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The Dangers of Double Leveraged ETFs
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While tens of thousands of active day traders use double leverage ETFs to boost returns, only a small minority of the entire trading populace knows of the hidden hanger of leveraged ETFs.
Double leverage ETFs are still a very new product, having been invented by PowerShares in 2006 with the release of the first leveraged product, the ProShares Ultra Dow 30 ETF (DDM). Unlike more powerful products that now extend into the 200 and 300 percent daily compounding leverage, the ProShares Ultra Dow 30 ETF was designed to be a relatively tame double leverage ETF based on the Dow Jones Industrial Index.
Within weeks of release, it was clear that investors would crave more and more double leveraged ETFs, and PowerShares quickly became the biggest issuer of leveraged products in the world. In that time, however, the danger of leveraged ETFs have become clearer as financial planners and institutions like FINRA have made vast claims about the problems stemming from daily compounding.
One danger of leveraged ETFs that isn't exactly far from the surface is their leveraging. Combined with the leverage offered in the form of a broker margin account, ordinary investors and stock traders can achieve leverage of up to 4 to 1 with the use of 2:1 margin on top of any one of the many double leverage ETFs.
However, that's not all. The next danger of leveraged ETFs is in the methods used to create double performing funds. Whereas a margin long position on a stock or ETF is never compounded with an exit, double leverage ETFs are compounded daily. That is, the ETF resets at the close of each trading day to rebalance itself for the next day.
Consider this example: an underlying index of an ETF falls 2% from $25 to $24.50, and then it drops another 2% from the original purchase price to $24. A regular, non-leveraged ETF would be down a total of 4% to $24 per share. Therefore, we should expect that double leverage ETFs would lose 8% in this case, right? Wrong.
Leveraged ETFs are compounded daily. Thus, the ETF would have declined 2%, generating a 4% decline in double leverage ETFs. The next day, the decline would have been larger at 2.04% ($.50/$24.50) for another decline of 4.04%. Thus, whereas the non-leveraged ETF would have lost 4%, the double leveraged, daily compounded ETF would have fell a total of 8.04%, slightly more than the return of a margin trade on a regular ETF.
The danger of leveraged ETFs is built in the basic idea of drawdown. That is, for each decline, a much larger return is required to return to parity. Try this exercise: take 100, subtract 10%, then add 10%, and you'll be left with 99, which 1% less than with which you started. Now reverse the equation and add 10%, then subtract 10%. You're still left with 99, a 1% loss even on two equal, but opposite performances. Over the long haul, it is this very simple drawdown effect that makes leveraged ETFs so fun, but yet so very dangerous as well!
Double Leverage ETFs
Double leverage ETFs are still a very new product, having been invented by PowerShares in 2006 with the release of the first leveraged product, the ProShares Ultra Dow 30 ETF (DDM). Unlike more powerful products that now extend into the 200 and 300 percent daily compounding leverage, the ProShares Ultra Dow 30 ETF was designed to be a relatively tame double leverage ETF based on the Dow Jones Industrial Index.
Within weeks of release, it was clear that investors would crave more and more double leveraged ETFs, and PowerShares quickly became the biggest issuer of leveraged products in the world. In that time, however, the danger of leveraged ETFs have become clearer as financial planners and institutions like FINRA have made vast claims about the problems stemming from daily compounding.
Danger of Leveraged ETFs
One danger of leveraged ETFs that isn't exactly far from the surface is their leveraging. Combined with the leverage offered in the form of a broker margin account, ordinary investors and stock traders can achieve leverage of up to 4 to 1 with the use of 2:1 margin on top of any one of the many double leverage ETFs.
However, that's not all. The next danger of leveraged ETFs is in the methods used to create double performing funds. Whereas a margin long position on a stock or ETF is never compounded with an exit, double leverage ETFs are compounded daily. That is, the ETF resets at the close of each trading day to rebalance itself for the next day.
Consider this example: an underlying index of an ETF falls 2% from $25 to $24.50, and then it drops another 2% from the original purchase price to $24. A regular, non-leveraged ETF would be down a total of 4% to $24 per share. Therefore, we should expect that double leverage ETFs would lose 8% in this case, right? Wrong.
Leveraged ETFs are compounded daily. Thus, the ETF would have declined 2%, generating a 4% decline in double leverage ETFs. The next day, the decline would have been larger at 2.04% ($.50/$24.50) for another decline of 4.04%. Thus, whereas the non-leveraged ETF would have lost 4%, the double leveraged, daily compounded ETF would have fell a total of 8.04%, slightly more than the return of a margin trade on a regular ETF.
The Basic Premise
The danger of leveraged ETFs is built in the basic idea of drawdown. That is, for each decline, a much larger return is required to return to parity. Try this exercise: take 100, subtract 10%, then add 10%, and you'll be left with 99, which 1% less than with which you started. Now reverse the equation and add 10%, then subtract 10%. You're still left with 99, a 1% loss even on two equal, but opposite performances. Over the long haul, it is this very simple drawdown effect that makes leveraged ETFs so fun, but yet so very dangerous as well!
