Over the last month, a number of commentators have begun to vocipherously denounce levered ETFs pointing out that, over periods of time longer than a day, many of these ETFs don’t deliver what you’d expect them to.
The first that I am aware of was Eric Oberg at TheStreet.com who argued against ProShares Short ETFs in two pieces: “Why Short Sector ETFs Aren’t So Smart”, TheStreet.com, December 23, 2008 and “The Perils of the ProShares UltraShorts”, January 13, 2009.
In those pieces, Oberg detailed how the ProShares UltraShort Real Estate ETF (SRS) actually fell 48.2% from Jan 2, 2008 through Dec 17, 2008 even though the index it is supposed to deliver double the inverse return of fell 39.2%! In other words, if you shorted real estate via this ETF last year you would have lost 50% of your money! Disgusting.
The same thing happened with the ProShares UltraShort Financial ETF (SKF) which returned 1.4% over the above period when the underlying index fell 49.3%. So much for double short! Terrible.
Ditto for the ProShares UltraShort FTSE/Xinhua China 25 ETF (FXP) which Dr. Doom Marc Faber recommended in Barron’s in 2008 as a way to short China. The long China ETF, iShares FTSE/Xinhua 25 Index (FXI), was down 46.7% in 2008 and the UltraShort ETF was down 57.2%! Brutal.
Yesterday, in a comprehensive piece “Warning: Leveraged and Inverse ETFs Kill Portfolios”, Paul Justice of Morningstar hammered home the point.
The ProShares UltraShort MSCI Emerging Market ETF (EEV) actually fell 25% last year even though the underlying index was down 52%!
The ProShares UltraShort Oil & Gas ETF (DUG) lost 19% last year when the Dow Jones Oil & Gas index was down around 40%.
Obviously, many of these ProShares UltraShort ETFs don’t work over periods of time longer than a day making them unsuitable to implement a longer term investment thesis.
One question is whether it’s just the ProShares UltraShort ETFs that are disasters. Looking at Oberg and Justices’s examples, the ProShares double levered long ETFs seem to have done a pretty good job: URE (Ultra Real Estate), UYG (Ultra Financials) and DIG (Ultra Oil & Gas) delivered about twice the return of their respective indexes in 2008. SSO (Ultra S&P 500) also appears to have done a good job.
One of the main reasons these ETFs fail is that they are designed to deliver double the return of the underlying index on a daily basis. This daily compounding leads to distortions over longer periods of time, especially when the underlying indexes are especially volatile. Oberg points out that the ProShares Ultra and UltraShort S&P 500 ETFs have done a pretty good job because volatility in the S&P 500 isn’t that great compared to some of the sectors like emerging markets, real estate and financials.
As someone who does some trades using these ETFs, this is a big worry for me. I’ve been studying the charts and the ETFs I’ve been trading lately (SSO, DIG, TBT) seem to have done a good job of delivering what I was hoping they would. But it’s raised some real doubts for me about the suitability of these investments. It’s worth realizing that these ETFs do what they do by owning derivatives and so it’s not a perfectly transparent implementation. I’m still thinking about whether or not I want to be involved with these vehicles. I’ll be watching them closely.
Disclosure: Top Gun owns SSO, DIG and TBT.