For years, warnings about exchange-traded funds that offer leveraged returns have flooded the investing world. Yet for those who remain unconvinced that leveraged ETFs are dangerous for long-term investors, a recent piece of news serves as just the latest reminder of the potential losses that investors can suffer from hanging onto leveraged ETFs too long.
Getting the splits
Yesterday, the ETF provider ProShares announced that one of its popular volatility-based ETFs, the ProShares Ultra VIX Short-Term Futures ETF, would do a reverse split. Having lost more than 90% of its value just since the beginning of the year, the ETF will exchange one new share for every 10 existing shares that investors own. As a result, the price of each ETF share will return almost to the price it fetched at the beginning of 2012, but investors will have only a tenth as many shares as they owned before the reverse split.
It's tempting to think that such a situation must not happen very often. Because leveraged ETFs often trade in pairs, with one ETF bullish while the other is bearish, you'd hope to see big gains from one ETF when its counterpart sustains major losses. The Ultra VIX ETF doesn't have a matching bearish sibling, but its unleveraged inverse cousin has indeed doubled in price so far this year.
But often, neither member of a pair of leveraged ETFs puts up decent gains. For instance, take silver. Both ProShares Ultra Silver (NYSE: AGQ ) and ProShares UltraShort Silver (NYSE: ZSL ) have lost ground over the past year, even though silver prices have fallen by about 25%. Granted, the UltraShort ETF is had much smaller losses than the Ultra ETF, but for neither to have eked out a gain is a serious disappointment for fund shareholders.
A big reverse
Nor is the ProShares volatility ETF the only one that's ever had to do a reverse split. Take a look at the ProShares UltraShort QQQ (NYSE: QID ) , for instance, which tracks the tech-laden Nasdaq 100 index with a leveraged bearish bet. As you'd expect during a three-year bull market, the shares have gotten crushed. Even after a 1-for-5 reverse split early last year, the ETF has given up more than 40% of its share price, suggesting that a future reverse split may again be necessary.
Even if an ETF chooses not to do a reverse split, it doesn't make the damage any easier to endure. For instance, a similar product to the ProShares volatility ETF called the VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX ) , has lost between 97% and 98% of its value since it first became available for trading back in November 2010. Yet at least so far, the exchange-traded note has stubbornly refused to do any sort of reverse split, even though it boasts a penny-stock price around $2.50 compared with its opening value above $100.
Watching out for problems
To be fair, leveraged ETFs aren't the only exchange-traded products to show consistent problems. With commodities, problems like the contango phenomenon can sometimes rear its ugly head, causing constant erosion of value. For instance, with United States Natural Gas ETF (NYSE: UNG ) , investors have had to endure two reverse splits in just the past year and a half, with one current share now representing eight old shares prior to March 2011.
But with leveraged ETFs, the impact can come a lot faster, especially if you're on the wrong side of the market. With an increasing number of triple-leveraged products coming to market, you can expect to see even more examples of accelerated declines in leveraged ETFs.
The complexities of leveraged ETFs have deprived many novice investors of part of their wealth over the years. But whenever you see reverse splits become commonplace in a particular investing niche, it pays to avoid it -- unless you can sell short. You're far better off not taking a chance that the ETF might turn itself round.
ETFs can be useful, but adding individual stocks to your portfolio can be quite lucrative. We've picked out several stocks that can help you retire rich, and you can find them in The Motley Fool's special report on retirement. It's entirely free, so don't wait; read yours today.