Leveraged and inverse ETFs
Leveraged and inverse ETFs (Exchange-traded funds)[note 1] are ETF structures intended to provide returns that are positive or negative multiples of an equivalent ETF benchmark. The purpose of this article is to explain why these ETFs present significant risks as long-term investments.
The SEC and FINRA has issued a joint alert, "Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors." It states:
There are 3 structures:
- Leveraged ETFs seek to deliver multiples of the performance of the index or benchmark they track.
- Inverse ETFs (also called "short" funds) seek to deliver the opposite of the performance of the index or benchmark they track.
- Leveraged inverse ETFs (also known as "ultra short" funds) seek to achieve a return that is a multiple of the inverse performance of the underlying index.
Here are several example ETF descriptions:
- ProShares UltraPro S&P500 (UPRO) seeks daily investment results, before fees and expenses, that correspond to three times (3x) the daily performance of the S&P 500®.
- ProShares Ultra S&P500 (SSO) seeks daily investment results, before fees and expenses, that correspond to two times (2x) the daily performance of the S&P 500®.
- ProShares UltraShort S&P500 (SDS) seeks daily investment results, before fees and expenses, that correspond to two times the inverse (-2x) of the daily performance of the S&P 500®.
- Direxion Emerging Markets Bear 3X ETF (EDZ) seeks daily investment results, before fees and expenses, of 300% of the inverse (or opposite) of the performance of the MSCI Emerging Markets Index.
Let's look at the 4th example fund provider, Direxion. Notice that Direxion itself says these funds are for "short-term trading." This is not a detail or a pro forma disclaimer - it is explicitly displayed in the figure below.
The first category, "Long Term Investment" contains 3 ETFs which match a benchmark. The second category contains 2 leveraged ETFs ("3X") and is titled "Short Term Trading" which is a warning sign that these ETFs will perform differently than those intended for long-term investments. The link "Are Direxion Shares ETFs for you?" is an additional warning sign, as there would be no reason to ask this question if these ETFs performed similarly to ETFs intended for long-term investments.
Brokerages typically require customers to sign a special disclaimer in order to open a margin account. Everyone understands that using leverage in the form of a margin account is taking on a big risk, the risk of losing more than your total investment. It is a mistake to think you can get essentially similar results, more conveniently and without the risk of losing more than your investment, simply by using an inverse or leveraged ETF.
Anyone thinking of using an inverse or leveraged ETF needs to read and understand the fund company's factsheets and prospectus, which disclose the issues in language varying from veiled to clear.
How does a daily leveraged ETF work?
A daily leveraged ETF holds a combination of derivatives and actual securities to track a multiple of the underlying index's daily performance.
Let's examine ProShares UltraPro S&P500 (UPRO), which promises to deliver 3x the daily performance of the S&P 500. It does this by holding 77% individual S&P 500 stocks, nominal exposure to 215% of the S&P 500 through total return swaps, and 8% S&P futures. Add it all up, and you get exposure to 300% of the S&P 500’s daily performance.
Total return swaps are contracts between the ETF and major investment banks. For UPRO, every day the banks pay the ETF the value of the S&P 500’s total return for that day, and in return the ETF pays the banks a pre-negotiated rate of interest, which is close to the short term treasury rate. As of May 2019, the borrowing rate of some UPRO's swap agreements was 3.01%. The corresponding cost is NOT included in UPRO's 0.92% expense ratio.
Daily results are significantly different than long-term
It is critical to understand that a movement in one direction followed by an equal movement in the opposite direction will not get you back to the starting value. For example, a gain of 10% followed by a loss of 10% will end up with a loss of 1.0%. This is nothing but math at work. The math works the same for any investment – regardless if it’s a single stock or a fund. See Percentage gain and loss for the details.
This math will be very evident as a fund performs over time. If the market has equal gains and losses over a period of time, the fund’s value will always be lower. For example, 6 consecutive days which alternate as +10% then -10% will result in a loss of 3.0%. The change in loss from 1.0% to 3.0% is known as volatility decay.[note 2]
Over the course of a single day, the fund will generate a return as advertised. For example, a 3X leveraged fund will generate three times the gain (and loss) of an unleveraged fund.
However, that’s not the entire story. Leveraged funds rebalance their exposure to their underlying benchmarks on a daily basis by trimming or adding to their positions. Over time, a longer-term investor is unlikely to continue to receive the fund's multiple of the benchmark's returns.
Investment returns compound over time. The effects of compounding will also cause the fund to deviate from the fund's stated objective, e.g. 2X or 3X of the index's return. In trending periods, compounding can enhance returns, but in volatile periods, compounding may hurt returns. Generally speaking, the greater the multiple or more volatile a fund's benchmark, the more pronounced the effects can be.
It is why the fund’s fact sheets have disclaimers stating that performance is only guaranteed on a daily basis.
A comprehensive example
Now, let's illustrate how big the difference is between "daily" and long-term results.
Some investors think they see interesting theoretical possibilities for using leverage in long-term investing. If so, they should not think that over long periods of time they can get double the return of the S&P 500 simply by investing in a 2X leveraged S&P 500 ETF.
The word "daily" has a very precise meaning. These products double or triple the long or short index for a single day, so if you are someone who trades in and out of positions on a daily basis, they actually do pretty much what you'd expect. Not so over long periods, and the difference can be large.
The ETF companies disclose this point fairly clearly in the factsheets, such as:
Direxion: "This leveraged ETF seeks a return that is -300% the return of its benchmark index for a single day. The fund should not be expected to provide three times the return of the benchmark’s cumulative return for periods greater than a day.", and
ProShares: "Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly [differ in] direction from the target return for the same period."
In order to illustrate the potential impact, let's ask: "How much is that in dollars?" which is quantified in the following sections.
"differ in amount"
"Differ in amount" means that the "2X" fund might not deliver twice the return of the index. For example, ProShares Ultra S&P 500 ETF, SSO began in 6/2007. $10,000 invested in the Vanguard 500 Index fund would have gained a total of $6,966 in total return since that time (6/20/2006 to 12/31/2013). Did the Ultra fund earn twice that ($13,932)?
It did not. It earned $6,097, which is less than the Vanguard 500 Index fund earnings. The 2X ETF earned less than the straight, unleveraged, direct investment.
"differ in direction"
This is a way of saying that over periods of more than a day, your ETF could go down even when the inverse or leveraged index it is tied to goes up. This is why ProShares says "Investors should monitor their holdings consistent with their strategies, as frequently as daily."
We will illustrate with a deliberately-picked and unusual period of time (12/31/2007 to 12/31/2010), but it is a valid illustration of the effect of volatility decay on a leveraged ETF. Before showing the results, here is a question.
Over this time period, an investment of $10,000 in Vanguard 500 Index fund lost $846. Knowing this, which of these three investments do you think did the best over that time period?
- a) Vanguard 500 Index Fund (VFINX)
- b) ProShares Ultra S&P (SSO), "two times (2x) the daily performance of the S&P 500"
- c) ProShares UltraShort S&P (SDS), "two times the inverse (-2x) of the daily performance of the S&P 500."
The answer is (a). If you reasoned that since the S&P 500 lost money, an ETF that shorts the S&P ought to have made money, you were mistaken.
- The Vanguard 500 index fund lost $846.
- ProShares Ultra S&P (SSO), the 2X ETF for the same index lost. But it didn't lose just twice as much as VFINX, it lost over four times as much-- $4,050.
- ProShares UltraShort S&P (SDS), the 2X short ETF (-2X, gains if benchmark drops) which should have earned a profit, lost even more -- $4,595.
Over this time period, you could have been right about the direction of the S&P but still lost money. And this isn't just a matter of a few percent or an expense ratio difference, the loss is more than 4.8 times the amount of an unleveraged direct investment.[note 3]
A major risk presented by leveraged funds is how the impact of stock market crises can get magnified. Drawdowns (sudden loss of value) will get amplified in both depth and duration. The following chart (1955-2019) presents a simulation of a regular index fund, a 2x leverage fund and a 3x leverage, all tracking the S&P 500 index. As you can see, the oil crisis in the 70s would have been magnified with dizzying drops and drawdowns lasting more than a decade. The more recent Internet and financial crises would have led to nearly two decades of misery, finally followed by a steep recovery. Staying the course with a long term investment in leveraged funds during such a crisis would seem extremely challenging.
Risks and rewards
As clearly illustrated by the charts in previous sections, leveraged (and inverse) ETFs are much more volatile than corresponding indices (and index funds). Between Jan-10 and Dec-19, the standard deviation of monthly returns was amplified by approximately the amount of leverage:
- VFIAX (regular S&P 500 passive index fund from Vanguard): 12.5%
- SSO (ProShares Ultra S&P500, 2x leverage): 25.3%
- UPRO (ProShares UltraPro S&P500, 3x leverage): 38.4%
A historical simulation of leveraged funds over the 1955 to 2019 time period showed similar characteristics:
- Regular S&P 500 passive fund: 14.4%
- S&P 500 2x leverage: 29.0%
- S&P 500 3x leverage: 43.6%
The question becomes the following. If a steely investor had been able to cope with such increased volatility (including dizzying drawdowns), what would have been the rewards for staying the course? Real-life funds would have provided attractive annualized growth from 2010 to 2019 (VFIAX 13.5%, SSO 23.6%, UPRO 32.8%), but this isn't a terribly representative time period, since it was essentially a long bull market.
Using the historical simulation, we can study rolling (annualized) returns over a much longer time frame, including three major crises of the US stock market.
As the table indicates, over short periods of time, leveraging can deliver stronger returns, albeit with a lot of risk. Over longer periods, the return premium disappears on average while the risk (dispersion of outcomes) remains very acute. Overall, the case for rewards (i.e. improved annualized returns) seems remarkably weak for long-term buy and hold investments, compared to the volatility and drawdown risks previously quantified.
Regardless of what you might or might not think about the possible usefulness of a long-term leveraged position achieved by using margin, leveraged and inverse ETFs are completely different products and do not give remotely comparable results.
In short, leveraged and inverse ETFs are specialized products, which present major risks as long-term buy and hold investments and little rewards in return for such risks. The use of such products as part of a regular asset allocation should be discouraged.
Other points of view
Long-term risks associated with a specific asset can sometimes be mitigated by the use of another asset (e.g. using rebalancing and risk parity strategies). These are sophisticated portfolios, constructed by investors who fully understand all the risks described above; they accept the irreducible potential risk of any portfolio, no matter how carefully constructed, that contains high-risk assets.
An article in the Journal of Indexes, authored by Joanne Hill and George Foster, both of ProShares, note that "it is likely that leveraged and inverse ETFs are commonly being utilized as short-term tactical trading tools" but state that, nevertheless, by applying certain rebalancing strategies, "leveraged and inverse funds have been and can be used successfully for periods longer than one day." The article, "Understanding Returns of Leveraged and Inverse Funds", gives a detailed analysis of how volatility affects leveraged and inverse ETFs.
Another article authored by Cliff Asness, from AQR Capital Management, "Risk Parity: Why We Lever", advocates that "willingness to use modest leverage allows a risk parity investor to build a more diversified, more balanced, higher-return-for-the-risk-taken portfolio."
- Leveraging is also called gearing. Leveraged ETFs and Geared ETFs mean the same thing.
- Also known as volatility drag, but volatility decay is the term used for leveraged funds.
- The loss is 4.8 times = 4050/846 for the 2X ETF, 5.4 times = 4,595/846 for the short -2X ETF.
- "Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors". Financial Industry Regulator Authority. August 18, 2009.
- ProShares ETFs: UltraPro S&P500
- ProShares ETFs: Ultra S&P500
- ProShares ETFs: UltraShort S&P500
- Direxion Daily Emerging Markets Bear 3x Shares
- Leveraged ETF List | Direxion
- ProShares Geared Funds Annual 5/31/2019, market exposure on printed page LIX.
- ProShares Geared Funds Annual 5/31/2019, swap agreements on printed page 138, e.g. BNP Paribas rate as of May 31, 2019.
- Details are in this Bogleheads® forum post: , LadyGeek. December 9, 2019
- Bogleheads blog (2019): Leveraging S&P 500 – Quantitative Analysis
- Investopedia: Risk Parity
- Hill, Joanne, and George Foster (2009), Understanding Returns of Leveraged and Inverse Funds. Dr. Hill is Head of Investment Strategy at ProShares; George Foster is Chief Investment Officer.
- Click Asness (2014), Risk Parity: Why We Lever.
- Considerations for Geared Investing, by ProShares. A brief overview of Geared ETFs.
- What You Should Know about Geared Fund Performance, by ProShares. A guide that covers several key concepts about geared fund performance.
- Bogleheads® forum topic: . Nov 30, 2019