The Danger of Leveraged ETFs

in Stock Analysis by
leverageThere is a tremendous misconception that leveraged (double, triple, long or short) ETFs are to be used as long-term investments.  On the surface they make a lot of sense.  You want to hedge your stock portfolio, for instance, you buy a double short ETF of the market SDS (double short of S&P 500) or QID (double short of Nasdaq 100) and for each 1% decline of the market you make 2%.  It does sound like a great deal.  Leveraged ETFs have been sold as panacea to this market volatility, but panacea they are not.   If used as investment (not trading) vehicles they may cause a lot of harm to your portfolio even if you were “right” on their use.  They should not be used as a long term investment, but only for short-term trading (i.e. days not months).  

Daily compounding (recalculation) will cause their returns to deviate substantially from the underlying index.  The math is too complex and too boring (here is an article by Morningstar that explains this well), but instead let me demonstrate by this very real example (click here to see the chart ).  Let suppose that six months ago you had a great insight that financial stocks will decline.  You figured to get bigger bang for the buck you’ll buy a double short of Dow Jones Financial Index (a simple plain vanilla long ETF for this index goes by symbol IYF).  The index and thus IYF declined almost 20% in six months thus you’d expect your double short (SKF) would be up about 40%.  However, if you look at the chart below you’ll see that it declined almost 60% instead, as much as double long ETF (UYG) of the same underlying index. 

Note that over the short term (days) these ETFs seem to work.  This is one of those investments where you have to make sure that you nail the timing perfectly, otherwise you are screwed.

P.S. I am off to Omaha for the Berkshire’s annual meeting. As I mentioned before, several friends and I are meeting up for a very informal cheap talk and water at the Double Tree hotel from 1:30 to 4pm on Friday (May 1st).  If you are in the area you are welcome to join us.  After I return home from Omaha on Sunday, I’ll spend 12 hours with my family and  then jump on the plane to Pasadena where I’ll attend the Value Investing Congress (VIC).  It is a terrific, must-attend event and a great source of investment ideas.  In fact one of the stocks that was presented last  year we are buying today – it takes a long time to process information I guess.  I presented to VIC last year (here is a link to that presentation).  Things did change in a year – a lot. I’ll be back on Wednesday. 

My religious Jewish wife wants me to wear a surgical mask while I travel due to the non kosher (swine) flu.  I am not sure if her trouble with the flu has to do with the fact that it is non kosher or because it kills people or both (she swears it’s the deadly part).  I figure I’ll wear a bandana and a cowboy hat instead of a surgical mask, so people will think I am a Jewish/Russian cowboy, not just a sissy who is scared of a deadly flu.     

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley). His books were translated into eight languages. Forbes Magazine called him "The new Benjamin Graham".

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