Investors looking at leveraged and inverse exchange traded funds (ETFs) should pay attention to the fine print in those products, so that one may not find any surprises in the end.
Those that are fervent traders using leverage for anything longer than a day’s time is better off using a margin account, says Paul Justice for Morningstar.
Leveraged and short ETFs work better on a day-to-day basis, but over time, there tends to be tracking error as daily compounding takes a toll. These funds are not meant to be bought and held.
A case in point that demonstrates the divergence over time is the MSCI emerging market versus leveraged ETFs. Vanguard Emerging Markets Stock ETF (VWO) tracks the index and has lost value, Short MSCI Emerging Markets ProShares (EUM) provides the inverse of the index and has gained value, but UltraShort MSCI Emerging Markets ProShares (EEV) has lost value over the same period as the other emerging market ETFs.
Another example in the energy sector with sister funds Ultra Oil & Gas ProShares (DIG) and UltraShort Oil & Gas ProShares (DUG). They have worked like they were supposed to, and consequently also lost in the long-term.
It is the common misconception that since it is “Ultra” or “Double” something then it should also provide double that of the returns or loses for those long investments. So how do they work? The fund’s fine print promises twice the daily return of the index, and the key word here is “daily.” By holding onto these ETFs for longer than their indicated compounding period mathematically guarantees one’s return would not double that of the index. The odds of getting nothing close to double the return increases the longer the ETF is held.
Back in November, Direxion introduced the triple-leveraged exchange traded fund, and the market embraced its new play toy. As market volatility has reigned in the last year, these types of funds are generating all kinds of interest and have been the subject of many back-and-forth debates.
Or take here is that not all products are right for all investors, but for investors looking for a hedge, these funds could have a home in their portfolios. The many available different long/short ETFs have a home in a portfolio if the user understands them, knows the risks and has decided he or she can handle it any volatility that comes along with them.