Along with oil and other energy-related exchange traded funds (ETFs), leveraged funds are no strangers to a little bit of attention, too. One major leveraged and inverse ETF provider, ProFunds, has stepped forward to defend the products with a study.

The Financial Industry Regulatory Authority, better known as FINRA, recently had a close look at leveraged and inverse ETFs. On June 11, the agency issued a notice reminding brokers to be mindful of the suitability of products they offer their customers and that the returns of some of these ETFs can differ from their daily targets, the indexes they’re designed to amplify.

Michael Sapir, chairman and chief executive of ProFunds, which offers the ProShares ETFs, told Herbert Lash for Reuters that he’s supportive of FINRA’s notice, except for their belief that they are one-day only investments. ProFunds feels this is an inaccurate perception of these ETFs.

In response, ProFunds put together a study to illustrate this point.

Most leveraged and inverse ETFs have an objective to provide a daily multiple, for example, plus or minus 200%. For example, in a leveraged inverse ETF, if the underlying index loses 1%, on any given day the ETF should in theory gain 2% that day. The funds have a daily target for a few reasons, according to ProFunds:

• It limits risk by preventing a case of too much leverage
• It mitigates risk of losing more than what’s in the fund
• Having an open-end fund that doesn’t rebalance daily, but provides a constant level of leverage for investors coming in after the first day isn’t possible

Daily, these ETFs work as they should. There are no issues here. “On a daily basis, they’re almost perfect,” says Steve Cohen, managing director at ProFunds.

Where the debate comes in is when they’re held for longer time periods. The common belief is that because of compounding, over time returns will be significantly lower than the one-day target. This, over time, chips away at a fund’s performance.

However, compounding works both ways. In both up and down markets, compounding can work in an investor’s favor. The negative impact is really only evident in markets such as those in 2008-2009, when record volatility hit the funds, Cohen says. But you can’t just judge these products based on the last year in the markets.

Compounding turns two consecutive gains of 10% into an overall 21% return. It works on the downside in a 2x fund, as well: two consecutive days of 20% losses will translate into a 36% loss through compounding. ProFunds’ study revealed several interesting points about compounding:

• There is a high probability of approximating the one-day target over longer periods
• The shorter the period and the lower volatility of the index, the more likely approximating the target becomes
• The impact of compounding over the long-term is essentially neutral

Even over longer periods, there’s a generally high likelihood that an investor would get close to the 2x index return as illustrated in the chart below:

(click the chart to enlarge)

The Volatility Myth?

ProFunds also conducted a volatility study, which compared the standard deviation of the S&P 500 index constituents, as well as the standard deviation of hypothetical 2x S&P 500 fund in each calendar year from 1999-2008. The hypothetical S&P 2x fund, in fact, is less volatile than 39% of the components of the S&P 500 index and the volatility in this fund is comparable to a number of other non-leveraged ETFs.

All in all, Cohen says, leveraged and inverse ETFs have been around for years and it’s only now that they’re under the gun. “These are not new products. For 15 years, they’ve worked well.”

Not to mention the fact that they’re a small piece of the market pie, even though many critics say these ETFs put downward pressure on the markets. Sapir told Reuters that from Sept. 30 to the March 9 market low, ProFunds’ net exposure to stocks was long $1.9 billion.

These ETFs have enormous benefits for investors when used correctly. Among them:

• They can help capture some short-term gains
• They can hedge current positions in a portfolio
• They can be used in a pairs trading strategy (matching a long position with a short position in two stocks of the same sector)

Tags: ETF 101, Feature Stories, Interviews, Long-Short ETFs