Leveraged and inverse exchange-traded funds were one of the fastest-growing segments of the exchange-traded fund industry in 2008. They were also one of the most controversial.
The growth, at least, comes as no surprise. These “traders’ funds” are designed to deliver some multiple of the daily return of different benchmark indexes: either 300%, 200%, -100%, -200% or -300%, depending on the product. With global equity markets crashing and market volatility sky-high, any product that helped investors hedge their portfolios—or profit on the downside—was sure to be a hit, as these were. ProShares, the leading provider of leveraged and inverse ETFs, was the fastest-growing ETF company in the world in 2008, with assets under management rising from $9.7 billion to $20.5 billion.
As 2008 wound to a close, however, concerns arose about the performance of these funds. Tom Eidelman summed up the problems in his Jan. 12, 2009 article in Barron’s magazine (“One-day Wonders”):
Suppose you had predicted—correctly, as it turned out—that the Chinese economy would slow following last summer’s Beijing Olympics, causing China’s stock markets to tumble. Also suppose that, to profit from your insight, you had invested in the ProShares UltraShort FTSE/Xinhua China 25, a leveraged exchange-traded fund (ticker: FXP) designed to go up by as much as twice the percentage that the FTSE/Xinhua China 25 Index falls on a given day.
When Chinese stocks crashed by 34% over the following four months, shouldn’t you have reaped a gaudy return around 68%? Not exactly. In fact, you would have lost 56%.
Take real estate. The Dow Jones U.S. Real Estate Index had a terrible year in 2008, falling 40.07%. The ProShares UltraShort Real Estate ETF (NYSE Arca: SRS) might have seemed like a smart way to play it. Its goal is to deliver -200 percent of the daily return of that index. But instead of rising 80 percent in 2008, as you might expect, SRS actually closed the year down 50 percent.
Figure 1 highlights the five most surprising examples of full-year 2008 returns for leveraged and inverse ETFs.
For an investor, being caught in one of these situations must have been hugely frustrating. Making the right call about the direction of the market is difficult. If you predicted one of these markets were going to fall, and then bought an ETF that promised to deliver -200% of the return of the index it tracked, you would have expected to earn a mint. To end up losing money … and in some cases, significant amounts of money … must have been infuriating.
It’s important to note, however, that these results were not created by a “flaw” in the funds. These funds largely delivered on their stated objective, which is to provide -200% of the daily return of their benchmark indexes. The problem is that -200% of the daily return of an index is very different from -200% of the long-term return.
Compounding
The difference between daily and long-term returns is well-documented in the literature surrounding leveraged and inverse funds. It all stems from the basic math of compounding.
Suppose you have an index that starts out with a value of 100. You also have a product that’s designed to provide 200 percent of the upside exposure of that index. That product starts out with a value of $100.
On Day 1, the index rises 10 percent to 110, and the product rises 20 percent to $120. Perfect. But on Day 2, the index falls 10 percent to 99, while the product falls 20 percent to $96. After just two days, the problem is obvious: The index is down 1 percent, and the leveraged product is down 4 percent.
| Daily Change | Index | Investment (200%) |
| Day 1 | 100 | $100 |
| 10% | 10 | $20 |
| Day 2 – Start | 110 | $120 |
| -10% | -11 | ($24) |
| Day 2 – Finish | 99 | $96 |
| Net Change | -1% | -4% |
You can play with the numbers to make funny things happen. Suppose, for instance, that the index rose 20 percent on the first day, fell 25 percent on the second day and rose 15 percent on the third day.
| Daily Change | Index | Value Investment (200%) |
| Day 1 | 100 | $100 |
| 20% | 20 | $40 |
| Day 2 – Start | 120 | $140 |
| -25% | -30 | ($70) |
| Day 3 – Start | 90 | $70 |
| 15% | 13.5 | 21 |
| Day 3 – Finish | 103.5 | $91 |
| Net Change | 3.5% | -9% |
