Wednesday, July 1, 2009

Inverse and Levered ETFs

Over the last decade, Exchange Traded Funds (ETFs), have been one of the fastest growing segments in financial services. Within ETFs, inverse (bear) and levered funds have been gaining enormous popularity. Let's take a few minutes to examine the performance of certain funds then we will draw some conclusions.

To see how an ETF should work, let's compare the 10 year performance of the S&P 500 with SPY, the SPDR S&P 500 ETF (click on images for larger views):

In the past 10 years, the S&P 500 has returned -29.8% while SPY has returned -29.89%. This is about as good as performance gets.

Now let's compare SPY to SH, the ProShares Short S&P 500 ETF. Ideally, SH should return the inverse of SPY:

The one month return for SPY is -2.56% while for SH it is +1.73%. That is a degradation of .83%. That might not seem like much, but let's look at the returns over a longer time period:

Over a 6 month period, SPY returned +2.31% while SH returned -9.16%, for a degradation of 6.85%. Let's zoom out just a bit farther to one year:

Over a one year period, SPY returned -28.1% while SH returned -5.87%, for a degradation of 33.97%! In other words, in one of the worst one year returns in stock market history, holding an inverse stock fund resulted in a net loss!

If you think this was a fluke let's look at the one year return of QQQQ, the Nasdaq ETF, versus PSQ, the ProShares Nasdaq ETF, versus PSQ, the Short Nasdaq ETF:

Over a one year period, QQQQ returned -20.53% while PSQ returned -5.67%, for a degradation of 26.2%.

For good measure, let's compare the one year performance of EEM, the iShares Emerging Market ETF, versus EUM, the ProShares Short Emerging Market ETF:

Over a one year period, EEM returned -26.05% while EUM returned -33.14%, for a degradation of 59.19%.

Not all inverse ETFs are made equal. Let's compare USO, the United States Oil Fund ETF, with USL, an alternative oil ETF, and SZO, the PowerShares Inverse Oil Exchange Traded Note (ETN):

USO and USL returned +31.07% and 26.28% respectively while SZO returned -29.58%, about what one would expect from an inverse fund.

Let's look at the one year returns:

USO and USL returned -67.26% and -55.47% respectively while SZO returned +112.81%. Again, this is about what one would expect from an inverse fund. I will try to post an article in the future on why SZO performs so well compared to the other inverse funds. Moving on...

In addition to inverse ETFs, levered funds have also become quite popular. What many investors might not realize is that these funds are geared to return the DAILY specified leverage and not long term leverage. What this means is that if the index returns +1% today, a 2x leverage fund should return +2% today. Over a longer time frame, however, returns will degrade in a similar (or worse) manner than inverse funds.

Let's examine our earlier chart with SPY, the S&P 500 ETF, and SH, the inverse S&P 500 ETF, but then add the double long fund (SSO) and the double short fund (SDS):

SDS, the double short fund, returned -17.42% while SSO, the double long, returned an astounding -55.99%.

With all of the power that double daily leverage brings you, let's go one step further and use three times leverage! Below is an 8 month comparison between XLF, the SPDR Financial Sector ETF, and FAZ, the now notorious Direxion Financial Bear 3x ETF:

While XLF returned -14.9%, FAZ returned a remarkable -93.67%! Being that FAZ launched a mere 8 months ago at $74 and it now trades at $4.70, how much longer will it be before the fund literally trades at zero?

Direxion has a whole portfolio of ETFs with 3x leverage which you can view here. Of the 20 funds they offer, all were launched in the past 8 months and all have negative returns (their return results are outdated). Talk about a fly by night organization.

***UPDATE***Just after posting this article I saw this piece of news. "The Board of Trustees of Direxion Shares ETF Trust has approved reverse splits of the issued and outstanding shares of both the Direxion Daily Financial Bull 3X Shares (“Financial Bull Fund”) and Direxion Daily Financial Bear 3X Shares (“Financial Bear Fund”)." The reverse split will be five to one. Absolutely hilarious.***

What conclusions can we draw from this exercise? Be very careful when investing in inverse or levered ETFs. Both usually work in a similar manner in that their performance degrades over time. Holding them short term might be OK but long term they are usually suicide. Before you invest in a levered or inverse fund, make sure to check the fund performance against its index over a time period equal to your expected holding period. If the fund does not have a long enough track record to compare it is likely not worth the risk.

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