ETFs Grow Leveraged Wings! (For Good Or Evil?)

30 May 2006
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Doesn’t it warm your heart seeing those kids grow up right in front of your eyes? I remember when mutual funds were plain-jane investment vehicles. Then came sector/industry funds, followed by asset-allocation funds, fund-of-funds, life-cycle funds. Each evolution becoming more exotic than the last incarnation — not as a way to provide better returns for investor, but as marketing gimmicks to attract investor capital.

ETFs are now heading down the same path. Arriving first on the scene were boring old index ETFs, then came currency ETFs, fixed income ETFs, and precious metal ETFs. The latest version from ProFunds has stirred some talk around the financial blogosophere (found here, and here) and even prompted a MarketWatch article; where I first read about leveraged ETFs. I have strong feelings about ETF’s new brother, and also the way they are marketing it. Care to hear my opinion?

ETFs Are A Paradox
ETFs are perfectly suited for market timers. Passive investors also like ETFs for the built in diversification. They tend to be less volatile than many traders would like. I still cannot make up my mind about an investment where speculators and long-term investors both sing its praises.

But my confusion shouldn’t deter anyone from giving ETFs a try right? How about the ProFunds leveraged ETFs whose mission is to seek to “double” the daily performance of a market index, or double the inverse, or opposite, daily move of an index. Sounds great, right? Let’s examine their marketing cliches!

Double The Trouble
The word “double” to investors has the same effect as the word “free” is to shopoholics — they’re condition to crave it! Examining the Marketwatch article and ProFunds write-up on Reuters, shows that this word is liberally used everywhere in the ProFund sales pitch.

Psychologically, “doubling” your return sounds irresistibly attainable and is heavily desired. It is why advisors still preach the rule of 72. Logically, why not go for more than twice the return if you are capable? Why not triple, quadruple the returns? Answer — it’s bad marketing! Remember fund managers and fund companies exist first to line their own pockets, then to attempt to earn those returns for you.

Bullish, Bearish, Ultra-Short
I’m also confused by the three strategies employed by ProFunds’ leveraged ETFs. These ETFs supposedly use borrowing, futures contracts, forward contracts, options and other techniques to create leverage. The techniques are nothing new as ProFunds is quick to point out that leveraged mutual funds already have been available for several years. That is true! But when was the last time you saw such mutual funds market and advertise leveraging as their main benefit? It has been tried, and it didn’t work!

What are ProFund ETFs’ three strategies? Here is MarketWatch’s description:

The first is a “bullish” ETF that uses leverage to double the market’s normal return. For example, if the S&P 500 index rose 2% in a day, the corresponding ProFunds ETF is designed to give investors a 4% return.

Second is a “bearish” strategy that aims to deliver the exact opposite, or inverse, of the market’s return. Accordingly, if the index declines 2%, then the inverse ETF aims for a positive 2% return.

Finally, a leveraged “ultra-short” bearish fund seeks to provide twice the opposite of the market’s return. So in the case of a 2% market decline, this portfolio would gain 4%.

Sounds strangely like a hedge fund with the market-neutral overtones, but with all the benefits of an ETF, right? A wolf in sheep’s clothing perhaps?

Read The Fine Print… Or The Prospectus
Dissappointedly, Marketwatch did not have the balls to warn about the magnified losses that can also come with leveraged investments. The closest they came to presenting the prudent point of view is:

Still, investors shouldn’t expect these funds to deliver exactly double or the inverse of an index due to trading costs and other fees. And the turnover rate for the ETFs is expected to be greater than 100%, according to the prospectus.

“A high level of portfolio turnover may negatively impact performance by increasing transaction expenses and generating taxable short-term capital gains,” the filing said.

High turnover? Potentially high MERs? Was I dreaming? Are they still talking about an ETF? Maybe I’m still stuck with the idea the ETFs mirror passive indexes. Sometimes kids grow up too fast, and you end up hardly recognizing them anymore!

  • joel
    what do you think about leveraged etf´s in this contest:

    if the market goes down 25% your ETF goes down 50%, so you need the market to jump 33% to reach your break even. in this case the etf would do up 66%:

    that means we, the etf owner will always lose from the geometrical of %´s ?

    plus how can they leverage etf´s without extra costs (interest rates...) ?

    kind regards!
  • That's a very good question, ETF Guy!

    My premise is not so much that ETFs are a bad idea. The generalization that market's go up over the long haul is soundly rooted in diversification as a means to represent the market. ETFs started as indexes but have involved to become more like actively managed mutual funds that are traded on the market.

    My problem with these leveraged funds are that they're really actively managed / leveraged mutual funds under the guise of ETF, enjoying the popular image that ETFs are diversified and enjoy market-like returns.

    As we all know, the majority of actively managed funds cannot beat the market. Leveraged ETFs don't seek to represent the market but seek to beat it. There's high turn over, there can be magnified gains but also magnified losses! How many investors can stand those before they bolt out of the fund? I would say that leveraged ETFs are merely wolves in sheeps' clothing. Looks like an ETF on the outside, but remember, ETFs are not strictly indexes.. some ETFs represent indexes just like some mutual funds represent indexes. The difference being the MER, cost etc.. But in this case... leveraged ETFs are merely an actively managed fund that's tradable on the market. Investors will be subject to the management capabilities of the fund manager. And until I see track record, leveraging with such unknowns isn't ideal for me!
  • Assume for a moment that you're a long-term investor and that you subscribe to the buy-and-hold philosophy. And of course, if you're a buy-and-hold type then you also believe that over the long haul, the market will go up.

    Given this investing style, is there any reason why buying in to a leveraged ETF that returns twice the market isn't a good move? It's something I've been considering, but have yet to move on.
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