When leveraged and inverse ETFs were first launched, many investors weren’t aware of the negative effects that daily rebalancing would have on the long-term performance of those ETFs relative to their benchmarks. Those potential problems are now more widely known, and coverage of leveraged and inverse products often includes the advice that they are best used as trading vehicles rather than investment products – i.e. to avoid investment shortfalls due to rebalancing effects, the holding period for positions using these products should be on the order of days, rather than weeks or months.
Research in the Winter 2010 issue of the Journal of Index Investing suggests that the message still hasn’t gotten through:
We find that many investors hold their leveraged ETFs for very long periods, at times longer than three months. Further, we calculate the shortfall of such a behavior compared to creating the leverage in a margin account. We find that some ETF inves- tors lose up to 3% of their original investment in just a few weeks, the equivalent of a 50% annualized return. This indicates that investors do not fully understand the risks associated with inappropriately using leveraged and inverse ETFs as long-term investments. (55)
The problem isn’t with the use of leverage as such. The graph below, from the paper, shows the relative outperformance for one fund in the Direxion Daily Dev Mkts Bear 3X Shrs ETF (NYSE:DPK) that would have been achieved by using a margin account instead of a daily rebalancing regime.
ETF Daily News Notes Some Popular Related Leveraged ETFs:Direxion Daily Financial Bear 3X Shares (NYSE:FAZ), Direxion Daily Financial Bull ETF (NYSE:FAS), Direxion Daily Real Estate Bear 3X Shrs (NYSE:DRV), Direxion Daily Real Estate Bull 3X Shrs (NYSE:DRN), Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA), Direxion Daily Small Cap Bull 3X Shares (NYSE:TNA), Direxion Daily Large Cap Bull 3X Shares (NYSE:BGU), Direxion Daily Large Cap Bear 3X Shares (NYSE:BGZ), Direxion Daily Energy Bull 3X Shares (NYSE:ERX), Direxion Daily Energy Bear 3X Shares (NYSE:ERY), Direxion Daily Emrg Mkts Bull 3X Shares (NYSE:EDC), Direxion Daily Emrg Mkts Bear 3X Shares (NYSE:EDZ).
Another interesting finding is that rebalancing over other periods (weekly, monthly) improves results slightly on average, but inconsistently: some funds experience worse shortfalls at a monthly rebalancing horizon.
There’s a larger point to be made here, of which the matter of rebalancing ETF shortfalls is just one instance: the complexity of modern financial products clearly outstrips the ability of investors to understand them, even when they are relatively “sophisticated” (e.g. the kinds of people willing and able to trade inverse/leveraged products) and are presented with proper disclosures. It’s no fairer to rest all of the blame on individual investors than it is to scold a toddler for burning his hand after you have just explained the physics of exothermic chemical reactions with regard to stove top ranges. The problem is either with the products themselves or with the opacity of the disclosures. I’m not disposed toward banning products for being “too complex.” But every incentive on the side of banks, dealers, and other financial institutions is to refuse forever to present risks in sentences of English, instead of evanescent tissues of lawyerly obfuscation. This is something the Consumer Financial Protection Bureau will address, with any luck, for the most widely-used consumer products; the public interest would also be served by expanding the scope of plain-language mandates.
Condor Options is a New York-based research and trading firm focusing on market neutral trading strategies. Condor Options publishes an educational newsletter teaching iron condors and volatility-based options trading, with a focus on risk management and quantitative analysis.
Jared Woodardis the principal of Condor Options. With over a decade of experience trading options, equities, and futures, he publishes the Condor Options newsletter (iron condors) and associated blog. Jared has been quoted in various media outlets including The Wall Street Journal, Bloomberg, Financial Times Alphaville, and The Chicago Sun-Times. In 2008 he was profiled as a top options mentor in Stocks, Futures, and Options magazine, and in 2010 was interviewed for Technical Analysis of Stocks & Commodities magazine. He is a founder and contributing editor of Expiring Monthly: The Option Trader’s Journal. He is also an associate member of the National Futures Association and registered principal of Clinamen Financial Group LLC, a commodity trading advisor.