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Among all the financial products that have gotten bad press in recent years, the one that's most familiar to ordinary investors is the leveraged ETF. Despite the product's near-universal scorn, however, recent research set out to debunk some of the myths surrounding leveraged ETFs -- and it could make you rethink your views on these funds.
Why the outrage?
The attention that leveraged ETFs have received hasn't been limited to the financial media. Even the SEC has gotten in on the act, recently announcing that it would investigate whether such funds, which often use derivatives to achieve their investment objectives, warrant additional disclosures so that investors will understand how they work.
The main problem that so many people have with leveraged ETFs comes from the misimpressions that some investors have about the returns the ETFs will generate. Some will assume that if an ETF says it provides double leverage, its long-term returns will double those of the index it tracks. You might think a triple-leveraged ETF would triple that return.
Unfortunately, over the long haul, leverage doesn't work that way. But it isn't as bad as recent experience might make you believe.
The right level of leverage
A study by the quantitative research company Double-Digit Numerics took a closer look at how using various levels of leverage would have affected your portfolio's returns over the long run. Using 125 years of stock market data, the research found that up to a certain point, additional leverage actually increased returns. Beyond that point, however, returns began to fall again.
What's the perfect amount of leverage? Historically, you get different results if you look at different markets. For the S&P over the past 60 years, triple leverage gets you the best return. For the small-cap Russell 200 index since 1987, double leverage optimizes your return. And in some cases, such as the Nikkei over the past 25 years, a leveraged approach would have been disastrous -- and you'd have been better off investing only part of your money in the index.
The key finding, though, is that you don't get double the return from doubling your leverage. The benefit from taking on extra leverage becomes smaller. For instance, with the S&P example, double leverage took your annualized return from 7% to 12%, but triple leverage only increased it to around 14%.
In some ways, the emergence of these products during such volatile times exacerbated their negative characteristics. Since the turmoil in the financial markets began, investors on both sides of given trades on leveraged ETFs have suffered significant losses. Over the past three years, both the bullish ProShares Ultra S&P ETF (NYSE: SSO ) and the bearish ProShares UltraShort S&P ETF (NYSE: SDS ) have suffered double-digit annualized percentage losses, due to the big ups and downs in the market since 2007.
You've seen even worse performance from some niche areas. Two real estate ETFs, ProShares Ultra Real Estate (NYSE: URE ) and ProShares UltraShort Real Estate (NYSE: SRS ) , have both lost well over 80% of their value since 2007. Similarly, for investors wanting to use leverage to play the crude oil market, ProShares Ultra Oil & Gas (NYSE: DIG ) has lost half its value in three years, and ProShares UltraShort Oil & Gas (NYSE: DUG ) is down almost 75%. In both areas, the swings of the markets these ETFs tracked were even more violent than those of the overall stock market, contributing to the leveraged losses.
Of course, that recent experience shows that leveraged ETFs aren't necessarily well-suited to extreme conditions. They may work for short-term traders, but the big swings we've seen lately are especially problematic for long-term owners.
Moreover, as Double-Digit itself discovered, applying the leverage theory to actual investment returns may not be possible even during better times. The trouble is that many leveraged ETFs charge fairly high expenses to shareholders. In one example involving a broad U.S. stock index, when the researchers applied a typical fee for a leveraged ETF, it entirely wiped out the benefits from the leverage. Even for shorter periods, fees can have a marked impact on the returns.
Nevertheless, the lesson that leverage isn't always a bad thing is an important one for every investor to understand. Just don't expect that tripling your risk will triple your money -- and get ready for a wild ride along the way.
Leverage isn't Warren Buffett's game, but making the most of his money is. Fool contributor Joe Magyer shares the Oracle of Omaha's latest wisdom from capitalism's answer to Woodstock.