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)