Understanding Returns Of Leveraged And Inverse Funds

August 25, 2009


Figure 0Leveraged and inverse exchange-traded funds (ETFs) are designed to achieve a multiple (positive or negative, e.g., 2x or -2x) of index returns on a daily basis. From their launch in June 2006 through June 30, 2009, leveraged and inverse ETFs attracted more than $33 billion of assets in the U.S.—about 6 percent of all U.S. ETF assets. As of mid-2009, there were 122 leveraged and inverse ETFs, covering a broad range of equity, sector, international, fixed-income, commodity and currency markets. The rapid growth of these types of ETFs has captured the attention of investors and the media—and generated some controversy about where and how this new investment tool best fits in the array of choices available to investors.

What is sometimes forgotten in discussions about these “new” ETFs is that the concept of leveraged and inverse funds is not really new—it is merely the latest chapter in a long history of investment products developed to provide investors access to various indexing strategies. Mutual funds that incorporate leverage or shorting of index exposure have been available in the U.S. for 15 years. Today there are more than 100 mutual funds that provide short and leveraged exposure to indexes.

Leveraged and inverse mutual funds and ETFs both evolved from unleveraged index fund strategies. Few investors would question the role of index funds in equity portfolio management now, but they too generated their share of controversy when they were introduced in the mid-1970s.

Like other index strategies before them, leveraged and inverse ETFs have attracted investors seeking gains from absolute or relative index moves or looking to manage risk.

What, then, is the source of the controversy? Since existing leveraged and inverse funds are designed to achieve a multiple of index return only on a daily basis, for periods greater than one day, the fund returns can be greater or less than the one-day target multiple times the index return. This is a result of the effects of compounding—gains or losses are compounded every day.

Much of the recent discussion of leveraged and inverse funds in the media has centered on how they perform over periods longer than one day. Focusing on a few examples of volatile indexes in a volatile market environment, some have asserted that over more than one day, investors’ returns cannot come close to the one-day target multiple times the index return, and will always be worse. Some then concluded that leveraged and inverse ETFs are not appropriate for holding periods greater than one day.

In this article, we take a broader view and provide empirical evidence based on leveraged and inverse S&P 500 returns for a long history (as well as for other indexes) that challenges these assertions. We explain why the funds have a one-day target and show that leveraged funds can be used successfully for longer periods than one day. Rather than focus on narrow examples, we analyzed 2x and -2x (daily target) leveraged and inverse S&P 500 index returns for thousands of holding periods ranging from two days to six months for the past 50 years (excluding fees, expenses, trading and financing costs). These were compared with each period’s index return multiplied by the same target. We show that:

• On average, the impact of compounding on leveraged and inverse fund returns is virtually neutral for most broad indexes.

• There is a high probability of approximating the one-day target leverage for periods longer than one day; the shorter the period and the lower the index volatility, the higher the probability.

• Rebalancing is an effective tool for investors whose goal is to approximate the daily leverage target over time. The process is straightforward and involves monitoring index returns versus fund returns and establishing a trigger percentage of deviation as a basis for the rebalancing strategy.

Before we present the details and results of our historical study and explain the basic rebalancing process and a case study, we first provide background on daily investment objectives (versus longer periods) and highlight some typical investment strategies in which leveraged and inverse ETFs and mutual funds are utilized.

Staying Aligned With The Daily Target

Most leveraged and inverse ETFs and mutual funds are designed to provide a target multiple (positive or negative) of index returns for one day (before fees and expenses). The manager of the fund typically holds stocks, index futures, swaps or short positions along with cash-equivalents to achieve this daily fund objective on an ongoing basis. To stay aligned with this one-day target, the fund manager adjusts fund holdings each day based on the closing value of fund assets, reflecting index returns and fund flows for that day.

Day-to-day consistency of index exposure is valuable to many investors with short-term or longer-term horizons. Although a leveraged or inverse fund could be created with a longer-term objective such as a monthly target leverage ratio, the fund’s index exposure would then vary within the month, as gains and losses in between monthly rebalancing change the fund’s market exposure. An ETF with a daily leverage target—say, 2x the daily return of the index—has the objective of providing that same leverage exposure at the end of each and every trading day, regardless of whether an investor bought, held or sold the ETF position on a particular day. Another rationale for having a daily objective is that adjusting holdings every day to match a target multiple reduces the risk of the fund experiencing a total loss. (The variation in leverage within the month for a monthly target leverage ratio fund could be sizable in higher-volatility environments and may lead to a significantly higher degree of leverage than the investor desires.)

Given their daily objective, it is important to note that leveraged and short ETFs have been extremely successful at delivering returns in line with the one-day target. In comments on a study of three leveraged and inverse ETFs benchmarked to the Dow Jones Industrial Average, Matt Hougan remarked in an IndexUniverse.com webinar that after examining “over 600 days of trading history … [one-day tracking] was pretty much perfect.”

Uses Of Leveraged And Inverse ETFs For Short And Long Horizons

Leveraged and inverse index exposure in a liquid, transparent ETF can be utilized in a variety of ways, with both short- and longer-term horizons. Since the trading volume for leveraged and inverse ETFs—whether measured in dollars or shares—is several times the percentage of ETF assets, it is likely that leveraged and inverse ETFs are commonly being utilized as short-term tactical trading tools. However, investors also regularly use leveraged and inverse ETFs as a key component of a longer-term portfolio strategy; for example, to pursue returns and manage the risk of long equity and fixed-income positions. The list below identifies a few of the most common applications, all of which can be employed for horizons beyond a day:

  • Pursue returns based on a tactical view (long or short) of an index based on an outlook for the economy or segments of the market.
  • Overweight or underweight an index exposure such as a particular market-cap segment, sector or country, by utilizing leverage and thereby avoiding the need to change other positions in the portfolio.
  • Hedge or reduce risk, either as a short-term tactical hedge or for longer-term risk management.
  • Execute an index-spread strategy designed to capture the relative returns of two indexes. For example, investors may wish to express a view that financial stocks are likely to outperform energy stocks, or that emerging market equities may outperform U.S. large-cap equities.
  • Isolate alpha from active strategies. The active risk component of an equity strategy (alpha) can be isolated by hedging the index or beta risk with the benchmark for that strategy using an inverse or leveraged inverse index ETF.



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