KIM: Investors should steer clear of
leveraged ETFs
Mickey Kim
August 31, 2013
If you are confident the S&P 500 will be 20% higher a year from now, wouldn’t it be great if
there was a way to magnify that gain for yourself?
You might think an exchange-traded fund (ETF) whose objective is to provide 2X or even 3X
the return of the S&P 500 would be just the ticket to earn 40% (2X) or 60% (3X). You couldn’t be more wrong.
Even if your prediction of a 20% gain comes to fruition, there is almost zero chance the ETF will return 40% or 60%.
In fact, depending on how bumpy the path was during the S&P 500’s year-long journey to a 20% gain, your ETF
could actually end up with a loss.
Shares of mutual funds and ETFs both represent interests in a portfolio of securities. For a mutual fund, a closing
Net Asset Value (NAV) is calculated and shares are purchased or redeemed at that single price.
The SPDR S&P 500 Trust launched in January 1993 as the first ETF. The “Spider” was the first S&P 500 index fund
whose shares both fluctuated in price with the underlying securities and traded on an exchange during the day.
ETFs exploded in popularity by offering investors the ability to gain exposure to a broad or very narrow sector of
the market quickly and efficiently.
Alas, as often happens on Wall Street, product development wizards came up with a way for investors to “juice”
their returns by creating “non-traditional” ETFs. These ETFs enable investors to place magnified, directional bets.
In other words, thanks to issuers like Direxion and ProShares, you can place a magnified bet (leveraged ETFs) on an
index or sector, either up or down (inverse ETFs).
What most investors fail to realize is, unlike buy-and-hold mutual funds or ETFs, leveraged ETFs are specifically
designed to be held no longer than one day. Their stated objective is to provide 2X or 3X the return of an index or
sector (or its inverse) for a single day. They create this magnified exposure by using a combination of securities,
including swaps, futures contracts and other derivative instruments.
Importantly, a leveraged ETF rebalances its positions so it starts each day with exactly its stated 2X or 3X exposure.
The upshot is if you hold a leveraged ETF for longer than one day, your return is not 2X or 3X the return of the
index or sector for the period, it is the product of the series of daily leveraged returns for the ETF. It’s surely
confusing, but there can be a huge difference as a holder of a leveraged ETF in a volatile market can be whipsawed
by the fund’s daily rebalancing.
Indeed, the SEC and Financial Industry Regulatory Authority (FINRA) issued an alert in 2009 that described inverse
and leveraged ETFs as “highly complex financial instruments” that “typically are unsuitable for retail investors who
plan to hold them for longer than one trading session, particularly in volatile markets.”
Stay away from inverse and leveraged ETFs. If you want to gamble, go to a casino. If you can accurately predict
which way stocks are headed, over what time frame and the daily volatility, you should be writing this column.
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser
based in Columbus, Ind. He can be reached at (812) 376-9444 or [email protected].