Triple Leveraged ETFs Are Not Suitable For Most Long-Term Investors

I have been a big fan of Exchange Traded Funds (ETFs) ever since they gained mass appeal during the late 1990s. ETFs tend to have lower management fees than most corresponding mutual funds and can be traded throughout the trading day instead of only at the end of the trading day as is the case with almost every mutual fund. ETFs are also very popular because almost every ETF tracks a particular stock market index. ETFs have especially driven down costs for individual investors investing in foreign equities.

In recent years some of the ETF sponsors such as Proshares and Rydex began introducing leveraged ETFs that utilize derivatives in an effort to produce daily price movements that are a multiple of the daily price movements of the underlying index. For example, if the S&P 500 Index were to increase 1% during a day, a leveraged ETF providing twice ("2x") the daily movement of the S&P 500 Index would increase 2% if it were able to meet its stated objective.

Proshares and Rydex also introduced bear or inverse ETFs that aimed to generate returns corresponding to a negative multiple of an underlying index. For example, if the S&P 500 Index were to rise 1%, a -2x S&P 500 ETF would decrease by 2% if it were to meet its stated objective.

The leveraged ETFs quickly became popular with investors and then another leveraged ETF provider, Direxion, entered the picture in 2008. Direxion offers many leveraged ETFs, including some that offer triple (3x) leverage. Several of Direxion's triple leveraged ETFs quickly became hits with investors. In particular, the Direxion Daily Financial Bull 3x ETF (symbol: FAS) and the Direxion Daily Financial Bear 3x ETF (symbol: FAZ) rapidly gained acceptance and were even blamed by many investors for an increase in stock market volatility at the end of 2008.

Although investors can make a lot of money in a short period of time by purchasing leveraged ETFs, these trading vehicles, especially the bear leveraged ETFs, are not suitable for long term investors. Many small investors have purchased leveraged ETFs without fully understanding how the ETF leverage is applied. Many investors assumed that the if they held a leveraged ETF for a certain period of time, such as one year, the a 2x bull ETF would rise about twice as much as the underlying index being tracked. However, this is not the case. All of the leveraged ETFs currently offered provide leverage that resets daily.

The daily resetting of the leverage can quickly destroy investor gains during a volatile market. For example, if the S&P 500 closed at a value of 1000 on one day, and then dropped 10% the next day (a drop to 900) and then rose 10% on the following day (an increase to 990), by the end of the third day, the S&P 500 would be 10 points, or 1% below where it was on the first day (e.g., at 1000). A 3x bull (triple leveraged) ETF, however would drop far more than 1%. For example, if the 3x bull ETF closed at 1000 on the first day, it would drop 30% on the second day (a drop to 700) and would subsequently rise 30% on the second day (from 700 to 910). Accordingly, by the end of the third day the 3x bull ETF would be 9% lower than it was on the first day. Investors refer to this disparity in returns of leveraged ETFs relative to the daily stated objective as "leveraged decay." An excellent detailed explanation of leveraged decay may be found at the Quantum Fading blog.

As a result of leveraged decay, triple leveraged ETFs are therefore not suitable for most long-term investors. Over long periods of time practically all triple leveraged ETFs will lose money and the bear triple leveraged ETFs will lose money the quickest in most markets.

I have been following the daily closes of the Direxion Daily Small Cap Bear 3X ETF (symbol: TZA), which aims to return -3x leverage relative to the daily closes of the Russell 2000 Index. TZA was introduced on November 19, 2008. However, I have obtained daily historical closing data for the Russell 2000 Index dating back to May 22, 2000 from the iShares website. Operating under the assumption that TZA provides exactly -3x leverage I was able to hypothesize the closing values of TZA dating back to May 22, 2000.

The results of my investigation are interesting and clearly show TZA is unsuitable for long-term investors. I created a chart of calendar returns from 2001-2009 and of returns for (a) the partial year in 2000 starting on May 22, 2000; and (b) the partial year in 2010 up through September 17, 2010. The chart is shown below (click on the image for a larger view).


As shown above, TZA would have lost money in every year except for 2002 when TZA would have gained 36.028% while the Russell 2000 Index lost 20.483%. Note that TZA would have actually lost 3.31% during the awful 2008 market when the Russell 2000 Index plummeted 33.787%. The primary reason for the loss during 2008 is the excessive market volatility during that time period.

TZA would have lost 99.70% of its value between May 22, 2000 and September 17, 2010, whereas the Russell 2000 Index actually gained 58.16%. Using the historical index data and working backward from the TZA daily closing data I have since November 17, 2008, I determined that the closing value of TZA on May 22, 2000 would have been 9976.89.

Although TZA would have lost almost all of its value over the past ten years, there are some time periods when the market plummeted and TZA would have soared in value. In the most extreme case, TZA would have soared about 300% from 175.31 on September 19, 2008 to 702.70 on November 20, 2008, a time period of a mere two months. However, such gains would be short-lived as TZA dropped back down to 169.16 by April 16, 2009 and fell below 100 on July 20, 2009.

TZA and other triple leveraged ETFs are therefore unsuitable for most long-term investors. Individual investors would be well-suited to stick to regular ETFs and leave the triple and double leveraged ETFs to day and short-swing traders.

Vanguard Has Drastically Cut Commissions at its Brokerage

Vanguard is one of the preeminent mutual fund investment companies, managing over $1 trillion in fund assets. Vanguard offered the first low-cost index fund, the Vanguard S&P 500 Index fund, back in 1976 and has been credited with essentially pressuring competitors to reduce fees on their mutual funds over the years. Vanguard expanded into the field of ETFs back in 2001 and has become a major force in the ETF industry.

Although primarily known for its mutual funds and ETFs, Vanguard also offers brokerage services. I have never used Vanguard's brokerage in the past because there have always been less expensive alternatives, such as Ameritrade and Fidelity. However, on May 4, 2010 Vanguard officially became a player among discount brokers when it began offering commission-free trades on its ETFs and substantially reduced commissions on trades of non-Vanguard ETFs and equities.

There are four tiers within the Vanguard commission schedule as shown below (click on the image for a larger view). An investor may fall within one of the tiers based on the dollar amount of assets that the individual holds within Vanguard mutual funds and Vanguard ETFs. The lowest tier is for investors with less than $50,000 in Vanguard funds. At the lowest tier, investors pay a $20 annual maintenance fee and $7 for the first 25 trades of non-Vanguard ETFs and $20 for each trade thereafter.

The second tier (entitled "Voyager") is for investors who have between $50,000 and $500,000 in Vanguard mutual funds and ETFs. At the Voyager level, investors pay $7 per trade of non-Vanguard ETFs and equities.

The third tier (entitled "Voyager Select") is for investors who have between $500,000 and $1,000,000 in Vanguard mutual funds and ETFs. At the Voyager Select level, investors pay a mere $2 per trade of non-Vanguard ETFs and equities.

The fourth or highest tier (entitled "Flagship Services") is for investors who have over $1,000,000 invested in Vanguard mutual funds and ETFs. At the Flagship Services level, investors pay nothing for the first 25 trades of non-Vanguard ETFs and equities and $2 for each trade thereafter.

I am very pleased to see that Vanguard has cut its commissions and now offers commission-free trades of its ETFs. I am certain that Vanguard's move will put pressure on other discount brokerages to further cut their rates as well. The annual maintenance fee of $20 for investors with less than $50,000 invested in Vanguard mutual funds and ETFs may dissuade some investors from opening a Vanguard brokerage account. However, many investors who already have $50,000 or more invested (especially those with $500,000 or more) in Vanguard funds may choose to open brokerage accounts with Vanguard.

Historical Returns for the MSCI EAFE Index

The Morgan Stanley Capital International, Inc. ("MSCI") Europe, Australasia Far East ("EAFE") Index is the benchmark index for foreign equity markets and is the foreign equity equivalent of the S&P 500 Index. The MSCI EAFE Index measures the equity market performance of developed markets in Europe, Australasia, and the Far East, excluding the U.S. and Canada.

The Index includes a selection of stocks from 21 developed markets, the largest of which are Japan and the United Kingdom. The MSCI EAFE Index has been calculated since December 31, 1969 and is the oldest truly international stock index.

The charts below illustrate annual and annualized returns in terms of U.S. Dollars for the MSCI EAFE Index between 1970 and 2009. The Index has returned a total of 3,657% over the past 40 years, or an annualized average of 9.49% per year. The annualized return of the MSCI during its first 20 years of existence (i.e., between 1970 and 1989) was an impressive 15.21%, but the annualized return of the Index over the last 20 years (i.e., between 1990 and 2009) was a much lower 4.05%.

A big reason for the subpar performance of the Index since 1990 is the bursting the the Japanese asset/equity bubble that began in 1990. As I discussed above, Japanese stocks comprise a large portion of the MSCI EAFE Index and therefore the horrible performance of the Japanese stock market since 1990 has dragged down overall returns of the MSCI EAFE Index over the past 20 years. However, the performance of the MSCI EAFE Index during its first 20 years of existence does somewhat compensate for its recent under-performance. The annualized return of the MSCI EAFE Index between 1970 and 2009 of 9.49% only slightly trails the return of 9.87% of the S&P 500 Index during the same time period.

Many investment advisers recommend investing 20-30% of one's equity portfolio in large cap foreign stocks, such as those comprising the MSCI EAFE Index. Vanguard, for example, offers the Developed Markets Index fund that tracks the MSCI EAFE Index.



*** Edit - August 27, 2011 ***
I have updated this chart with results through 2010.

Historical Returns for the MSCI Emerging Markets Index (1989-2009)

The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index is one of the most widely-followed emerging markets equity indices. In the investment community, "Emerging Markets" typically refers to a social or business activity of nations that are in the process of rapid growth and industrialization. In March 2009, I discussed annual returns between 1989 and 2008 for the MSCI EM Index. I have updated the information in the current post and in the chart shown below (click on the image for a larger view) to include results for the year 2009.

The chart below lists annual returns for the MSCI EM Index in terms of U.S. Dollars between 1989 and 2008. Returns for the MSCI EM Index from 1993-1998 represent gross dividend reinvested returns, and returns from 1999-2009 represent net dividend reinvested return.*

As shown in the chart below, the MSCI EM Index is extremely volatile. During the 21 years for which I have data (i.e., 1989-2009), the MSCI EM Index lost value during 9 calendar years and gained value in 12 other calendar years. The worst returns came during 2008 when the Index plumetted 53.33% and the best annual gains came during 2009 when the Index soared 78.51%. However, despite the massive return during 2009, the Index finished 2009 at a level 16.68% below where it was at the start of 2008.

The annualized returns were 15.51% for the 5-year period, 9.78% for the 10-year period, and 7.14% for the 15-year period ending in 2009. Annualized returns between 1989 and 2009 were 12.55% and the Index had a total new return of 1,096% between 1989 and 2009. The performance of the MSCI EM Index between 1989 and 2009 greatly exceeds the 9.22% annualized return and 537% total return of the S&P 500 Index during the same time period.

Emerging Markets may be a critical portion of an investment portfolio of any stock market investor. The economies of Emerging Markets typically grow much faster than those of Developed Markets, such as the United States. The performance of equity markets of such countries often has a strong correlation with the overall economic growth of such countries. Also, as I have discussed previously, the U.S. Dollar will likely continue to weaken in the future as the country becomes more and more dependent upon foreign investment.

Many investment advisers recommend limiting Emerging Markets to no more than 10-15% of an aggressive investor's portfolio because of the inherent volatility of equities in Emerging Markets.


* The performance data shown is slightly different than the performance data I saw for the MSCI EM Index at Index Universe, and I am not sure of the reason for the discrepancy.

*** I have updated this chart to include returns for 2013 in another post.

1980 - 2009 Stock Market Returns for Various Indices

In 2007, 2008, and 2009, I posted charts of the annual stock market and bond market returns for various indices for the time periods from 1980-2006, 1980-2007, and 1980-2008, respectively. The charts I previously posted included returns for small cap indices (Russell 2000, Russell 2000 Value, and Russell 2000 Growth), large cap indices (S&P 500, S&P/Citi 500 Value, and S&P/Citi 500 Growth), a broad-based foreign stock index(Morgan Stanley Capital International Index for the developed stock markets of Europe, Australasia, and the Far East ("MSCI EAFE index")), an index of bonds (Barclays Capital Aggregate Bond Index Lehman Brothers Aggregate Bond Index ("BC Agg."))*, and the Nasdaq Composite Index. I have updated the chart (click on the image for a larger view) to reflect returns for 2009.

2009 was a great year for practically all stock indices as equities and bonds rebounded strongly from an abysmal 2008. Stocks had plummeted in throughout 2008 and up through early 2009 as there was a was real risk of full-scale financial collapse and an ensuing Depression as many banks appears to be on a rapid trip toward insolvency and default on obligations. However, the government provided the short-term guarantees and liquidity that the banks needed and was able to stave off economic collapse. The common view is that we experienced a once- or twice- a century economic catastrophe, It appears as though the worst is behind us, although it will probably be years until America and Europe experiences strong economic growth.

All of the equity indices that I track returned at least 20% in 2009, led by the 43,89% of the Nasdaq Composite. The MSCI EAFE Index also provided strong returns, appreciating 31.78% as economic conditions improved and the U.S. Dollar depreciated against many foreign currencies. Growth stocks outperformed their Value counterparts and the Russell 2000 Growth and S&P 500 Growth indices each returned over 30% and at least 10% more then their Value counterparts (i.e., the Russell 2000 Value and S&P 500 Value indices, respectively).

The Russell 2000 Value Index provided the strongest returns between 1980 and 2009, returning a total of 3,474.25%, or an average of 12.66% per year. The total returns of the Russell 2000 Value Index has returned more than 1,000% relative to its initial value on December 31, 1979 more than the next best index I tracked, the S&P 500 Index.

The chart below clearly shows that stocks can provide substantial returns over long periods of time (click on the chart for a larger view). This may come as news to anyone who has been investing over the past 10 years, but one needs to appreciate that these are extraordinary times and that although short-term returns can be extremely volatile, longer term returns are still quite strong.



* The BC Agg. bong index was known as the Lehman Brothers Aggregate Bond Index prior to 2008.

** Edit - January 2, 2017 ***
I have updated this chart with results through 2016.

Historical Annual Returns for the S&P 500 Index - Updated Through 2009

Last year I wrote a post about the annual returns of the S&P 500 Index and its precursor S&P 90 Index from 1926-2008. Some people have been emailing me to write a new post and update chars with full year returns for 2008. Updated charts are shown in the two images below (click on each image for a larger view).

As shown below, 2009 was one of the better years for the S&P 500 Index. This should come as no surprise, as the returns in 2008 were the second worst since 1926, so the Index was likely due for a rebound. The S&P 500 Index bottomed out on March 9, 2009 at a value of 676.53 and rallied about 67.8%, including reinvested dividends, at close at a value of 1115.10 on December 31, 2009, as shown in the chart below. This was a furious rally and one of the strongest 9-10 rallies in the history of the S&P 500 Index.


The annualized return for the S&P 500 Index from 1926-2009 was 9.81% and the 5-year annualized return through the end of 2009 was 0.41%, an improvement over the negative value for the 5-year period that ended in 2008. The 10-year annualized return through 2009 was a pathetic -0.95%, the second-worst 10-year annualized return based on all of the annual return data I have going back to 1926. In fact, the only worse 10-year annualized return was achieved at the end of 2008, when the 10-year annualized return was -1.39%. Luckily, however, 10-year annualized returns should improve over the next few years because S&P 500 Index returns were negative during 2000-2002 when the markets recovered from the bursting of the tech stock bubble.



I have posted an updated chart for the returns of the S&P 500 Index during the period between 1926-2015.