Did Barclays Fix Leveraged ETFs?

For impatient investors looking to score on big short-term price movements, leveraged ETFs seemed like the product of their dreams. Yet leveraged ETFs created problems that turned many of those dreams into nightmares.

Now, though, the search for safer leverage is back. Barclays (NYSE: BCS  ) has rolled out a line of exchange-traded notes (ETNs) that promise to fix the biggest flaw that leveraged ETFs have.

Going beyond daily
Traditional leveraged ETFs were designed to track daily movements of market indexes. For instance, if the Dow rose 1% on a given day, then a double-leveraged ETF pegged to the Dow should go up 2% in value. Similarly, an inverse double-leveraged ETF would fall 2% with a 1% rise in its benchmark index.

The daily emphasis that traditional leveraged ETFs used, however, caused a problem for longer-term investors. Over time, if a market zigged and zagged back and forth, then leveraged ETFs would often lose value -- even if the overall market went in the direction it was supposed to go.

That created situations where pairs of leveraged ETFs, one bullish on a market and the other bearish, would both lose value. For instance, over the past three years, the ProShares Ultra Oil & Gas ETF (NYSE: DIG  ) , which is bullish on oil and gas stocks, has lost 57% of its value, while its bearish counterpart, ProShares UltraShort Oil & Gas ETF (NYSE: DUG  ) , is down 72% since 2007.

Similarly, volatility among financial stocks has given sector-linked leveraged ETFs trouble. ProShares Ultra Financials (NYSE: UYG  ) is down 3% in the past year, while ProShares UltraShort Financials (NYSE: SKF  ) has fallen 21%. Triple-leveraged financial ETFs have done even worse: the bullish Direxion Daily Financial Bull 3x (NYSE: FAS  ) is off 15% since last year, while the bearish Direxion Daily Financial Bear 3x (NYSE: FAZ  ) has dropped a much steeper 35%.

The easy fix?
Clearly, the problem with daily leveraged ETFs was that long-term investors were misusing them. But the fact that so many investors had problems showed that there was strong demand for a leveraged product that would work over the long haul.

That's the demand that Barclays is trying to address with its ETNs. The new products allow long-term investors to make bullish or bearish bets on a wide range of popular indexes, including the S&P 500, Russell 2000, and MSCI indexes on developed and emerging markets.

Unfortunately, deciphering how the ETNs work is anything but easy. The returns are based not only on changes in the underlying index and the particular leverage factor of the ETN but also by what's called the constant financing rate. The prospectus goes through several examples, many of which show that even when the underlying index goes up, investors won't receive the simple leveraged return they'd expect. In a nutshell, if short-term interest rates rise, the notes could lose value even if the index goes up.

That makes sense from one perspective. Leverage involves borrowing money, and if interest rates rise, it costs more to borrow. So expecting not to pay up for leverage if borrowing costs rise isn't realistic.

Time to move on
What even the overly simplistic examples in the prospectus show, though, is that these ETNs won't give you an easy, automatic way to multiply your returns. With 293 pages of materials in the prospectus and associated supplements, it's incredibly difficult to get a good handle on exactly how these notes work. After all the lessons from the financial crisis, the last thing any investor should want to buy is something they don't understand.

Moreover, unlike ETFs, ETNs expose investors to the credit risk of the issuing bank. Although you may reasonably think Barclays is unlikely to collapse, many would have said the same of Lehman Brothers before the financial crisis hit.

Whether these ETNs actually give investors the leveraged returns they expect will depend on exactly how the market reacts. But you shouldn't volunteer to be the guinea pig for these new products. Let others jump in before you get a rude awakening on how these products actually perform in real life.

You don't need leveraged ETFs to succeed with your investing. Click here to read The Motley Fool's free report, 3 ETFs Set to Soar During the Recovery.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger hates financial products that are more complicated than they need to be. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policynever leverages its integrity.


Read/Post Comments (4) | Recommend This Article (10)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 02, 2010, at 8:23 AM, rfaramir wrote:

    Shorting the UltraShorts has been a very good strategy on CAPS. In my Real Life, not yet.

    Shorting the UltraLongs has been good at times. It's a timing thing, which again, I don't depend on being able to do in Real Life.

  • Report this Comment On December 02, 2010, at 12:31 PM, slpmn wrote:

    Thanks for the article. I've always thought the leveraged ETF returns looked odd and didn't seem useful as a longer term hedge or speculation tool. I like the Barclay's option, but boy, those ETN structures seem to have their own risk factors that should make one hesitate. They lose value if short term rates go up? Umm, isn't that what just about everyone in the world assumes will happen within a couple of years? Perhaps dramatically?

  • Report this Comment On December 03, 2010, at 4:09 AM, ChrisFs wrote:

    Rfaramir,

    I have found a few wrinkles in trying to short leveraged ETF pairs in real life instead of CAPS.

    I'm still trying it myself, but I wanted to share them with other people, so they aren't caught off guard.

    1) Many leveraged ETFs are classified by a broker as 'hard to borrow', so they may not have many (or any) in their inventory to short

    2) If they do have some, but they are officially 'hard to borrow', there will be a daily 'hard to borrow' fee you have to pay. This is fee is a percentage of the amount invested. It can be anywhere from 1% to 100% of the invested amount PER YEAR (depending on how hard the stock is to borrow), paid on a daily basis (so take the yearly percentage and divide by 365).

    This figures into how profitable the trade actually is, since you are paying this without knowing how much you will actually make on the ETFs in 6 months to a year from now.

  • Report this Comment On December 03, 2010, at 8:32 PM, psych4biz wrote:

    First of all UYG closed on the dateline of this article, Dec 1 2010, at 57.21; on Dec 1 2009 it closed at 56.24. I'm not sure how you calculate that as "down 3% in the past year"? If you used a different date pair then you should have updated them in line with the article's publication date.

    Secondly, there is a lot of hot air written about UYG especially. I am a long term investor in it and find it performing exactly as advertised. I have a predictive model on Excel done more than a year and a half ago with XLF vs. UYG and I have predicted UYG's current price within a few cents vs. XLF. The model goes up and down like the market with UYG doing double what XLF does in both directions. That does not sound like a broken promise, does it? In fact its a superbly executed ETF and I hope others find out and use it to their advantage, as I am using it to mine.

    Long UYG and ready for the huge rebound in the US Financials, starting with dividends to be announced in Jan.....

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