A look at leveraged exchange-traded funds

By Christopher Raby

The Daily Record Newswire

With the recent increase in volatility in the markets, many investors are looking to place bets on the future direction of the market. With the numerous leveraged exchange-traded funds (ETFs) on the market, investors can place both long and short trades with ease.

With these ETFs, investors can earn leveraged returns on index investments without the direct use of advanced market instruments (futures, options, etc.) or by tapping into margin. One such vehicle, ticker symbol SSO, has the objective of returning double the daily return of the S&P 500 index, less expenses.

A significant controversy has erupted as brokerage firms have begun to prohibit the purchase of these ETFs by their clients. Why? One may expect that earning double the daily return of the S&P 500 index would translate into an investment that would also double the total return of the S&P 500 over an extended period of time. However, unfortunately that is not always the case, leaving many investors frustrated with the returns they've received.

Consider a simple example as detailed in the fund's prospectus: An investor has $10,000 to invest in each of two funds. Fund A earns the daily index return while Fund B earns twice that daily return. On day 1, the index increases in value 1 percent, resulting in a 1 percent increase in Fund A and a 2 percent increase in Fund B.

On day 2, the index decreases 2 percent, resulting in a 2 percent decrease in Fund A and a 4 percent decrease in Fund B. At the end of day 2, the value of the investment in Fund A and B would be approximately $9,999 and $9,996, respectfully.

Fund A saw an increase of $100 on day 1 and a decrease of $101 on day 2. Fund B saw an increase of $200 on day 1 and a decrease of $204 on day 2. Because of the leverage involved in Fund B and the volatility over the two days, Fund B underperformed Fund A by 3 basis points over just one day.

Many feel that investors are misled by these leveraged ETFs and believe that they should earn twice the daily return of the underlying index over periods longer than a day. However, as illustrated above, doubling a string of daily returns is not the same thing as doubling annual returns. The chart shows that while returns are similar, they are not perfectly aligned as one might expect. In fact, increased volatility coupled with the daily return objective, will lead to the leveraged ETF underperforming the 2x return objective over longer term periods.

Fund sponsors continually push ETFs that have ever-increasing investment complexity. While leveraged ETFs can be successfully used by experienced investors and traders, the introduction of levered ETFs hands a new level of sophistication to many novice investors.

With the glut of ETFs currently on the market, many investors need to pay careful attention to a fund's prospectus to ensure the fund will perform as the investor expects.

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Christopher Raby is an Analyst/Portfolio Manager for Karpus Investment Management. He can be reached at (585) 586-4680.

Published: Tue, Oct 18, 2011

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