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Leveraged ETF's

Rebound Quickly With Leveraged ETFs
by Matthew McCall

The appeal of exchange-traded funds (ETFs) is simple. They mix the diversification benefits of mutual funds with the ability to trade on an intraday basis. These investment products have been grabbed up eagerly by investors and there is now a myriad of choices in the ETF arena, from ETFs that track large cap U.S. stocks to those that track individual sectors. There are now thousands of ETFs to choose from and more are being added on a regular basis.

Another category of ETFs that has started to sprout up is leveraged ETFs. The purpose of a leveraged ETF is to increase the exposure and impact from the underlying index or investments in the ETF. For example, the leveraged ETF may attempt to double the return of an index on a daily basis. (To learn more about indexes, see The ABCs Of Stock Indexes and Index Investing.)

These leveraged ETFs provide another tool for investors to access leverage in the financial markets. And because with purchasing an ETF is as simple as issuing a buy order through your trading account, it is a much simpler process for most than using options, futures and margin. In this article, we’ll show you some key considerations to watch out for when purchasing leveraged ETFs.

ProShares Leveraged ETFs
In June 2006, ProShares introduced the first wave of leveraged ETFs, referred to by the company as "Ultra ProShares". The ultra ETFs are designed to double the daily performance of the underlying indexes they tracks. For example, the ProShares Ultra Dow 30 ETF (DDM) is structured to gain 2% when the Dow Jones Industrial Average gains 1%. Consequently, DDM will lose 2% if the Dow loses 1%.

Since the initial launch of four ultra ETFs in June 2006, ProShares continues to roll out more leveraged options for investors; as of June 2007, the total stood at 23. The ultra ETFs are broken into three categories: market cap, style and sector. The market cap section includes ETFs that track major indexes, such as the Dow and S&P 500. The style ETFs concentrate on the value and growth areas of the Russell 1000, Russell 2000 and Russell Mid-Cap indexes. The newest addition to the group is the ultra sector ETFs, which offer investors leverage in 11 different sectors such as oil & gas and semiconductors.

To generate the magnified returns, ProShares implements a number of investment strategies. According to its prospectus, it uses equities and other financial products to capture the leveraged return. One of the vehicle classes used to help magnify the results is derivatives such as options or futures contacts.

Other fund companies have also started providing leveraged ETFs, including Rydex Investments.

Are they accurate?
In theory, a leveraged ETF that returns twice that of the S&P 500 would have generated a return of more than 650% from 1990 through May 2006. Unfortunately, there is no way to track the exact returns because these ETFs have been around for less than a year. However, a study of the performance since the first batch of ProShares ETFs hit the market does make for an interesting discussion.

On a daily basis, the return of the ultra ETFs has been fairly accurate, but over the long term there are some issues. Remember that the goal of the ultra ETFs is to return twice the underlying index on a daily basis. Therefore, each day ProShares strives to achieve that goal, but less consideration is placed on the product's long-term performance accuracy.

Assume the Nasdaq falls 2% in one day and rebounds with a 1% gain the following session. The index will have a two-day loss of 1.02%. An ETF that gives investors double the index will result in a 2.08% loss after two days. If the ETF returned exactly twice the index the return should be -2.04%. Granted the difference is small in the example, but it can increase drastically over time with compounding. If a stock falls 2%, it must rally 2.04% to get back to even. Over time, this takes a toll on performance.

In the ProShares prospectus for the leveraged ETFs, it clearly states that investors should not expect the long-term performance to be double the underlying index. But, they do not make this point very clear when advertising the leverage ETFs, and most average investors will buy under false pretenses. As a result, it is important to know, before buying an ultra ETF, that the goal is double the daily return and not the long-term return.

The Time for Leveraged ETFs
Leveraged ETFs are typically best used by investors that are using a short-term trading strategy. Traders that are seeking to capitalize on daily movements - either in the market or in a specific sector - are able to use the ultra ETFs to gain leverage. Because the ultra ETFs give short-term traders the leverage needed on a daily basis without the negative compounding error thus a managed short-term or intermediate-term strategy magnifies the positives and diminishes any negatives.

Wrapping It UP
To recap, the advantages of the leveraged ETFs are:

They offer an easy and inexpensive way to lower volatility in your portfolio (hedge) and use leverage without using options or margin .
They are available in retirement accounts.
They are a great trading tool for short-term traders.
The negatives associated with leveraged ETFs include:
        The impact of negative compounding can result if you try a buy and hold approach to leveraged ETF's resulting in long-term inaccuracy.

Leveraged ETFs are a high-risk investment that could be dangerous to the uneducated investor
Overall, leveraged ETFs are a useful new vehicle for the right strategy and for an investor who implements a managed strategy.