Leveraged Funds: Enticing Idea, But "The Math Will Not Work"

Battered by big losses from the great market swoon of '08-'09, some investors are being tempted by investments offering the prospect of quickly reversing their fortunes. "Leveraged funds" offer exactly that type of hope.

These funds and ETFs (exchange-traded funds), which often have "ultra" or "2x" in their name, use derivatives and debt to "amplify" returns. (There is little difference between leveraged mutal funds and ETFs; in this article the terms are used interchangeably.)

A leveraged ETF with a 2:1 ratio is designed to provide double the return of a specific underlying index — such as the S&P 500. Of course, this leverage works both ways, amplifying both gains and losses. With a 2:1 leveraged ETF, your gains will theoretically come twice as fast as the index it tracks.

Pick the right market direction and the gains can come quickly. Of course, if you get the market direction wrong, the losses can also mount quickly. (Bearish investors can invest in "short" or "inverse" leveraged ETFs, which are designed to return a 2% gain for every 1% loss in the underlying index. If the index gains, these funds suffer losses at double the index's rate of gain.)

The "double-your-pleasure"/"double-your-trouble" nature of leveraged ETFs mean they are definitely not for the faint of heart. But there's another characteristic that makes them especially dangerous for the average investor: gains/losses are amplified on a daily basis. What's so dangerous about that? Let's do the math.

Suppose you invest $100 in a 2x leveraged ETF that's tracking the S&P 500. On the first day you own the fund, the S&P gains 10%. In a traditional index fund, your holdings would be worth 10% more, or $110. But because you are invested in a 2x ETF, your holdings are now worth $120. Great!

However, the following day, the index loses 10%. In an ordinary index fund, your holdings would fall from $110 to $99. But because the S&P loss is being amplified by your leveraged ETF, your holdings lose 20%, falling from $120 to $96.

In other words, after two volatile days — up 10% one day, down 10% the next — your losses are four times greater than the losses incurred by an investor in an ordinary index fund (he lost $1; you've lost $4).

Of course, things could get better as the days go by, but probability is not on your side. This example is continued in the table at right, showing what happens to both a traditional index fund and a 2x-leveraged ETF when the hypothetical index they both track experiences six alternating days of 10% gains and losses. The regular index fund finishes this stretch with a small loss of roughly 3%. So it makes sense that the 2x-leveraged ETF would experience losses roughly double that, or 6%, right?

Wrong. The actual loss is much higher at roughly 11.5%. While the leveraged fund is accomplishing its stated goal — doubling the daily return of the index — it clearly is not accomplishing that goal over a longer time period, which is the faulty expectation of many investors buying these products.

How can the long-term performance of a leveraged fund differ so much from the performance of its underlying index? The unfortunate mathematical fact, as pointed out by Morningstar ETF analyst Paul Justice, is that "anytime you compound a negative return, its impact is always more pronounced than a positive compounding of the same magnitude."

The earlier example uses dramatic gains and losses to quickly illustrate the point, but a similar outcome is likely in real life, only more slowly. The losses compound more quickly than the gains, often keeping investors from the long-term results they expect.

Responding to reports of investors getting burned by leveraged ETFs, the Financial Industry Regulatory Authority (FINRA) issued a notice [PDF] in June recommending that brokers and registered investment advisers steer average investors away from leveraged funds.

"While such products may be useful in some sophisticated trading strategies, they are highly complex financial instruments," the notice said. "Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, inverse and leveraged ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets."

FINRA offered this example of how a leveraged ETF can diverge significantly from the index it is tracking. "[B]etween December 1, 2008, and April 30, 2009, the Dow Jones U.S. Oil & Gas Index gained 2 percent, while an ETF seeking to deliver twice the index's daily return fell 6 percent."

Unfortunately, many investors — enticed by the prospect of earning double returns — aren't heeding the warnings. "In every leveraged ETF report that we write, we warn investors that the math behind daily compounding will not work... [But] I get the feeling that the message is not getting across," worries Morningstar ETF analyst Paul Justice.

Still he tries. In an article earlier this year, he made the warning as clear as possible: "Leveraged and inverse ETFs are NOT meant to be held as long-term investments."

Joseph Slife is a contributing author and editor for SMI. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting. In addition to his work with SMI, Joseph is an adjunct instructor in the Dept. of Communication at Emmanuel College in Georgia.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• FINRA Regulatory Notice
• Commentary: Leveraged ETFs get bad rap as investor trap | Chuck Jaffe, MarketWatch

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