Another Painful Year for Leveraged ETFs

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With the market apparently on the verge of another freefall, aggressive investors are once more looking at the promise of leveraged ETFs to try to multiply their gains from a big move in the market. Yet 2010 has once again shown how trying to turn leveraged ETFs into a long-term play on an investment trend can turn out very badly -- even if you pick the direction of the market correctly.

The worst kind of market
For those who buy leveraged ETFs, the best possible outcome is for whatever market the ETF tracks to move sharply and quickly in the correct direction. For instance, during the 2008 financial crisis, after Congress passed the bailout bill, those who bet against financial stocks using the ProShares UltraShort Financials (NYSE: SKF  ) in early November more than doubled their money in just a few weeks. That's because financials pretty much headed straight down during that period.

The problem with most leveraged ETFs, though, is that they aren't able to handle markets that zig and zag back and forth. And after 2009's powerful rally that had stocks moving mostly straight up, we're now in exactly the sort of market that really punishes leveraged ETFs. Consider these examples:

  • Over the past year, the price of oil has stayed in a fairly narrow range between $65 and $85 per barrel and is roughly unchanged since last summer. But no matter which way you thought oil and gas stocks would move, using leveraged ETFs to invest long-term has been a losing proposition: The bullish ProShares Ultra Oil & Gas (NYSE: DIG  ) is down 12% from a year ago, while the bearish ProShares UltraShort Oil & Gas (NYSE: DUG  ) has lost 13%.
  • Financial stocks have been all over the map over the past year, and leveraged ETFs haven't responded well. The ProShares bearish leveraged ETF has lost 14% in the past year, while the bullish ProShares Ultra Financials (NYSE: UYG  ) is off 15%. The triple-leveraged Direxion Daily Financial Bull 3x (NYSE: FAS  ) and Direxion Daily Financial Bear 3x (NYSE: FAZ  ) pair have done even worse, down 31% and 28% respectively.
  • Small-cap stocks have been particularly volatile in both directions. Yet with the Russell 2000 up around 3% in the past 12 months, you might expect better than a 0.3% loss from the double-leveraged ProShares Ultra Russell 2000 (UWM). Meanwhile, the bearish analogue, ProShares UltraShort Russell 200 (TWM), has fallen 25%.

You can't really blame ProShares or any other leveraged ETF provider for these results. They're a natural mathematical consequence of how these ETFs are structured. By focusing on short-term daily returns, these ETF providers have created funds that are completely unsuitable for long-term investors and that lead to the poor results above and many like them.

What's next: Rolling out the bond funds
Now, attention is squarely moving toward the bond market, where leveraged funds are producing some attractive returns. With long-term Treasuries up 16% in the past 12 months, the relatively new ProShares bullish leveraged Treasury fund has risen more than 40% since its inception in January.

Yet here, the choices investors have made tell the story. While the bullish fund had about $13 million in assets as of July 30, the bearish ProShares UltraShort Treasury 20+ Year (NYSE: TBT  ) had a whopping $4.4 billion -- and it's down 35% in the past year as investors betting against bonds were far too early.

Steer clear
With leveraged ETFs, it pays to listen to the disclosures that the ETF companies themselves are now providing, thanks to a little SEC coaxing. The daily reset puts long-term investors in serious danger of losing their money even when they're right about the general direction a particular market moves in.

If you want to bet against stocks, the better move is simply to sell them short yourself. While that's typically not possible in an IRA or other retirement account, taking on leverage is likely to leave you wondering why your good call ended up costing you money.

Some say investors are giving up on stocks, but stock ETF inflows tell a different story. Get the latest scoop from Morgan Housel on how the death of the individual investor has been greatly exaggerated.

Fool contributor Dan Caplinger only likes leverage when it works. He doesn't own shares of the companies mentioned above. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never makes you take a risk.

Read/Post Comments (6) | Recommend This Article (5)

Comments from our Foolish Readers

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  • Report this Comment On August 25, 2010, at 11:35 AM, player23m wrote:

    Your calculations are wrong, very very wrong, diversify your portfolio, use ETFs leveraged against each other, I'm up 52.22% after commissions, and rising, bought right after the crash.

    For example:

    FAS up 54.42%

    FAZ also up 230.04%

    ERY up 152.48%

    ERX also up 31.46%

    What are your figures based on? Are you forgetting all the splits?

  • Report this Comment On August 25, 2010, at 4:50 PM, TMFGalagan wrote:

    @player23m -

    Information came from Yahoo Finance, which accounts for splits and any distributions:

    These are figures from 8/25/2009 to 8/24/2010. I strongly suspect that your figures ignore the reverse splits that FAZ and ERY have made.


    dan (TMF Galagan)

  • Report this Comment On August 26, 2010, at 12:57 AM, ChrisBern wrote:

    (a) You can't usually short stocks in an IRA, but you CAN buy puts, which is a better bet than straight-shorting anyway.

    (b) The strategy I'm currently employing (in agreement with the thrust of your article) is buying 2012 LEAP puts on these decaying ETFs. I'm bearish on the market anyway, so I have 2012 puts on leveraged ETFs such as UYG and UYM. The strategy is that regardless of market movement, the ETFs will decay around 20% over the next year or two anyway. If I get the market direction right anytime in the next 18 months, that's gravy.

  • Report this Comment On September 01, 2010, at 1:23 PM, FASnFAZrLOSERS wrote:

    @player23m has been commenting for months how his FAZ investment from July 2009 has been up 200%-300%. Early in that month the stock was at the $4-$5 range and now is bouncing in the $17 range, but the adjusted price of his shares for the July 9th reverse split of 1-10 is around $47-$56. If were actually invested in the stock he would have noticed the decline in his portfolio value of 40%-50%.

    The Russell 1000 is up since July 2009, does it make sense that a Triple bear fund would be up? I guess I should not use that logic, because based on that a triple bull fund such as FAS would be up and it also is declining.

    As I have said before, something does not smell right about the Direxion 3x funds.

  • Report this Comment On September 02, 2010, at 8:27 PM, jts187 wrote:

    I wont comment on any other leveraged ETFs other than FAS/FAZ, because those are the only ones I have dealt with at this point.

    I have only one real point to make about the two. They are not for long term exposure. Trade em in the same day, or maybe within a day or two of opening the position, and only when you are at least 99% sure something is going to break.

    I cant claim to have made huge gains with them, but Ive never ran afoul as long as they are played properly, which IMO, is that you have to be aggressive at your entry and exit points, but you have to be conservative about what reasoning behind getting into the position. It does seem counter-intuitive to say be aggresive and conservative at the same time. However, you will find in alot of cases, that if handle that in the reverse, being conservative with your entry and exit points, and aggresive with your reasoning for opening the position, you are setting yourself up for the loss. I learned this the hard way.

  • Report this Comment On September 17, 2010, at 4:57 PM, player23m wrote:

    Actually no, when they started the fund I just took even positions for each. I knew the market would move, probably up, but couldn't afford the risk so I hedged 2 reversed 3X shares against each other, that way no matter which way it goes I either break even or make a 33% gain.

    You are all missing something but are right when you say something stinks. Maybe dividends and delays work into the equation somehow to make them money?

    The scheme only works when the market moves though, and in only one direction. You invest $100 in each, lose $100 on 1 and make $300 on the other, it amounts to a 33% gain or better. (or better because a 33% gain is slightly more cash then a 33% fall when the stock value percentages are compounded daily)

    You can pretty much make good assumptions any single month about which way a single market will move too so it makes things pretty easy and less risky than a major index.

    For example, try hedging even amounts of TNA and ERY together. This portfolio has yielded 5.48% since the buy on 8/13/10.

    These combinations create easy low risk calls that can easily yield 60% gains on any given year! Try it for yourself...

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