Leveraged ETFs Offer Double-Edged Sword

November 06, 2008

Leveraged ETFs make sophisticated strategies seem easy. But take careful note of how they're really performing in today's volatile markets.

 

Exchange-traded funds that use leverage are proving extremely popular these days. In rough markets, the ability to go short or long either 200% or 300% of an index's daily value can prove to be a useful trading tool.

But investors need to realize that such power can also prove deadly for one's financial health. And that's not an exaggeration.

Suppose you invest $100 in the Ultra S&P 500 ProShares (AMEX: SSO). It's designed to provide 2x the returns of the S&P 500 index on a daily basis. So if the market goes up 10%, you'd make $20. But if the market drops 10% the next day, you'd lose $22.

So you can actually not only be wiped out of your original investment, but also wind up losing money. And in very volatile times, leveraged funds on the whole are prone to wide disparities between their net asset values and underlying prices.

For example, the S&P 500 was down 3% at one point near midday on Thursday. At the same time, the UltraShort S&P 500 ProShares (AMEX: SDS) was up 6.6%. That's odd, since the ETF is designed to provide 200% short exposure to its benchmark. That means it should be up 6%, at least in theory.

So the bottom line is that SDS had tracking error, at the time we looked, of 60 basis points. A few minutes later in the day, that was up to about 80 basis points. The market was selling off hard, driving up demand.

Toward the end of such active days, leveraged and inverse ETFs tend to gravitate back toward fair value. But they don't always. When there is extreme volatility in a day and trading volume spikes in the last 10 minutes or so, we've seen that gap rise to as much as 300 basis points.

Trading In Time

If you're trying to make a quick buck using a leveraged or inverse ETF, market conditions can make things extremely tricky. But there's another problem when trying to make short-term trades with these financial vehicles. Namely, that's having the right idea, but lacking a fully developed plan of execution.

For example, we were looking at the Direxion Large Cap Bear 3x ETF (NYSEArca: BGZ) early Thursday. That's the brand new fund that provides the market's first 300% short exposure to a major benchmark. (See related story here.)

This morning, BGZ was trading in a range that fluctuated by $1.50 a share within a five-minute span. Over the course of several hours, share prices were trading in a range as much as 12% apart. So if you got in to the ETF at the bottom of that range and sold at the top, you'd have locked in a nice tidy profit.

But you'd need to be extremely nimble to even come close, not just on Thursday but during almost any market at any time. And if any sort of turnaround takes place while you're attempting such maneuvers, you could wind up losing a lot more than first imagined.

Given these realities, should a typical investor buy such juiced-up funds? Let's put it this way: If you do, it sure wouldn't be smart to put in your order and then go out and play 18 holes of golf. These aren't buy-and-hold types of investments.

Having said that, our firm does use inverse and leveraged ETFs with some client portfolios. But we're using them strictly as hedges. Let me explain what that means.

One of our models for accounts is to take long positions only in sectors showing the strongest relative strength characteristics. We pair those long investments with a certain percentage of ETFs that play the S&P 500 on the short-side.

This is a constant strategy we use with about a third of client assets. That model was down less than 1.5% in October, to give you an idea of how it can help defray losses in such volatile times. But it's something our staff pretty much has to monitor every second of every business day.

If it's something you want to try, we'd highly recommend that you put it on paper first. Watch various markets through different cycles. You need to give it enough time to see how particular funds react in a wide range of different situations. Using leveraged ETFs aren't for the faint of heart.

Inverse and leveraged ETFs are really a two-edged sword. They can be useful as insurance for a broader portfolio against markets like we're seeing right now. But if you're not careful, they can easily lose a lot of money. And in a hurry.


Anthony Welch is a portfolio manager and principal at Sarasota Capital Strategies in Osprey, Fla. He invites comments and ideas for future columns at: [email protected].

 

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