Friday, September 17, 2010

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.