A Leveraged ETF Investor’s Checklist

December 09, 2014

If you’re trying to capitalize on huge price swings in commodities or anything else, how you get from A to B matters.

Looking to make geared bets on volatile price swings in assets like oil or energy stocks? You’ll need to get three things right to achieve the best performance.

The first two are clear: timing and the direction. A trader betting that oil would sink in November would have done well in inverse-double-exposure or inverse- triple-exposure oil ETFs.

The third factor is the actual pattern of returns, and its impact is clear: Choppy returns hurt performance, and strong trends help in a geared fund, whether you’re short or long.

In case you were wondering about the complexity of what we’re getting into here, consider that any prospectus detailing a leveraged or inverse security pretty much says that such ETFs need to be watched closely and are really designed for sophisticated investors. Translation: Most investors probably shouldn’t try this at home.

My purpose here is to shed a bit more light on what “watched closely” means.

Path Dependence In The Real World

You can see this in real-world data by looking at performance of pairs of geared funds. Oil’s drop in November was especially sharp and steady toward the end of the month. No doubt, the short fund beat the pants off the long fund, but the comparison point is to the triple-exposure returns you’d expect.

Specifically, I’m comparing the VelocityShares 3X Inverse Crude Oil ETN (DWTI) with the VelocityShares 3X Long Crude Oil ETN (UWTI).

In November, oil dropped 16.0 percent, so you might expect a 48.0 percent for the triple-exposure bearish fund, DWTI. However, it did even better: 55.0 percent. Meanwhile, the triple-exposure long fund UWTI lost less than it should have at -44.0 percent rather than -48.0 percent in November.


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