How Investors Use Leveraged/Inverse

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.

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.

The volatility of the underlying investment matters, too. Here is turnover broken down by asset class. The following example is again based only on daily-reset funds.

These figures make intuitive sense.

Fixed income and currencies are generally less volatile than equity, and so see less turnover.

The alternatives asset class, a grab bag of wildly unpredictable VIX futures and sophisticated spread strategies, is a hot potato by comparison.

Commodities is a blend, including both stable agriculture futures and volatile energy contracts, so it's not surprising to see it fall in the middle.

So far we've only looked at turnover in aggregate.

Let's examine some individual ETFs at the extreme ends of the turnover spectrum, in the table below.

ProShares dominates the low end, probably because it controls more than half of the leveraged and inverse market.

None of the five lowest-turnover funds should be held long term, definitely not the implied holding period of about a year. What stands out most here is a lack of assets under management—these funds just don't have the asset base to be liquid trading vehicles. Without a capital infusion, they're dead in the water.

Caution And Success

At the opposite end of the spectrum are arguably the biggest success stories of the leveraged and inverse universe. One might question the wisdom of taking a 3x levered short position on gold miners for a few days, but if that's your pleasure, the Direxion Daily Gold Miners Bear 3X ETF (DUST) is a popular choice.

UVXY, the ProShares Ultra VIX Short-Term Futures ETF (UVXY) lost 92 percent of its value in 2013, but the average investor held it for only 2 days, using it as the tactical tool it was intended to be.

So is the average investor using leveraged and inverse funds correctly? Generally, yes.

These are risky securities, and it's heartening to see that few are trying to ride them for the long haul.

But correct use doesn't necessarily mean responsible use.

John Q. Investor has no business trying to call the VIX a week from now, let alone levering up that bet. And because turnover is dollar-weighted, the littlest of the little guys—those who can likely least afford serious losses or volatility of returns—barely make a dent in the numbers.

Still, it's nice to know someone's listening.

At the time this article was written, the author held no positions in the securities mentioned. Contact Scott Burley at [email protected].