How Investors Use Leveraged/Inverse

February 27, 2014

Most people now realize leveraged ETFs can hurt you, but how, then, to use them?

We've often written about the dangers of holding leveraged and inverse ETFs.

By now, you've likely heard of the compounding effect: a mathematical peculiarity whereby leveraged and inverse funds tend to perform worse than their stated leverage when held longer than their reset period, which is usually just one day.

Adding insult to injury, these funds are usually expensive to hold; a 1 percent annual fee—$100 for each $10,000 invested—is typical. We warn against them for the vast majority of ETF investors.

But is anyone listening?

Considering the wacky ideas that tend to crop up on popular investing blogs and forums, it's easy to imagine John Q. Investor loading up his retirement account with triple-exposure (3x) levered ETFs in a misguided attempt to beat the system.

Getting Under The Hood

I decided to investigate how investors are actually using these funds: to buy and hold, or as tactical tools?

To do that, I measured turnover—the average number of times each dollar in a fund changes hands in a year.

I took the cumulative volume for each leveraged and inverse ETF for the six-month period ending Feb. 19, 2014, multiplied by 2 to annualize, then divided by the fund's average assets for the six months.

A turnover of 28, for example, indicates that a typical dollar invested in a fund changes hands slightly more than twice a month, and has an average holding period of about nine trading days.

So what can turnover tell us about how investors use leveraged and inverse ETFs?

These funds aren't created equal when it comes to the compounding problem.

Some attempt to mitigate the problem by resetting their leverage monthly rather than daily. Others reset only when leverage strays outside of an acceptable range. Some don't reset at all.

We'd expect such funds to have a lower turnover than their daily-reset peers, and that's exactly what the data show. The average daily-reset fund turns over more than 45 times a year, versus just 2.5 times for all other leveraged and inverse funds, as the table below shows.

Reset Frequency Average AUM ($M) Turnover
Daily 33,389.5 45.6
Monthly 68.8 14.1
Variable 2,477.2 0.7
None 1,040.2 6.3
All 36,975.7 41.4

Another complicating factor is the leverage ratio. Higher leverage magnifies the compounding effect, so we'd hope to see higher turnover among the most highly leveraged ETFs. Again, the data bear this out; as shown in the table below, triple-exposure (3x) funds turn over more than twice as often as double-exposure (2x) funds. For equal comparison, only daily-reset funds are included in the study.

 

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