bold—about the impact of compounding.

But ProShares hasn’t been perfect, either. A quick glance on their Web site pulls up one piece of marketing collateral called “The Power Of Sectors, Magnified.” This paper tells investors that, “Using Ultra Health Care ProShares, you can virtually double your exposure to health care with the same investment a traditional sector fund might require.”

That may technically be true on a daily basis, but it misses the point. For a longterm investor, daily returns aren’t the question: What matters is how these funds perform over the long haul. And over the long-haul, they come nowhere close to doubling the performance of the indexes.

You cannot simply sink half your money into these funds and half into Treasuries, and sit back and enjoy a “portable Alpha” benefit. Nor can you hedge the value of your portfolio using half the assets. The funds simply don’t work that way. The data suggest that you can ratchet up your long-term exposure somewhere between 20 and 75%, although how much exactly is anyone’s guess.

Institutional investors who are familiar with leverage know this, and they have the time and money to spend constantly adjusting their hedge levels using futures, options, and other tools. But individual investors aren’t as well-informed. I spoke at a panel session about these ETFs in March, and afterwards, I had three financial advisors come up to me with visions of simple and long-term portable alpha strategies. Clearly, the message of daily returns is not getting across to everyone.

Image 1


A Bigger Problem

It’s not fair to pick on the ProShares. The more fundamental issue is that as ETFs have opened up institutionalquality strategies to retail investors, providers—and the media—have not done enough to educate investors about the more complicated aspects of these strategies.

Image 2


There has been a huge uproar, for instance, around commodities ETFs like the US Oil Fund (AMEX: USO). Many investors bought that fund thinking it would track the spot price of oil, whereas it actually tracks a rolling position in crude oil futures. Those two things are very, very different: USO is trading down 28.6% since inception, while the spot price of crude is down about 15%.

Image 3


Similarly, there are huge differences in the tax treatment of the various newfangled ETFs, which can have an enormous impact on returns. How many investors in the $10 billion streetTRACKS Gold (AMEX: GLD) ETF know that any longterm gains on that fund are taxed at 28%, instead of the 15% long-term tax rate that applies to most equity investments. The reason? The IRS considers gold a “collectible,” and GLD is just another way to own gold.

These new ETFs are good news for investors, allowing them to create better portfolios at lower costs. But they’re not perfect, and they come with nuances that investors need to understand. While everything may look great on the surface, in certain cases, one plus one may not equal two.

Matt Hougan is editor of IndexUniverse.com and senior editor of Journal of Indexes.