Is It Safe To Own Leveraged ETFs Again?

April 20, 2012

If ever there was a golden era to hold inverse or leveraged equity ETFs, the past six months have been it.

These products have long been considered the wildlings of ETF performance: Hold any one of them for longer than one rebalance period and it could spell doom for your portfolio, according to some.

But really, these funds are deeply misunderstood. Thankfully, a recent low-volatility, trending equities market shines much-needed light on them.

I'll explain, but first, a variation on the standard financial disclosure language you’ve seen a million times: Leveraged and inverse funds are designed to deliver what’s in their title—leveraged or inverse returns, on a daily basis only. Investors holding these funds longer than one day do so at their own risk.

Leveraged And Inverse ETFs

Leveraged and inverse funds can wreak havoc on portfolios over the long haul because of their compounding principals.

The only “safe” way to hold inverse and leveraged ETFs long term is in low-volatility, trending markets. In these markets, compounding can actually help you; that is, in the right market, geared ETFs can deliver more than their daily leverage targets over long periods of time. At the very least, they can come close.

This is pretty much what the market has been doing recently.

Take a look at the table below of long-term returns of leveraged and inverse funds. Although most people wouldn’t classify six months as a long-term investment, for funds that are typically held only one day, I'll take the liberty of calling them “long term.”

I’ve compared the “simple multiple return” for various S&P 500 ETFs with their actual, realized return. By “simple multiple return,” I mean the return of the benchmark S&P 500 index over the full time period, multiplied by the leverage factor, with no adjustments for compounding. This is the return an investor would expect if they naively didn’t understand that these were daily compounding funds.

For example, if the S&P 500 Index returned 16.97 percent, a double-exposure S&P 500 ETF would have a “simple multiple return” of 33.94 percent. Meanwhile, an inverse double-exposure version of this fund would have a simple multiple return of -33.94 percent.


6-Month Index/ETF Performance

Source: Bloomberg


The returns are surprisingly close for the equity products, considering that this does not imagine any rebalancing activity on the part of the shareholder. For example, the Guggenheim 2x S&P 500 ETF (NYSEArca: RSU) returned 30.14 percent, falling short of the six-month simple multiple return by only -3.80 percentage points. The inverse version of RSU, the Guggenheim Inverse 2x S&P 500 ETF (NYSEArca: RSW), returned -28.91 percent, or about -5.02 percentage points off the simple multiple.

Interestingly, things haven’t been so clear on the bond side.


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