One of the most often-cited and oldest criticism of leveraged exchange traded funds is that these geared funds are not buy-and-hold instruments.
Compelling math suggests that, in some cases, double-leveraged ETFs can be held for time frames extending beyond a few days and weeks. In the study Should Leveraged ETFs Be Held for Long Horizons? Do They Enhance Portfolio Returns? By C. Thomas Howard, Lambert Bunker and David Stock posted on Advisor Perspectives, the authors explore the idea of holding double-leveraged ETFs for extended periods.
A primary reason why leveraged ETFs are criticized and said to be best suited for short-term traders is how the leveraged is obtained. To get their added juice, leveraged ETFs must use derivatives. That leads to higher fees and the belief that daily reseting is a drag on long-term returns.
Leveraged ETFs tend to be more expensive than the average index-based ETFs, which could also eat away at returns over the long run. The average expense ratio for leveraged ETFs is 0.92%, whereas the non-leveraged ETFs have an average expense ratio of 0.54%, according to XTF data.
“When using leverage, the volatility drag is amplified exponentially and has a much greater effect on overall returns as a result of an increased standard deviation. Volatility drag over longer time periods causes a greater degree of tracking error than the return times the leverage multiple over the same time period,” according to the study’s authors. “The most important determinant of whether leverage will increase compound returns is the level of expected returns. For a 2x U.S. equity LETF, the critical value is 6% expected return based on a 17.5% standard deviation. That is, if the expected market return is higher than 6%, then on average a 2x LETF generates higher compound returns and increased long horizon wealth, as compared to a non-levered 1x holding.” [No Love for the Best Leveraged ETFs]
The authors go on to note that if a hypothetical double-leveraged broad market U.S. equity was held from 1951 through 2014, that make believe ETF would have generated returns 1.67 times better than its non-levered equivalent. That is to say over 63 years, the hypothetical double-leveraged ETF did a fair job of delivering nearly twice the returns of is non-leveraged counterpart.
There are real world examples of double-leveraged ETFs doing their jobs and then some over long holding periods. For example, the ProShares Ultra Russell2000 (NYSEArca: UWM), a double leveraged bet on the Russell 2000, is up 167% over the past five years while the iShares Russell 2000 ETF (NYSEArca: IWM) is up 75.4%. The ProShares Ultra S&P 500 ETF (NYSEArca: SSO), which attempts to deliver twice the daily returns of the S&P 500 index, is up 209% over the past five years, or nearly triple the returns of the S&P 500 over the same period. [Know how Your Leveraged ETFs Work]
“In an upward-trending market, compounding can result in longer-term returns that are greater than the sum of the individual daily returns,” according to ProShares. “In a downward-trending market, compounding can also result in longer-term returns that are less negative than the sum of the individual daily returns.”
However, in times of increased volatility, leveraged ETF returns can fall behindtheir intended 2x or 3x strategies. For instance, when including the period leading up to the financial crisis and the financial meltdown, SSO lagged the S&P 500.
“A 2x LETF doubles the average return while increasing volatility drag by a factor of 4; 3x triples the average return while increasing drag by a factor of 9; and so forth. That is, average return increases linearly, and drag increases exponentially. So as leverage increases, growing drag eventually overwhelms the levered return, resulting in lower compound returns,” according to Howard, Bunker and Stock.
For all the criticism they endure, well-heeled leveraged ETFs may not be as volatile some believe. [A Gentler View of Leveraged ETFs]
“What the researchers are saying is that money tends to move out of leveraged funds on the days the funds move up significantly—mostly due to profit-taking—and money flows in after down days. Such movement helps keep the asset base steady, thus reducing the fund’s need to rebalance its leveraged exposure in the direction of the market, which is what can contribute to volatility,” reports Ari Weinberg for the Wall Street Journal.
UWM vs. IWM Five-Year Chart
Chart Courtesy: StockCharts.com
Tom Lydon’s clients own shares of IWM.