Leveraged ETFs and Volatility: A Powerful Mix (SRS, URE, IYR, SSO, SDS)

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November 8, 2012 12:59pm NYSE:IYR NYSE:SDS

Eric Dutram: The last five years have certainly been a rocky one for investors in pretty much every corner of the market. In the time period, the S&P 500 was more or less flat although it experienced two incredible stretches in which it first lost roughly half of its value in one,

and then proceeded to double over the next few years to recoup nearly all of its losses.

These shifting trends—which put the S&P 500 back within striking distance of its all-time (non-inflation adjusted) high—have also obviously led to a very high level of volatility for the benchmark index. In fact, according to data from XTF.com, the standard deviation for SPY over the past five years was 26.4%, a level that is roughly 75% higher than what investors have seen in the same index over the last few months, underscoring just how uncertain markets have been over the past half decade.

Unsurprisingly, the volatility levels go up even more when investors take a closer look at some of the leveraged and inverse funds on the market. For example, two of the oldest leveraged and inverse ETFs tracking the broad market out there—SSO and SDS—both have five year standard deviation levels over 50% (see the Guide to the 10 Most Popular Leveraged ETFs).

This shouldn’t be too surprising to investors, as SSO and SDS track the return of the S&P 500 using, respectively, 2x and -2x leverage, albeit on a daily basis. Given this, one should probably expect these two funds to have roughly double the standard deviation that their underlying index exhibited over the same time period.

Yet beyond these two, investors have also seen incredible standard deviation levels in a number of other leveraged and inverse ETFs in the time period in question. While leveraged and inverse financial ETFs, basic materials, and oil ETFs all saw extremely volatile five year periods, they all paled in comparison to one segment of the economy in this respect, real estate (see Is ROOF a Better Real Estate ETF?).

The -2x and 2x real estate ETFs, the ProShares Ultra Short Real Estate Fund (NYSEARCA:SRS) and the ProShares Ultra Real Estate Fund (NYSEARCA:URE), both experienced truly tremendous five year periods from a volatility perspective, with readings above 90% for both funds. While the leverage was certainly a necessary component to bring about such extreme standard deviation levels for these relatively old funds, the general trend of the real estate market was also a key contributor to the volatility as well.

What Happened?

After both URE and SRS’ debut in early 2007, the broad real estate market reached a historic high, spurred by a variety of factors. Soon after that, as we all now know, real estate cratered in a catastrophic fashion leaving the sector decimated (read Three Best Performing Small Cap Growth ETFs).

This was especially true for URE and SRS as these two ETFs are dominated by REITs in the American market. Furthermore, mid caps and small caps take up a big chunk of assets—nearly 50% at this point—so higher volatility levels should be expected anyway.

This slump was followed by a long and steady rise back to nearly breakeven—granted with a few modest drops along the way. The performance was actually enough to move the iShares Dow Jones US Real Estate ETF (NYSEARCA:IYR)—a product that tracks the same index as URE and SRS—to a performance of -8.7% for the trailing five year period (see Leveraged and Inverse ETFs: Suitable Only For Short Term Trading).

However, when leveraged ETFs are seeing high levels of volatility, along with deep trends, the impact on long term performance is usually devastating. That has certainly been the case for the leveraged real estate ETFs as both are down more than 60% for the time frame in question, with SRS losing more than 98% of its value in the past half decade.

The Bottom Line

While leveraged ETFs can certainly work in your favor during short-term periods, long term performance is usually terrible for these products. This can be especially the case during periods in which deep trends form and a great deal of gains evaporate (seeUnderstanding Leveraged ETFs).

URE has actually been a pretty solid performer over the trailing three year period—up 142%– but it hasn’t been able to shake the turmoil of the 2008-2009 crisis. Meanwhile, SRS was up roughly 119% at one point in the trailing five year period, but the long term recovery of the housing sector helped to erase these gains over the long haul, making the ETF actually the underperformer of the two.

So while leveraged and inverse ETFs can certainly help portfolio returns when you pick the correct side, there are also significant long-term risks to these potent instruments as well. As we have seen in the real estate ETF example above, the combination of performance trends and long term volatility can be extremely devastating for investors, once more demonstrating that leveraged funds need to be monitored closely and only utilized for short time periods.

Written By Eric Dutram From Zacks Investment Research   

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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