Avoid The ETF Leverage Trap

March 08, 2012

Sometimes working in the ETF industry can cause you to lose sight of the way retail investors view exchange-traded products.

I got a refreshing reminder of that talking to someone who had lost a lot by buying and holding a leveraged ETF.

The crux of the issue is the “constant leverage trap”—a term that applies to funds that reset their leverage daily. In short, the constant leverage trap means that in trendless, volatile markets, leveraged ETFs lose far more of their value than you’d expect intuitively.

Explanations of the constant leverage trap abound on the Web, and they’re worth a review if you’re considering—or already invested in—leveraged ETFs. (See this IndexUniverse webinar and an article by New York University’s Marco Avellaneda and Jian Zhang published a year ago in “Risk Professional.”)

Even after a reminder of how the returns on these funds erode in volatile markets, there are a couple of points worth hammering home.

Firstly, the constant leverage trap applies to inverse (-1X) ETFs too. I once assumed only leverage factors greater than 1 resulted in the unexpected decay of returns. That’s wrong. The daily reset on single-exposure inverse funds results in exactly the same effects, albeit muted compared with larger leverage factors. It helps to see a concrete example.


Single-Exposure Inverse Fund Returns


In the example, the index was wildly volatile, but was unchanged over the time period—sort of like the S&P 500 Index last year.

An uninformed investor might assume that an inverse ETF would also return 0 period over the same time period. In fact, the volatility would have eroded the fund’s NAV by more than a quarter, to just $73 from $100.

A second point I want to emphasize is that two funds that offer 2X and -2X exposure on the same index can both lose money over the same time period.

For example, the Direxion Small Cap Bear 3X (NYSE Arca: TZA) and Small Cap Bull 3X (NYSE Arca: TNA) offer equal and opposite daily exposure to the Russell 2000 Index. On the face of it, it seems like returns from the two funds should be mirror images of each other—if one is down, the other is up. On a day-to-day basis, that’s exactly how they work.

But over longer periods, the relationship doesn’t hold up. Over the last 12 months, TNA lost 17.6 percent while its bearish counterpart, TZA, lost 57 percent.

In fact, in a survey of 40 paired funds, 65 percent of the time, both ETFs have lost money.

The two charts below show those 12-month returns of TNA and TZA and the money-losing return profiles of most of these bull-and-bear pairs.


12-Mo Returns of TZA & TNA

Twelve-month returns of the Direxion Daily Small Cap Bear 3X (in blue) and Direxion Daily Small Cap Bull 3X (in red).


Leveraged pair returns

The 12- month returns of 40 ETFs and ETNs that are part of a pair; 65% of the time, both members of the pair had negative returns.


I think those two points go a long way toward illustrating the risks of holding these funds over the long term. More generally, they underscore the danger of investing in a product you don’t understand fully. With issuers branching out into more esoteric products each year, understanding exactly how their ETFs work should become increasingly important to investors.

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