Leveraged ETFs
The following is an edited excerpt from Chapter 12 of Enhanced Indexing Strategies. We have written many articles on this topic and our research was cited in the Wall Street Journal. The takeaway is simply that Leveraged ETFs suffer from a poor reinvestment strategy that causes them to lose value significantly over longer periods and as a result are unlikely to outperform the underlying index.
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[from Chapter 12]
Proshares ETF Analysis
On June 21st, 2006, the Ultra S&P 500 ProShares ETF (ticker: SSO) began trading at a dividend-adjusted price of $64.90. This ETF was developed by ProShares as a security that delivered twice the daily return of the underlying investment, in this case the S&P 500. The security became extremely popular with both retail and institutional investors, and trading volume ramped up quickly.
On April 1, 2008, this security closed at a dividend-adjusted price of $70.55. This represents a total return of 8.7 percent for the just over twenty-one month period, and an annualized return of 4.8 percent. In contrast, the SPY ETF rose from $121.61 to $136.61 in the same period, a 12.3 percent total return for the 21 months and a 6.7 percent annualized return (see Figure 12.1).
Ultra S&P500 ProShares (SSO) in YAHOO Finance
Clearly the leveraged fund is designed to provide a higher, not a lower, return than the underlying index. What went wrong?
It would be easy to blame the poor performance on the S&P 500, and as a rule, a leveraged investment will underperform when the returns of the underlying are lower than the cost of capital. For example, if a fund borrows at 5 percent and invests at 4 percent, it is going to have a negative return for the leveraged portion of the portfolio.
However, the annualized return of the underlying index during this period was 6.7 percent, and while somewhat disappointing, this certainly exceeds any imaginable cost of capital. Thus we should expect higher returns from any leveraged fund, and a 2 leveraged fund would be expected to provide an annual return in the 8 percent to 10 percent annual range. If we take the entire 21-month period into account, there's essentially a six- to nine-point return deficit that needs to be explained.
There are three issues affecting the performance. The first is that SSO has a relatively high management fee of 0.95 percent, and this lowers the performance. However, this would only contribute perhaps 1.8 percentage points to the shortfall over the period.
This fund uses futures contracts and equity swaps and rebalances daily in order to maintain a leverage ratio of 2x. In order to do so, this requires the fund to either increase or decrease their exposure to the index depending upon the previous day's return. For example, if the index falls 1 percent, then the fund must immediately thereafter sell index futures in order to reduce the leverage.
Daily rebalancing increases transaction costs somewhat, and this is the second issue. If we double the daily returns of the S&P 500 and then subtract a small amount that would be equal to an annual 6 percent expense, then the results are almost identical to the performance of the ETF on a daily basis and for the entire period.
The third issue is a little more complex and has to do with the leverage and volatility of the investment. During the 21 months studied, the volatility of the leveraged ETF is extremely high, reaching 31 percent on an annualized basis. This is expected, as the underlying index has a volatility of 15.5 percent for the period and the fund is leveraged 2 . But this high volatility creates the potential for sharp negative returns, which then occur in the latter part of the period.
Peaks and Valleys
When gains and losses are multiplied, the results are asymmetrical and create situations that are difficult to recover from. Consider an underlying investment that loses 20 percent and a 2x leveraged fund based upon this investment that loses 40 percent of its value as a result of the leverage, as shown in Table 12.1. Then assume that the underlying investment recovers 10 percent of its value. What are the fund's results? For simplicity, assume no capital or transaction costs.
Table 12.1: Effect of Index Declines and Advances on a Leveraged Portfolio
| Underlying | Leveraged | |
|---|---|---|
| Starting Price | $100 | $100 |
| After 20% Loss | 1.83% | 1.71% |
| After 10% Gain | $100 | $100 |
| Shortfall | -12% | -28% |
| Needed to Recover | +13.6% | +38.9% |
| ---------------------------- | ------------ | ---------- |
| After 15% Gain | $101.20 | $93.60 |
For the underlying investment, the 20 percent loss and 10 percent gain still leaves a significant shortfall. The fund has lost 12 percent total, and an additional +13.6 percent return would now be required for the fund to recover its initial value.
As the negative returns for the leveraged fund are magnified, the value has fallen much further, -28 percent, and a +38.9 percent return would now be required to recover the rest of the losses.
Now let's assume that the index then rises 15 percent. This amount is just above the amount needed to bring it back to its original level, but is not enough to recover the losses in the leveraged fund. The difference in value between the two funds is now $7.60, a considerable disappointment for anyone expecting the leveraged fund to have higher performance.
And this is very similar to what happened to the leveraged ETF during the final months of the period. In the last several months of the period examined, the SPY falls from a peak of almost $155 to a low of $127, an 18 percent drop, but then recovers about 7 percent, leaving a shortfall of about 12 percent. The multiplier effect of leverage wipes out a third of the value of the leveraged ETF, but then recovers only a fraction of that loss.
By the end of the timeframe analyzed, the S&P 500 needs a +13.3 percent gain to recover its losses and hit its earlier peak, but the leveraged ETF would require a much larger +17.8 percent return from the underlying in order to do the same. It is easy to see how the shortfall in the leveraged fund could continue going forward.
Learning from Failure
This leveraged fund and return scenario holds valuable insights about leveraged portfolios. The first is that even with 2:1 leverage and an underlying investment with returns higher than the cost of capital it is very easy to lose money through a poor reinvestment strategy.
At the start of the period, one share of SSO is worth $64.90 and represents $129.80 of index exposure. As the index appreciates, this exposure climbs to $191.24, based on the SSO share price of $95.62. Then as the index falls, the fund exposure falls to $123.98. Aggressively increasing exposure during a bull market and then reducing it during a bear market may seem like smart trading at the time, but the result is a poorly positioned portfolio.
If improper selection of the level of leverage and index exposure can lead to a fund shortfall, then could a good reinvestment strategy increase returns as compared to the underlying index? Absolutely.
Below we show three reinvestment strategies in which the level of index exposure grows at a slow and constant rate. The annualized growth rates are +0 percent, +5 percent, and +10 percent. All provide annualized returns much higher than the 6.7 percent annualized return of the underlying. In this example, the higher growth rates have lower returns, but this won't always be the case, as it depends upon the price trends of the underlying.
Table 12.2 Return Statistics with Controlled Exposure Growth Rates
| Growth Rate (Annual) | |||
| Ticker | Index | ||
|---|---|---|---|
| Daily Return | 0.0530% | 0.0530% | 0.0531% |
| Std Dev | 1.83% | 1.71% | 1.61% |
| Min. | -6.50% | -6.31% | -6.12% |
| Max. | 9.64% | 8.69% | 7.82% |
| Ann. Return | 14.16% | 14.16% | 14.19% |
| Ann. Vol | 28.99% | 27.19% | 25.49% |
| Tot Return (21 mos) | 17.63% | 18.67% | 19.67% |
| ---------- | ---------- | ---------- | |
Reinvestment strategies were covered in earlier chapters, but there are a few important lessons to be found in this example. The first is that even a popular ETF can suffer from flaws in the reinvestment strategy that make it a failure as a long-term investment. In fairness to ProShares, the leveraged funds are marketed primarily to short-term traders, but undoubtedly there are some longer-term investors that purchase the security without understanding its limitations.
In a long-term leveraged investment, the level of index exposure needs to be constantly managed and maintained. This applies not only to a managed futures fund, which is technically what the leveraged ETF is, but to any investment that takes a leveraged long position on the index using any of the derivative strategies mentioned in the book.
[end excerpt]