Do the new leveraged ETFs have a place in the
financial advisor's toolbox?
For some things in life, two is better than one. If
one dollar is good, two dollars is better. If one week of vacation is
fun, two weeks is fantastic.
But what's true of vacation time isn't true of everything else. One hot fudge sundae is yummy, but two? Two is asking for trouble.
That's what investors are trying to figure out about the new, leveraged exchange-traded funds (ETFs) from ProFunds: If having exposure to the market is a good thing, is having twice the exposure better?
The new ETFs, called "ProShares," listed on the American Stock Exchange on June 21. They include four leveraged ETFs, which offer 2X exposure to four major market indexes: the S&P 500, S&P MidCap 400, Dow Jones Industrial Average (DJIA) and Nasdaq-100. In theory, these ETFs should double the performance of the relevant index: If the S&P 500 rises 1%, the Ultra S&P 500 ProShares ETF (ticker: SSO) should jump 2%.
Accompanying the leveraged funds, ProFunds also debuted four "short" ETFs tied to the same four market indexes. These funds are supposed to provide inverse exposure: If the S&P 500 rises 1%, the Short S&P 500 ProShares ETF (ticker: SH) should fall by 1%.
By all accounts, these are among the most anticipated ETFs ever developed (see list). ProFunds has been working on the funds since 1999, and they were officially "under review" at the Securities and Exchange Commission (SEC) for more than three years.
So far, the market has embraced the new funds with open arms. Only two weeks post-launch, the leveraged funds are regularly trading more than 100,000 shares per day.
Of course, the idea offering leveraged mutual funds isn't new. ProFunds and Rydex have both offered leveraged mutual funds for years. What's new is that the idea of offering leveraged and inverse ETFs, with all the tax benefits and lower costs you would expect from the innovative fund structure.
Consider the expense ratio. While ProFunds charges 1.44% for its traditional leveraged mutual funds, it charges just 95 basis points for the new ETFs. By bringing the expense ratio down below the 1% mark-and indeed, below the average for a traditional mutual fund-the ETFs make leveraged investing a real possibility for cost-sensitive investors.
How Will They Be Used?
The first thing most folks thinks of when they hear about these funds is day trading. For investors crazy enough to bet-and bet is the right word-on short-term movements in the market, the new leveraged funds are nirvana. It's no surprise that the most popular fund out of the gate is the Ultra QQQ-100 ETF (QLD). Offering double exposure to the highly volatile Nasdaq-100 Index, QLD could become one of the most highly traded securities on the market.
Because they were so quickly embraced by the day-trading set, some longer-term investors and advisors have dismissed the funds as novelties. That dismissal is too quick: In truth, the funds can be used in some very interesting and sophisticated ways.
Consider the inverse ETFs. Suppose you have a client's portfolio perfectly positioned for the long-term, but you are concerned about short-term volatility in the market. Using the inverse ETFs, you can hedge the portfolio without selling any underlying positions-potentially dodging a major tax bill in the process.
"I'm happy, happy, happy," says Dave Fry, founder of ETF Digest, which offers ETF-based trading advice to individual investors and financial advisors. "They're opening a lot of doors for people. In the past, it's been very difficult to short many ETFs. And retirement accounts have been restricted from shorting. But not anymore."
Fry says the 95-basis-point expense ratio was high, but that it was a price he was "willing to pay." On the long side, investors can use the leveraged funds to build simple "portable alpha" strategies.
"An advisor could take approximately 50% of his client's assets and put them into the Ultra S&P 500 ETF, and get approximately 100% market exposure on Day 1," explained Michael Sapir, CEO of ProShares. "Then he could use the remaining 50% to try to outperform the market ... by investing in alternative asset classes."
In the classic form of the portable alpha strategy, the leftover cash is plowed into Treasuries, and the interest income is used to outperform the market by a small margin.
Portable alpha strategies are not without risks, nor are the funds. ProFunds and Rydex both have done a good job achieving leveraged and/or inverse exposure in their traditional mutual funds, but there's no guarantee that the ETFs will perfectly track their intended targets. Moreover, investors have to worry about transaction costs, taxes and other issues.
The Unmentioned Possibility?
One topic that's gone unmentioned in coverage of these ETFs is the idea I mentioned at the top of the article: If market exposure is good over the long haul, is 2X market exposure better?
My interest in this question isn't entirely academic. My wife and I are expecting, and I've thought about setting up a retirement account for the little one at birth. Even if I set aside a small sum, I figure that 70 years of compounding returns will turn it into a nice chunk of change for Junior's retirement. Should I put it into a traditional fund, or one of the leveraged ETFs?
To find out, I pulled data from Yahoo! Finance on the Dow Jones Industrial Average stretching all the way back to October 1, 1928. If, on that day, I had sunk $1,000 into the Dow using the traditional Dow Jones Diamonds ETF (ticker: DIA, with an expense ratio of 0.17%), that investment would have grown to $26,912 after 70 years. If, on the other hand, I had sunk that money into the leveraged ProShares ETF (DDM, with an expense ratio of 0.95%), it would have grown into $44,871-or nearly 67% more the traditional fund.
In fact, for each of the eight 70-year periods in my study, the leveraged ETF came out on top. Pretty good, huh?
Scanning back through the data, however, revealed the risk. Because I started the experiment just before the Great Depression, the leveraged investment was ravaged in the early years. In fact, using the first example, my initial $1,000 investment fell in value to just $15.67 by July 1932! Try explaining that one to the missus! It wasn't until December 21, 1994-nearly 65 years after the original investment-that the leveraged fund surged into the lead for good.
At 70 years, this is a longer time frame than all but the youngest investors can even consider. What happens if you shorten that time frame to just 20 years-about the time frame for the average college fund?
Surprisingly, the leveraged funds still do well. Using my data, if you invested $1,000 on the first of the year beginning in 1929 and held it for 20 years, the leveraged funds would come out ahead four out of five times.
Not surprisingly, you had a much greater chance of losing money in the leveraged fund: 9% vs. 3%. But you also had a much better shot of doing very well, too: The leveraged fund rose more than 1,000% in 41% of the 20-year periods, compared to just 7% for the traditional funds.
Does that mean we should all rush out and throw money at the leveraged funds? Hardly. For one, they're not for the faint of heart. Double exposure on the upside means double exposure on the downside, and that can create some frightening losses. Even the folks at ProShares shy away from endorsing the "double-up" strategy.
"We don't see these funds by themselves as complete investment programs," says Sapir. "We see them as being supplemental to an investment strategy. We don't expect financial advisors to take 100% of their client's assets and put them into any one of these new ProShares."
Most financial advisors I spoke with agreed. It's one thing, after all, to do these exercises on paper-and quite another to walk a client through a period of extreme volatility.
"I just can't imagine getting a phone call from an investor saying, 'Hey Ed, the market is down 10% and I'm down 20% ... what should I do?" says Ed Hynes, CFA, founder and president of Farm Creek Securities. "For most investors in the leveraged funds, their angst level would more than double in a down market, and they would bail out too soon."
Hynes explained: "You can think of the doubled volatility as doubling the likelihood that you'll buy or sell at the wrong price."
Could an investor really sit tight if their portfolio fell 98%? Should they? The answer is probably no.
Nonetheless, the data are certainly fun to consider. And back in the real world, the funds offer real solutions for hedging and tax-related strategies. They may be tools for day-traders, but advisors should take a close look as well.