The Truth About Leveraged ETFs

Over the past 12-24 months ETFs have grown 10 fold in popularity and 100's if not 1,000's of new ETFs have been created in the past year tracking everything from emerging markets to gold to bonds to small cap company indexes. Many of these investment instruments claim to track the returns of whatever asset class they are tracking - but there is a catch. While daily returns are meant to track returns of these assets, over a long period of time, this is often not the case. This is especially true of leveraged and inverse ETFs which use complex derivatives to achieve their goal.

Take for example the ETF with ticker symbol EDZ. Direxion Daily Emrg Mrkts Bear 3X Shares. This ETF by definition should return 3x the inverse of emerging markets daily. The problem is that this only works when the market is moving consistently in the direction the ETF is meant to track. the explaination is as follows:

Assume the current price of EDZ is $20.00

Day 1: emerging markets go down by 3%. The fund returns 9% that day - raising the price by $1.80 to $21.80 per share.

Over the next 7 days the market zig-zags going up 3% one day, down 3% the next and so on, for a total of four days up 3% and four days down 3%. The returns would look as follows:

Day 1: $21.80

Day 2:  $19.84

Day 3:  $21.62

Day 4:  $19.68

Day 5:  $21.45

Day 6:  $19.52

Day 7:  $21.27

Day 8:  $19.36

As the above demonstration illustrates, while the market has had an equal number of days with positive return and the identical number of days with negative returns, the security has lost value. This example illustrates the effect of compounding on returns and shows why leveraged/inversed ETFs are best used as short term trading tools rather than long term investments. Also the above example doesn't take into account the transaction fees that are needed to execute such a strategy of tracking the 3x inverse returns of an index.  Also in the above example, if it was to extend out for 100 days instead of 8 days, the trend of downward returns would be even more pronounced as every down day has a greater impact on returns than an up day.  In a more simple example, If the ETF has negative returns of 50% in a given period, it will take a 100% return to make up for that loss.  

Stock A:  price: $10.00.  Loses 50% of its value and now trades at $5.00.  a 100% gain would make the stock double and get back to $10.00, while a 50% gain would only make the stock worth $7.50 - leaving a delta of $2.50 - that additional 50% gain needed to get back to even.