[This article previously ran in the Exchange-Traded Funds Report.]

Concerns about the massive expansion of the U.S. budget deficit and the Federal Reserve’s balance sheet have most economists and pundits at least talking about inflation. Understandably, many investors have begun to fret about the outlook for U.S. Treasuries. And with that, investors have started turning to inverse Treasury exchange-traded funds.

In fact, ETFs that provide leveraged short exposure to U.S. Treasuries have seen some of the most dramatic inflows of any ETFs in 2009. According to the National Stock Exchange, the ProShares UltraShort 20+ Year Treasury ETF (NYSE Arca: TBT) attracted $1.5 billion in net inflows in the first five months of 2009. Its sister fund, the ProShares UltraShort 7-10 Year Treasury ETF (NYSE Arca: PST), has pulled in $271 million.

Two newer inverse Treasury ETFs from DirexionShares have so far attracted little attention, despite offering -300% exposure to Treasury markets. They are new to market, however, and may yet succeed.

The biggest question is whether these funds will deliver the returns investors expect. As covered previously in this magazine, and as discussed recently in a webinar at IndexUniverse.com (replay available), inverse and leveraged ETFs are not designed for long-term exposure. TBT, for instance, is designed to provide -200% of the daily return of its benchmark index, but there is no guarantee that it will provide -200% of the long-term return of that index.

Indeed it has not. For the year ending May 29, 2009, the index that the fund tracks―the Barclays Capital (née Lehman) 20+ Year Treasury Index rose by 5.35%. Investors might have expected to lose 10.70% of their money in TBT, or negative two times the index. But TBT actually lost 28% over that one-year time frame.

This apparently dismal performance has nothing to do with problems in the fund, and everything to do with simple math. When you compound leveraged or inverse returns in a volatile environment, you inevitably fall behind the simple long-term multiple of the index itself. That’s how it’s supposed to work.

An example makes this clear. Suppose you start off with an index at 100 and a -2X ETF worth $100/share. On day 1, the index rises 10% to 110 and the ETF falls 20% to $80/share. On day 2, the index falls 10% to 99 and the ETF rises 20% to $96/share.

After two days, the index is down 1% (from 100 to 99) and the ETF—which is designed to deliver -200% of the return of the index—is down 4% (from $100 to $96). Yet, everything has worked perfectly.

It’s just the nature of the beast. In volatile markets, leverage hurts returns.

Interestingly, the opposite is also true: In a trending market—one with low volatility—leverage boosts returns. Again, simple math offers the explanation. To return to our example, suppose that the index rises 10% on day 1 and another 10% on day 2. The index goes from 100 to 121, up 21%, while the ETF falls to $64/share, down 36% ... a better return than the -42% you might expect.

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