Leveraged and inverse-leveraged exchange-traded products have promised to be some of the most exciting tactical tools for investors. These products use leverage to amplify the returns of broad indexes in both positive and negative directions-in some cases either doubling the returns of an index or doing the exact opposite if you're a bear, giving you inverse exposure to specific asset classes.
The initial enthusiasm for these products was reflected by their phenomenal growth since they first appeared in March 2006. By March 31, 2010, the number of funds had grown to 151 with $27.6 billion in assets. They now come in all major asset classes, investment styles, sectors, commodities and currencies.
But a backlash has started, and exchange-traded products have recently become embroiled in controversy, misunderstanding and disappointment-especially in their long-term performance. The stock market's severe decline in 2008 and 2009 and its subsequent rise have made the public painfully aware that timing is everything when it comes to ETPs.
According to their prospectuses, leveraged exchange-traded funds and their cousins offer leverage at twice or more than the return of a designated benchmark-but only if it's typically for no longer than one day. Thus, many investors suffered significant losses not fully understanding the consequences of holding these products for extended periods.
The shock has led to a number of class action suits by investors alleging that leveraged ETPs are not doing what they're designed to do because, over the long run, they do not track plus or minus two or three times the investment results of the underlying benchmarks.
The SEC has effectively frozen the release of new ETPs as part of its investigation into products that rely on swaps and other derivative instruments to achieve their investment objectives. While its review goes on, the agency has deferred requests for exemptions to this freeze from exchange-traded product sponsors.
Figure 1 explains why investors have been unhappy with leveraged and inverse fund long-term performance. Between July 11, 2006, and April 16, 2010, the ProShares Ultra S&P 500 Fund (designed to track twice the daily return of the S&P 500) had a total loss of 33.3%, or five times the S&P 500's. The ProShares UltraShort S&P 500 Fund should have appreciated with the market's decline, but instead it suffered a total loss of 44.9%.
Funds tracking the Dow Jones Industrial Average also disappointed, as both the long and short leveraged funds lost-19.5% and 46.3%, respectively. Of the six funds shown in the figure, only the ProShares UltraShort QQQ Fund recorded the anticipated negative return, approximating twice the Nasdaq-100's inverse return.
The stated and realized leverages differ from each other over time because of the rates at which the period's returns are compounded and also because of the disparate values of a fund and its underlying index over time. Figure 2 illustrates that an ETP with constant leverage will generally under- or outperform its unleveraged benchmark over time regardless of market trends.
The three market trends depicted in Figure 2 are, of course, hypothetical examples of bear markets, bull markets and whipsawing markets. Few markets if any consistently rise, fall or whipsaw without interruption. Nor do they change by a constant 1% per period over 12 periods. Nevertheless, the figure demonstrates the importance of differences in compounding a fund's leveraged returns and an index's unleveraged returns over time.
In declining markets, the returns of a twice-leveraged inverse fund will be equal to twice the loss of its benchmark index only in the first period. Beyond that, its returns will be less than twice its benchmark's. The benchmark's loss in period 2 is -1.99% ((98.01 / 100) - 1) and the fund's loss is -3.96%. The implied leverage is therefore 1.99 (-3.96% / -1.99%). This result stems from the fact that the leveraged fund initially declines by the stated leverage but later declines by less because of its proportionally smaller value. Over the 12 periods, the benchmark's loss of -11.36% is more than half that of the bull market fund's -21.53%. The implied leverage is 1.89.
In rising markets, meanwhile, the returns of a twice-leveraged fund will be equal to twice the gain of the benchmark-but once again, only in the first period. Beyond that, its returns will exceed twice its benchmark's because of the leveraged fund's initial increase by the stated leverage and because of its subsequent increase over the stated leverage given its proportionally larger value. Over the 12 periods, the bull market fund's return of 26.82% exceeds twice the benchmark's 12.68%, for an implied leverage of 2.12.
Although the direction of a bull market fund's implied leverage can be determined in steadily rising or falling markets, its price trend is uncertain in whipsawing markets because of the different compounding effects, first by declines and then by increases. The whipsawing market illustrated in the figure rises 1% in one period and declines 1% the next, thereby combining the characteristics of both bear and bull markets.
In markets characterized by moderate reversals, the implied leverage remains closer to the stated leverage. The benchmark's small 1.96% gain against the fund's 3.83% gain results in an implied leverage of 1.96, very close to 2.
Figure 3 shows that despite market trends an inverse leveraged bear market fund with constant leverage will also generally under- or outperform its unleveraged benchmark over time.
Again, the returns of an inverse fund in a declining market twice leveraged will equal twice the loss of its benchmark index in the first period. But after that, its returns will exceed its benchmark's losses. The benchmark's total loss by period two is -1.99% ((98.01 / 100) - 1) while the fund has gained 4.04%, with the implied leverage being -2.03.
This is due to the inverse leveraged fund's initial rise by the stated leverage and its later increase of more than the stated leverage given its proportionally larger value. Over the 12 periods, the benchmark's decline of -11.36% is less than half the bear fund's gain of 26.82%, and thus the implied leverage is negative 2.36.
In rising markets, meanwhile, the loss of an inverse fund twice leveraged will equal twice the gain of the benchmark in the first period only, but beyond that its losses fall short of two times its benchmark's gains. These later, lesser declines occur because of the inverse fund's proportionally smaller value. Over the twelve periods, the bear market fund's loss of -21.53% is less than twice the benchmark's gain of 12.68%, for an implied leverage of negative 1.70.
The gyrating market illustrated in this figure combines characteristics of both bear and bull markets. Although the direction of a bear market fund is supposed to be predictable in steadily rising or falling markets, its course is more uncertain in whipsawing markets because of the different compounding effects, first as the market declines and then as it increases. In markets with moderate reversals, the implied leverage deviates greatly from its stated leverage. The benchmark's small 1.96% return and the fund's tiny loss of -0.24% shows virtually no leverage at all: only -0.12.
Results like these are called "price path dependence," or simply "path dependence." And they explain why many long-term investors were disappointed with the performance of leveraged and inverse leveraged funds during the extremely volatile markets in 2008 and 2009, particularly after the less turbulent markets (in 2006 and 2007).
Path dependence also explains why leveraged ETPs appeal to market makers and proprietary traders. These investors have holding periods that are very short (frequently lasting less than one day) and they are thus less concerned with distortions in leverage caused by path dependence.
Given the difficulty in assessing the long-term performance of these products against their underlying benchmarks, financial advisors must ask themselves the following questions before investing in leveraged or inverse funds for a client:
1. Is the magnified exposure to a particular asset class suitable for the client?
2. Does your client understand the inherent risks?
3. Does your client understand that the stated leverage is likely to be realized only in the short term?
4. What is your client's expected holding period? Is it appropriate for these products?
If the answer to all these questions is yes, leveraged and inverse ETPs can provide tactical advantages to a portfolio by offering timely and magnified exposure to an asset class with a small capital commitment. They also allow advisors to avoid margin costs, the expiration dates related to options or roll periods with futures.
There may also be new factors for you to take into account once the SEC completes its review. Since these funds use swaps and other derivative instruments, the SEC could impose new regulations-such as standards establishing when these products would be deemed suitable or prudent for a particular client.
Or the agency could require proof that the client understands the inherent risks (that a fund's stated leverage can only be realized in the short run, for example). It's difficult to say for sure what will come out of the review, but any such requirements might likely complicate your clients' decision to use the funds or discourage your clients from using them outright.
The regulatory environment will also be a factor because of their impact on the funds' sponsors. The SEC review could force ETP sponsors to choose between maintaining the present form of existing products (possibly extending them to more asset classes), or developing new funds that overcome the path dependency problems. What the sponsors choose to do will greatly affect the applicability and variety of products available. Innovative sponsors will likely accept the challenge of eliminating or reducing price path dependency in future products since the profit potential in replacing existing products is simply too great to be ignored. This may give ETPs more potential in the future to have more predictable long-term leverage.
Currently, all leveraged and inverse leveraged ETPs are subject to price path dependency, and it's uncertain how sponsors will overcome it. They will likely have to vary the leverage at different path levels periodically to more closely approximate the desired long-run leverage. Such changes will likely augur a paradigm shift in the creation of these products.
C. Michael Carty is principal of New Millennium Advisors, a registered investment advisor in New York City. Julia M. Carty is a marketing communications professional specializing in financial media, product and brand management and research.
