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In this case, the index ends Day 3 up 3.5 percent, but the leveraged investment closes down 9 percent.
Flip the numbers around and you can figure out what happened to funds like FXP and SRS. Compounding reared its ugly head, and what should have been up, ended up being down.
In other words, the eventual returns on leveraged funds like these are “path-dependent.” It matters less where the underlying index ends the year, than how it got there. The more a market jumps around from day to day, the greater the eventual divergence between a leveraged or leveraged inverse ETF and the relevant multiple of the index return is likely to be.
To its credit, ProShares and other providers of leveraged and inverse ETFs warned investors about this very phenomenon on their Web sites. The ProShares Web site, for instance, notes:
Like most leveraged and short funds, ProShares are designed to provide a positive or negative multiple (e.g., 200 percent, -200 percent) of an index’s performance on a daily basis (before fees and expenses). Generally, these funds have achieved their daily objective with a high degree of accuracy and consistency.
However, ProShares and other leveraged or short funds with daily objectives are unlikely to provide a simple multiple (e.g., 2x, -2x) of an index’s performance over periods longer than one day.
It goes on to say that, “[i]n general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted effect.”
2008 was a period of historic volatility, and that caused the performance of leveraged and inverse ETFs to diverge significantly from a simple multiple of the index. The more volatile the index, the larger that divergence was over time.
Media Fury
Just because it’s easy to explain, however, doesn’t make it any more palatable for investors, and a media fury erupted in 2009 surrounding the unusual performance of these funds. Paul Justice, CFA, of Morningstar, captured the zeitgeist in a Jan. 22, 2009 article titled, “Warning: Leveraged and Inverse ETFs Kill Portfolios.” In the piece, Justice tells investors that these funds are “appropriate only for less than 1% of the investing community.”
He goes on to say, “If you’re hell-bent on using leverage for any period of time longer than a day, you’d be better off using a margin account in almost any real-world scenario.”
The righteousness is justified, but it is also too simple. Just as these ETFs do not provide exactly 200 percent or -200 percent of the long-term returns of a benchmark index, neither do they go wildly aflutter in most situations after a single day.
The leveraged and inverse ETFs have a number of advantages over a traditional margin account. For instance, you cannot lose more than your original investment in the fund. In addition, you never face margin calls, which you do face in margin accounts.
The question, therefore, is simple: How long can you really hold these funds and still expect to earn returns that stay reasonably close to the linear leveraged or inverse results many investors desire?
Methodology
To answer that question, this study examines the historical performance of three of the first leveraged and inverse ETFs to launch in the U.S. These funds, all offered by ProShares, are designed to provide 200 percent, -100 percent and -200 percent of the daily return of the oldest and most established market index in the world: the Dow Jones industrial average.
The funds are:
- ProShares Ultra Dow30 (NYSE Arca: DDM)
- ProShares Short Dow30 (NYSE Arca: DOG)
- ProShares UltraShort Dow30 (NYSE Arca: DXD)
The study compares the performance of these funds versus their benchmark indexes over the following periods: one day, one week (five trading days), one month (21 trading days), one quarter (63 trading days) and one year (251 trading days).
For each period, the study compares the performance of the ETF versus the comparable linear performance of its benchmark, adjusted for the leverage factor. For instance, when looking at the ProShares Ultra Dow30 ETF, the study compares the performance of the ETF with the following returns: 200 percent of the one-day return, 200 percent of the one-week return, 200 percent of the one-month return, etc.
The study uses the net asset value of the ETF, adjusted for distributions, when making performance calculations. The choice to use NAV rather than share price was made because, in the early days of the study, liquidity was limited in these ETFs, causing share prices to occasionally deviate from the NAV.
The index returns used in this study are price returns, not total returns. This creates a small positive skew in the results, suggesting that tracking error in the funds are more positive than they might otherwise have been.
The study started at the earliest date that all three funds were trading and data was available (July 13, 2006) and ended on Dec. 15, 2008. The study evaluates the time periods on a rolling basis: 611 one-day periods, 607 five-day periods, 591 one-month periods, 549 one-quarter periods and 361 one-year periods.
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