What are leveraged ETFs?

This question has been raised quite a bit recently especially with last weeks anouncement of a second company ProShares joining Direxion in offering 3x daily leveraged ETFs. While Short ETFs,Double or 2x ETFs have been around for a bit longer, these vehicles can be a bit confusing as traders struggle to understand how these products exactly track an underlying index on a longer term basis and why there seems to be the perception that there are widespread tracking errors. Lets try to simply once and for all the nuances of the growing world of leveraged and inverse etfs.

Having names such as the Ultra Dow,Double Short Crude Oil, or 3X S&P ETF, these exchange traded funds look to provide greater leverage for both up and down moves on a daily basis. The inverse or bear market ETFs seek to replicate daily performance to the down side. Previously the only way for investors to capitalize on down moves was to sell short where the goal is to sell high and buy lower to realize a profit. This left stock traders using IRA’s or non margin accounts without a way to play the downside or hedge. To help explain, lets review a couple examples.

ETFs Which Track Both Daily and Long Term Performance

Take the Diamonds Trust which tracks the performance of the Dow Jones Index. Symbol:DIA represents 1/100th of the price of the Dow Jones. So if the Dow closes at 8300.00, the ETF Symbol:DIA NAV should close at 83.00. If the Index closed down 100 points, those holding a long position in the Diamonds DIA would be down 1 point. Those looking to capitalize on down moves would short the ETF to attempt to yield profits on the downside. Since this simply represents 1/100th of the underlying index, it would track almost exactly the daily and longer term performance.

Those looking at trading a vehicle that would track the S&P 500 Index both on a long or short term basis might choose the Spyder Symbol:SPY which represents 1/10th of the underlying index. Traders interested in trading Gold via an ETF might look at Symbol:GLD which represents 1/10th the near month futures quote.

Understanding Double and 3X Leverage ETFs

One of the common refrains these days is that these ETFs suffer from widespread tracking errors hinting that their constuction produces false returns. The truth is that these vehicles are only looking to produce returns equal to the Daily Performance of the underlying index and in most cases they are accomplishing what they say they will. While the Diamonds (DIA) year to date return is -1.10%, the YTD return on the Proshares UltraDow30 (DDM) double leveraged ETF is -6.91%. Thats about 6.28 times different not 2 times and it comes down the the daily compounding and some simple math as to why.

So Why Don’t Leveraged ETFs track exactly?

It really is a product of the daily objectives of these funds and the result of compounding returns. As the funds state it is a daily objective and infact Direxion now lists all of their 3X ETFs with “Daily” in the title.

Here is how compounding daily returns produces different outcomes.
Index Price= Price of underlying index
DR= Daily Return
CR=Cumulative Return
Nav=Net Asset Value

XYZ Index price of $100 with the 3X ETF at $50.

Day Index DR CR CRx3 3xDR NAV Actual CR
1 97 -3.00% -3.00% -9.00% -9.00% 44.50 -9.00%
2 101 +4.12% +1.00% + 3.00% +12.36% 50.00 – 0.00%
3 105 +3.96% +5.00% +15.00% +11.88% 55.94 + 5.94%
4 108 +3.15% +8.00% +24.00% + 9.45% 61.23 +22.46%
5 105 -2.77% +5.00% +15.00% – 8.31% 56.14 + 12.28%

In this example, we can see that 3X the index return of 5% would be 15% but the 3X ETF return was only 12.28%. Generally the leveraged ETFs do worse during sideways but volatile markets. If one were long a 3X ETF and the market continued a strong trend higher seeing higher volatility on the up days than on the few down days, one might see greater than 3x returns since the nature of these funds see them putting on more leverage as they move higher.

Understanding why they do or don’t track the underlying index can assist traders when making decisions. These leveraged ETFs do look to replicate a multiplied DAILY return so daytraders have quickly adopted these vehicles while those looking for longer term returns might see the compounding effect work against or in some cases for them.

Consider this, say you are holding a 3X leveraged product and are currently +30% for the year. With one 10% down day on the underlying index, the entire years gains could be erased since 3 times that would be 30%. When thinking about risk, these products will see greater volatility and as mentioned previously, those looking to not put on more than a fixed dollar trade risk might actually be trading less shares thus negating the leverage. For example, if one might use 100 shares of a single leverage fund, perhaps traders might pair back their position to 33 shares.

Another reason investors might see a difference even for that days results in the exact up or down percentage X 3 of an index is the NAV or net asset value with relation to the actual buy or sell price. Since an ETF trades on the open market, the demand on either the buy side or sell side might see the trading price of the fund be higher or lower than the actual NAV which is set each day at the end of the regular market trading session. Generally, we haven’t seen this make more than slight variations especially when funds have tight bid/ask spreads and good liquidity.

So when will we see 4xETFs and 5xETFs?

For now it seems like the 3x leveraged etf is as far as it will go as it might not be that practical to infuse anything higher. Currently a 33% move down would be required to theoretically wipe out the bull ETF shares and vice versa. With 5 X leverage it would go down to a 20% move so while it would seem daytraders might seek out additional leveraged ETF products, fund companies that would offer such a vehicle might have to price the shares initially very high. Large moves in the underlying as we’ve seen in the financial sector have recently resulted in reverse splits in some cases and vice versa to bring them back into balance. Quite frankly, many traders seeking greater leverage have already transfered to the futures and forex markets. But we’ll save that discussion for another time.

List of Current 3x Leveraged ETFS

Direxion

Bull 3x ETFs

BGU Daily Large Cap Bull 3x Shares Russell 1000
MWJ Daily Mid Cap Bull 3x Shares Russell Midcap Index
TNA Daily Small Cap Bull 3x Shares Russell 2000
ERX Daily Energy Bull 3x Shares Russell 1000 Energy
FAS Daily Financial Bull 3x Shares Russell 1000 Financial Services
TYH Daily Technology Bull 3X Shares Russell 1000 Technology Index
DZK Daily Developed Markets Bull 3X Shares MSCI EAFE Index
EDC Daily Emerging Markets Bull 3X Shares MSCI Emerging Markets Index
TYD Daily 10-Year Treasury Bull 3x Shares NYSE Arca Current 10-Year U.S. Treasury Index
TMF Daily 30-Year Treasury Bull 3x Shares NYSE Arca Current 30-Year U.S. Treasury Index

Bear Market 3x ETFs

BGZ Daily Large Cap Bear 3x Shares Russell 1000
MWN Daily Mid Cap Bear 3x Shares Russell Midcap Index
TZA Daily Small Cap Bear 3x Shares Russell 2000
ERY Daily Energy Bear 3x Shares Russell 1000 Energy
FAZ Daily Financial Bear 3x Shares Russell 1000 Financial Services
TYP Daily Technology Bear 3X Shares Russell 1000 Technology Index
DPK Daily Developed Markets Bear 3X Shares MSCI EAFE Index
EDZ Daily Emerging Markets Bear 3x Shares MSCI Emerging Markets Index
TYO Daily 10-Year Treasury Bear 3x Shares NYSE Arca Current 10-Year U.S. Treasury Index
TMV Daily 30-Year Treasury Bear 3x Shares NYSE Arca Current 30-Year U.S. Treasury Index

Proshares 3X S&P ETF

UltraPro Short S&P500 SPXU

UltraPro S&P500 UPRO