Dangers of inverse and leveraged ETFs

Tuesday, May 20th, 2008 @ 2:51 am | Finance

Recently I have heard a lot of talk about double and short ETFs. There are certain things I think that most people overlook especially people with a math background that shouldn’t have been overlooked.

These instruments are not meant to be an INVESTMENT. They are there to hedge risk. They do NOT double returns of an index and will under no circumstances get close to two times the historical return of an index. They only match twice the daily returns of the index. Due to their reliance on derivatives, swaps, and futures contracts they face heavy heavy slippage under volatility much higher than implied by the 1-2% fees.

This case can be proven very quickly by charting quickly any two pairs (SSO, SDS for example) against each other and looking at the crosses. They are close to 10% annual rate for the S&P. Looking at more volatile pairs (SKF, UYG)  this approaches almost 20% slippage. If there was zero slippage the ETFs would cross almost near zero but slightly below it at a slope of 1%. Market returns are a function of expected value and volatility (risk). With volatility always representing a negative values on turns. When one multiplies a return by a scalar, expected value goes up linearly, but volatility is raised to the power of the scalar.

This can be shown by using an initial investment of $100. Lets say on day one you have a return of 10 percent and on the second day you have a loss of 10%. Overall your account is down 1%. Now lets say you have invested that in a double ETF, you would have 120 on first day and 96 in the second day for a loss of four percent. More than twice the expected loss due to higher volatility losses. Please understand that this is a super volatile example but it is there to show that you are increasing your risk by a greater amount than your reward and over the long term (hundreds of days) you will fall much shorter than twice the annual returns of the index in exchange for much higher risk.

These funds have been around for only a few years, but you will see the funds post lower values for exactly the same value of the index they are following, by double digit declines. In a volatile market where the index is flat you WILL lose significant amounts of capital due to slippage. They are their for hedging risk not as a long term vehicle for stellar returns.



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